-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, I7WNGhL1Bg2NM889j5nhfb/lb9CIu5vOeC1S6MWjbUywE+1VArb4Hwc5DQvNxmUU w4iaGHJbMol/RzZeNbv95g== 0000844828-00-000003.txt : 20001227 0000844828-00-000003.hdr.sgml : 20001227 ACCESSION NUMBER: 0000844828-00-000003 CONFORMED SUBMISSION TYPE: S-4 PUBLIC DOCUMENT COUNT: 13 FILED AS OF DATE: 20001226 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CII FINANCIAL INC CENTRAL INDEX KEY: 0000844828 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 954188244 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-4 SEC ACT: SEC FILE NUMBER: 333-52726 FILM NUMBER: 795444 BUSINESS ADDRESS: STREET 1: 2716 N TENAYA WAY CITY: LAS VEGAS STATE: NV ZIP: 89128 BUSINESS PHONE: 7022427000 MAIL ADDRESS: STREET 1: PO BOX 15645 CITY: LAS VEGAS STATE: NV ZIP: 89114-5645 S-4 1 0001.txt As filed with the Securities and Exchange Commission on December 26, 2000 Registration No. 333- ============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM S-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 CII FINANCIAL, INC. (Exact name of Registrant as specified in its charter)
California 6719 95-4188244 (State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer incorporation or organization) Classification Code Number) Identification Number) 2716 North Tenaya Way Las Vegas, Nevada 89128 (702) 242-7040
(Name and address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) David Sonenstein, Esq. General Counsel 2716 North Tenaya Way Las Vegas, Nevada 89128 (702) 242-7046 (Name and address, including zip code, and telephone number, including area code, of agent for service) Copies to: Stephen P. Farrell, Esq. Howard A. Kenny, Esq. Morgan, Lewis & Bockius LLP 101 Park Avenue New York, New York 10178 (212) 309-6000 Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement is declared effective in connection with the exchange offer described in the prospectus contained in this Registration Statement. If the securities being registered on this Form are being offered in connection with the formation of a holding company and there is compliance with General Instruction G, check the following box. o If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o __________ If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o ____________ CALCULATION OF REGISTRATION FEE
Amount Aggregate Title of Each Class of to be Offering Price Offering Amount of Securities to be Registered Registered Per Unit Price Registration Fee - -------------------------------------------------- --------------- ---------------- --------------- ----------------- 9% Senior Subordinated Debentures of CII Financial, Inc.............................. $47,059,000 N/A $47,059,000 (1) $11,765 (1) ================================================== =============== ================ =============== =================
(1) The registration fee has been calculated pursuant to Rule 457(f)(2) under the Securities Act, based upon the book value of the $47,059,000 aggregate principal amount of the 7 1/2% convertible subordinated debentures due September 15, 2001 of CII Financial, Inc. that may be received in the exchange offer. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. ============================================================================= Subject to Completion. Dated December 26, 2000 - ------------ --------------------------------------------------------------- PROSPECTUS AND EXCHANGE OFFER The information in this preliminary prospectus is not complete and may be changed. The securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospects is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. CII FINANCIAL, INC. ------------ EXCHANGE OFFER FOR ALL OUTSTANDING 7 1/2% CONVERTIBLE SUBORDINATED DEBENTURES DUE SEPTEMBER 15, 2001 OF CII FINANCIAL, INC. (CUSIP NO. 12551LAB7) EXCHANGE OFFER EXPIRATION: January 25, 2001 at 5:00 p.m., New York time. EXCHANGE OFFER We are offering to exchange new consideration for your 7 1/2% convertible subordinated debentures due September 15, 2001 of CII Financial. You can choose to exchange your debentures under either of the following two options: o $1,000 in principal amount of new 9% senior subordinated debentures due September 15, 2006 of CII Financial for each $1,000 in principal amount of the old junior subordinated debentures that you tender; or o $525 in cash for each $1,000 in principal amount of the old junior subordinated debentures that you tender, up to a maximum of $19,500,000 in aggregate principal amount of old junior subordinated debentures, as described below. We will pay in cash accrued and unpaid interest on all old junior subordinated debentures accepted in the exchange offer through, but not including, the date of acceptance. We intend to list the new senior subordinated debentures on the New York Stock Exchange. We are only offering to purchase a maximum of $19,500,000 aggregate principal amount of old junior subordinated debentures for cash. If holders of more than $19,500,000 aggregate principal amount of old junior subordinated debentures elect the cash option, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19,500,000 principal amount of old junior subordinated debentures for cash and we will exchange the balance of the old junior subordinated debentures we receive for new senior subordinated debentures. All holders who elect the cash option will be permitted to sell the same fraction of their old junior subordinated debentures for cash. This fraction will equal $19,500,000, divided by the aggregate principal amount of all debentures tendered for cash by all holders. We will not determine whether the cash option has been oversubscribed until after the expiration of the exchange offer. You will not be able to withdraw your tender of old junior subordinated debentures once we make this determination even though it may affect the type of exchange consideration you will receive in the exchange offer. We will publicly announce whether the cash option has been oversubscribed, and the resulting proration of exchange consideration. You do not have to choose the same option for all of the old junior subordinated debentures that you tender. You do not have to tender all of your old junior subordinated debentures to participate in the exchange offer. You may withdraw all or part of your tender of old junior subordinated debentures at any time before the expiration of the exchange offer. The exchange offer is subject to the following conditions: o valid tenders of at least 90% of the aggregate principal amount of the old junior subordinated debentures; o the receipt of the consent of the lenders under the $185 million senior secured credit facility of our parent, Sierra Health Services, Inc., which has been irrevocably and unconditionally guaranteed by us, to the issuance by us of the new senior subordinated debentures in the exchange offer; o the receipt of the approval of the California Department of Insurance required for one or more of our subsidiaries to directly or indirectly fund all or part of the cash to be paid as exchange consideration; o our obtaining sufficient cash to pay any cash consideration required to be paid as exchange consideration; and o other customary conditions. Both acceptance and rejection of this exchange offer involve a high degree of risk. See "Risk Factors" beginning on page 9 of this prospectus for a discussion of some of the risks you should consider in evaluating the exchange offer and an investment in the securities offered through this prospectus. Neither the Securities and Exchange Commission nor any state securities regulator has approved or disapproved these securities, or determined if this prospectus is adequate or accurate. Any representation to the contrary is a criminal offense. The exclusive dealer manager for the exchange offer is: Banc of America Securities LLC The date of this prospectus is . - -------------------------------------------------------------------------- - ------------------------------------------------------------------------------ TABLE OF CONTENTS
Page PROSPECTUS SUMMARY...............................................................................................1 RISK FACTORS.....................................................................................................9 SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS...............................................................14 WHERE YOU CAN FIND ADDITIONAL INFORMATION.......................................................................14 RATIO OF EARNINGS TO FIXED CHARGES..............................................................................15 USE OF PROCEEDS.................................................................................................15 CAPITALIZATION..................................................................................................16 THE EXCHANGE OFFER..............................................................................................17 BUSINESS 28 SELECTED FINANCIAL AND OTHER DATA...............................................................................42 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS...........................44 MANAGEMENT......................................................................................................53 CERTAIN TRANSACTIONS............................................................................................59 PRINCIPAL STOCKHOLDERS..........................................................................................60 DESCRIPTION OF OTHER INDEBTEDNESS...............................................................................60 UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS...........................................................62 DESCRIPTION OF DEBENTURES.......................................................................................67 BOOK-ENTRY SYSTEM-- THE DEPOSITORY TRUST COMPANY................................................................75 UNITED STATES FEDERAL INCOME TAX CONSEQUENCES...................................................................76 LEGAL MATTERS...................................................................................................81 EXPERTS 81 ANNEX I a-1 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.....................................................................f-1
PROSPECTUS SUMMARY This summary highlights selected information from this prospectus and may not contain all of the information that is important to you. To understand the exchange offer fully and for a more complete description of the legal terms of the exchange offer, you should read carefully this entire prospectus and the other documents to which we have referred you, including the letter of transmittal accompanying this prospectus. Unless otherwise indicated, "CII Financial," "we," "us," and "our" refer to CII Financial, Inc. and its subsidiaries. Although we refer to CII Financial, Inc. in this manner, CII Financial, Inc. is a holding company and conducts all of its operations through its subsidiaries. CII Financial, Inc. is the sole obligor on all of the debentures discussed in this prospectus. Throughout this prospectus, we sometimes refer to our existing 7 1/2% convertible subordinated debentures due September 15, 2001 as our "old junior subordinated debentures," to our new 9% senior subordinated debentures due September 15, 2006 as our "new senior subordinated debentures" and to those new senior subordinated debentures and the cash payment offered in exchange for your old junior subordinated debentures collectively as the "exchange consideration." CII Financial, Inc. We are a holding company primarily engaged in writing workers' compensation insurance in nine western and midwestern states through our wholly owned subsidiaries, California Indemnity Insurance Company, Commercial Casualty Insurance Company, Sierra Insurance Company of Texas and CII Insurance Company. In addition, we have other smaller subsidiaries that we consider immaterial to our overall results. Our insurance subsidiaries write workers' compensation insurance in the states of California, Colorado, Nevada, Texas, Nebraska, Kansas, Missouri, New Mexico and Utah primarily through independent insurance agents and brokers. We have licenses in 33 states and the District of Columbia and have applications pending for licenses in other states. California, Colorado and Nevada represented approximately 77%, 8%, and 7%, respectively, of our direct written premiums for the nine months ending September 30, 2000. We were acquired by Sierra Health Services, Inc. on October 31, 1995 in a transaction treated as a pooling of interests. However, our old junior subordinated debentures remain solely our obligation and Sierra has not guaranteed the debentures. Sierra is a diversified health care services company that operates health maintenance organizations, indemnity and workers' compensation insurers, military health programs, preferred provider organizations and multi-specialty medical groups. When Sierra acquired us, each share of our common stock was exchanged for .37 of a share of Sierra common stock and our old junior subordinated debentures became convertible into Sierra common stock. The old junior subordinated debentures are now convertible into Sierra common stock at a conversion price of $39.398 per share. As a result, $1,000 in principal is convertible into 25.382 shares of Sierra common stock. Based on the closing price of Sierra common stock on December 19, 2000, 25.382 shares of Sierra's common stock had a market value of $84.27. In August 2000, we became a guarantor of Sierra's revolving credit facility, which at December 15, 2000 was fully drawn and had an outstanding balance of $185 million. The old junior subordinated debentures and the new senior subordinated debentures are subordinated to this guaranty of the credit facility debt. We were incorporated in the State of California on September 15, 1988. The principal executive offices of CII Financial are located at 2716 North Tenaya Way, Las Vegas, Nevada 89128, and CII Financial's telephone number at that address is (702) 242-7040. Summary Background, Purposes and Effects of the Exchange Offer CII Financial, as a holding company, has limited sources for cash and is dependent upon dividends from its subsidiary, California Indemnity Insurance Company, to meet its debt payment obligations. California Indemnity cannot currently pay any dividends without prior approval by the California Department of Insurance. In addition, CII Financial, as a holding company and sole obligor under the old junior subordinated debentures, has no available source of cash with which to pay the old junior subordinated debentures when they mature on September 15, 2001. Due to the foregoing, we are making this exchange offer in an effort to extend the maturity date and reduce our indebtedness. Summary of the Exchange Offer The Old Junior Subordinated Debentures: We are making the exchange offer with respect to the entire $47,059,000 aggregate principal amount of our old junior subordinated debentures, CUSIP No. 12551LAB7. The Exchange Offer: We are offering to acquire your old junior subordinated debentures in exchange for: o $1,000 in principal amount of new senior subordinated debentures for each $1,000 in principal amount of old junior subordinated debentures that you tender; or o $525 in cash for each $1,000 in principal amount of old junior subordinated debentures that you tender, up to a maximum of $19,500,000 aggregate principal amount of old junior subordinated debentures as described below. We are only offering to purchase a maximum of $19,500,000 aggregate principal amount of old junior subordinated debentures for cash. If holders of more than $19,500,000 aggregate principal amount of old junior subordinated debentures elect the cash option, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19,500,000 principal amount of old junior subordinated debentures for cash and we will exchange the balance of the old junior subordinated debentures we receive for new senior subordinated debentures. All holders who elect the cash option will be permitted to sell the same fraction of their old junior subordinated debentures for cash. This fraction will equal $19,500,000, divided by the aggregate principal amount of all debentures tendered for cash by all holders. We refer to this as "oversubscription" of the cash option. We will publicly announce whether the cash option is oversubscribed and the effect of any required proration as soon as practicable after the expiration of the exchange offer. You do not have to choose the same option for all of the old junior subordinated debentures that you tender. You do not have to tender all of your old junior subordinated debentures to participate in the exchange offer. Accrued Interest: We will pay in cash accrued, and unpaid interest on all old junior subordinated debentures accepted in the exchange offer through, but not including, the date of acceptance. Source of Funds: We intend to fund the cash portion of the exchange consideration from: o dividends or other transfers of funds from our operating subsidiaries, subject to approval by the California Department of Insurance; and o a loan from an affiliate, which will be represented by our demand promissory note bearing interest at a rate equal to the then current interest rate on Sierra's credit facility, which will rank senior to the new senior subordinated debentures and the old junior subordinated debentures. Purpose: We are making the exchange offer for old junior subordinated debentures to extend the maturity date of the debentures and to reduce indebtedness. Expiration of the Exchange 5:00 p.m. New York time, on January 25, 2001, unless extended. Offer: Exchange Date: The exchange of old junior subordinated debentures for the exchange consideration will be made promptly following the expiration of the exchange offer and the satisfaction or waiver of all conditions. Conditions to the Exchange The exchange offer is subject to the conditions that: Offer: o we must receive valid tenders for at least 90% of the aggregate principal amount of the old junior subordinated debentures; o we must receive the consent of the lenders under Sierra's senior secured credit facility, which has been irrevocably and unconditionally guaranteed by us, to our issuing the new senior subordinated debentures in the exchange offer; o we must receive the approval of the California Department of Insurance required for one or more of our subsidiaries to directly or indirectly fund all or part of the cash to be paid as the exchange consideration; o we must obtain sufficient cash to pay any cash consideration required to be paid as exchange offer consideration; and o other customary conditions. Subject to satisfaction or waiver of the conditions, we will accept for exchange any and all old junior subordinated debentures that are validly tendered and not withdrawn before 5:00 p.m., New York City time, on the expiration date of the exchange offer. However, we reserve the right to: o delay the acceptance of the old junior subordinated debentures for exchange; o terminate the exchange offer; o extend the expiration date and retain all old junior subordinated debentures that have been tendered, subject to the right of owners of old junior subordinated debentures to withdraw their tendered old junior subordinated debentures; o refuse to accept the old junior subordinated debentures and return all old junior subordinated debentures that have been tendered to us; or o waive any condition or otherwise amend the terms of the exchange offer in any respect. Procedures for Tendering If you hold your old junior subordinated debentures in book-entry Debentures: form, you must request your broker, dealer, commercial bank, trust company or other nominee to effect the transaction for you. If you own old junior subordinated debentures that are registered in the name of a broker, dealer, commercial bank, trust company or other nominee, you must contact that broker, dealer, commercial bank, trust company or other nominee. We have arranged to have this exchange offer eligible for the Depository Trust Company's, or DTC's, Automated Tender Offer Program, or ATOP. DTC participants that are accepting the exchange offer must transmit their acceptance to DTC, which will verify the acceptance and execute a book-entry delivery to the exchange agent's account at DTC. DTC will then send an agent's message to the exchange agent for its acceptance. Delivery of the agent's message by DTC will satisfy the terms of the exchange offer as to the tender of old junior subordinated debentures. If you hold physical certificates evidencing your old junior subordinated debentures, complete and sign the enclosed letter of transmittal, or a manually signed facsimile thereof, in accordance with the instructions in that document, have your signature guaranteed if required by Instruction 1 of the letter of transmittal, and send or deliver your manually signed letter of transmittal, or manually signed facsimile, together with the certificates evidencing the old junior subordinated debentures being tendered and any other required documents to the exchange agent. If you desire to tender old junior subordinated debentures in the exchange offer and cannot comply with the procedures described in this prospectus for tender or delivery on a timely basis or if your old junior subordinated debentures are not immediately available, you may tender your old junior subordinated debentures using the procedures for guaranteed delivery described in this prospectus. Withdrawal of Tenders of Debentures: You may withdraw your tender of old junior subordinated debentures at any time prior to the expiration of the exchange offer, but the exchange consideration will not be payable in respect of any old junior subordinated debentures so withdrawn. We will not determine and announce whether the cash option for the exchange consideration has been oversubscribed until after the expiration of the exchange offer. You will not be able to withdraw your tender of old junior subordinated debentures once we make this determination even though it may affect the type of exchange consideration you will receive in the exchange offer. Untendered Debentures: If you do not tender your old junior subordinated debentures, they will remain outstanding. The old junior subordinated debentures will be subordinated to the new senior subordinated debentures. We will have up to $232,059,000 of senior indebtedness, consisting of the new senior subordinated debentures, the credit facility guaranty and the demand promissory note held by an affiliate. In addition, as a result of the consummation of the exchange offer, the aggregate principal amount of the old junior subordinated debentures that are outstanding will be significantly reduced, which may adversely affect their market price, if any. Old junior subordinated debentures that remain outstanding will remain convertible into shares of Sierra common stock at $39.398 per share. As of close of business on December 19, 2000, the closing price of Sierra common stock on the New York Stock Exchange was $3.32. Acceptance of Tendered Under the terms of Debentures and Exchange: Under the terms of the exchange offer and upon satisfaction or our waiver of the conditions to the exchange offer, we will accept for exchange old junior subordinated debentures validly tendered on or prior to the expiration of the exchange offer. You will only receive the exchange consideration if you validly tender your old junior subordinated debentures. We will make payment of the exchange consideration for old junior subordinated debentures validly tendered and accepted for payment by deposit of the appropriate amount of cash and the appropriate amount of new senior subordinated debentures with the exchange agent, who will act as agent for the tendering holders of old junior subordinated debentures. We expect the exchange will be made on the exchange date described in this prospectus. Accounting Treatment for the Exchange Offer: The new senior subordinated debentures will be recorded at the carrying amount of the old junior subordinated debentures less cash consideration given, if any, and that amount will be used to determine the effective interest rate of the new senior subordinated debentures. United States Federal Income Tax Considerations: You are referred to the discussion about the federal income tax consequences of the exchange offer in "United States Federal Income Tax Consequences." Tax matters are very complicated and the tax consequences of the exchange offer to you will depend on the facts of your own situation. You should consult your own tax advisor for a full understanding of the tax consequences to you of the exchange offer. No Appraisal Rights: In connection with the exchange offer, you will not have any right to dissent or to receive an appraisal of your old junior subordinated debentures. Use of Proceeds: Our new senior subordinated debentures are being issued only in exchange for your old junior subordinated debentures. All old junior subordinated debentures accepted by us in the exchange offer will be canceled. We will not receive any cash proceeds from the issuance of new senior subordinated debentures in the exchange offer. "Blue Sky" Compliance: We are notmaking this offer to, and we will not accept tenders from, holders of old junior subordinated debentures in any jurisdiction in which this exchange offer or the acceptance of old junior subordinated debentures would not comply with the applicable securities or "blue sky" laws of that jurisdiction. Dealer Manager: Banc of America Securities LLC is serving as exclusive dealer manager in connection with the exchange offer. Its address and telephone numbers are set forth on the back cover of this prospectus. Exchange Agent: Wells Fargo Corporate Trust is serving as exchange agent in connection with the exchange offer. Its address and telephone numbers are located on the back cover of this prospectus. Information Agent: D.F. King & Co., Inc. is serving as the information agent in connection with the exchange offer. Its address and telephone numbers are located on the back cover of this prospectus. Summary Description of New Senior Subordinated Debentures: The New Senior Subordinated Debentures: Up to $47,059,000 aggregate principal amount of 9% senior subordinated debentures due September 15, 2006. Issuer: CII Financial, Inc. Trustee: Wells Fargo Bank Minnesota, N.A. Maturity: September 15, 2006 Interest: Interest on the new senior subordinated debentures will be payable in cash at a rate of 9% per year, payable on March 15 and September 15 of each year, commencing March 15, 2001. Ranking: The new senior subordinated debentures, like the old junior subordinated debentures, will be subordinated to all our senior indebtedness, including our guaranty of Sierra's credit facility. However, the new senior subordinated debentures will rank senior to any remaining old junior subordinated debentures. Optional Redemption: Until September 15, 2001, the new senior subordinated debentures may be redeemed at our option at any time, from time to time, at a price equal to $1,007.50 per $1,000 principal amount of the new senior subordinated debentures, plus accrued and unpaid interest, if any. After September 15, 2001, the new senior subordinated debentures may be redeemed at our option at any time, from time to time, at a price equal to $1,000 per $1,000 principal amount of the new senior subordinated debentures, plus accrued and unpaid interest, if any. Repurchase at Option of Holders: In the event of a change in control of CII Financial, the holders of these new senior subordinated debentures may require that we repurchase the new senior subordinated debentures at $1,000 per $1,000 principal amount of the new senior subordinated debentures, plus accrued and unpaid interest, if any. Listing: We intend to list the new senior subordinated debentures on the New York Stock Exchange. However, we do not expect the new senior subordinated debentures to be listed until after 30 days following the consummation of the exchange offer. Principal Differences Between Old and New o The new senior subordinated debentures will rank senior in Debentures: right of payment to any old junior subordinated debentures which are not tendered. o You will receive a higher rate of interest on the new senior subordinated debentures, which will pay 9% per annum, than on the old junior subordinated debentures, which pay 7 1/2% per annum. o The scheduled maturity date of the new senior subordinated debentures is September 15, 2006, which is five years later than September 15, 2001, the scheduled maturity date of the old junior subordinated debentures. o The new senior subordinated debentures will not be convertible into Sierra common stock. The old junior subordinated debentures are convertible into Sierra common stock at $39.398 per share. Summary Historical Financial and Other Data of CII Financial The table below presents our selected consolidated financial information for the periods indicated and at the end of these periods. The consolidated financial statement information as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998 and 1997 was derived from our consolidated financial statements included elsewhere in this prospectus. These financial statements were prepared in accordance with accounting principles generally accepted in the United States of America, and were audited by Deloitte & Touche LLP. The consolidated financial statement information at and for the nine months ended September 30, 2000 and 1999 has been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The unaudited consolidated financial statements have been prepared by us on a basis consistent with the audited financial statements and include all normal recurring adjustments necessary for a fair presentation of the information set forth therein. Operating results for the nine months ended September 30, 2000 are not necessarily indicative of the results that will be achieved for future periods, including the entire year ending December 31, 2000. See the Glossary of Selected Insurance Terms annexed to this prospectus for an explanation of certain of the financial and other items included below.
Nine Months Ended September 30, Year Ended December 31, ----------------- ----------------------- (dollars in thousands) (dollars in thousands) 2000 1999 1999 1998 1997 ---- ---- ---- ---- ---- Income Statement Data: Direct written premiums $153,034 $106,291 $148,824 $153,914 $135,580 ======== ======== ======== ======== ======== Net written premiums $93,857 $60,833 $85,097 $134,147 $130,597 ======= ======= ======= ======== ======== Net earned premiums $90,951 $58,254 $82,955 $134,274 $129,197 Net investment income and net realized gains and losses 10,757 11,901 15,395 20,229 17,361 ------- ------- ------- ------- ------- Total revenues 101,708 70,155 98,350 154,503 146,558 Total costs and expenses 115,715 58,301 91,255 136,625 135,745 ------- ------ ------ ------- ------- (Loss) income before federal income taxes and extraordinary gain (14,007) 11,854 7,095 17,878 10,813 Federal income tax (benefit) expense (4,902) 4,815 3,602 4,166 272 --------- ------- ------- -------- ---------- Income before extraordinary gain (9,105) 7,039 3,493 13,712 10,541 Extraordinary gain from debt extinguishment, net of tax 654 0 111 48 2 ----------- ----------- --------- ------------ ------------- Net (Loss) Income $(8,451) $7,039 $3,604 $13,760 $10,543 ======== ====== ====== ======= ======= Combined Ratios: Loss ratio 92.38% 59.76% 74.08% 70.26% 72.24% Underwriting expense ratio (1) 28.59% 35.61% 31.45% 28.45% 29.67% -------- ------ -------- ------ -------- Combined ratio 120.97% 95.37% 105.53% 98.71% 101.91% ======= ====== ======= ====== ======= Balance Sheet Data: Total cash, cash equivalents and invested assets $231,604 $238,864 $226,572 $283,509 Total assets 492,852 380,766 404,338 379,880 Total debt 47,059 51,196 50,498 51,251 Total liabilities 434,338 309,669 338,285 305,933 Total stockholder's equity 58,514 71,097 66,053 73,947
- ------------------------------------------------------------------------------ (1) Includes policyholders' dividend ratio of 1.83% for nine months ended September 30, 2000. RISK FACTORS By exchanging your old junior subordinated debentures for the exchange consideration, you may be choosing to invest in the new senior subordinated debentures. If you do not participate in the exchange offer, you will continue to hold old junior subordinated debentures. An investment in our debentures involves a high degree of risk. In addition to the other information contained in or incorporated by reference into this prospectus, you should carefully consider the following risk factors in deciding whether to tender your old junior subordinated debentures in the exchange offer and what form of consideration to request. Risks relating to CII Financial We may not be able to repay the principal amount of our debentures at their maturity date. CII Financial, as a holding company and sole obligor of the old junior subordinated debentures, has no available source of cash with which to pay the old junior subordinated debentures when they mature on September 15, 2001. Our ability to service our indebtedness following the exchange offer, including our payment obligations under the new senior subordinated debentures and any old junior subordinated debentures that remain outstanding, and to meet our other financial obligations, will depend upon our future operating performance, which in turn is subject to market conditions and other factors, including factors beyond our control. CII Financial, as a holding company, does not currently generate cash flows that will be sufficient to pay the principal amount of the debentures on their stated maturity dates. Our ability to repay the debentures or to refinance our debentures will depend on the availability of new sources of funding, which will in turn depend on our operating performance, the state of the financial markets and other factors at the time that we want to repay or refinance the debentures. Accordingly, we can give no assurance that we will have the cash resources required to meet our obligations to repay the old junior subordinated or new senior subordinated debentures when they become due. Our operational structure adversely affects our ability to service our debt. Substantially all our assets consist of investments in our subsidiaries, and our operations are currently conducted through our subsidiaries. Accordingly, our ability to service our debt, including the debentures, will depend upon both the earnings of our subsidiaries and their ability to distribute those earnings to us. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the debentures, whether by dividends, loans or other payments. In addition, the payment of dividends and the making of loan advances to us by our subsidiaries are and will continue to be subject to statutory and regulatory restrictions. California Indemnity Insurance Company, which is our only direct subsidiary, cannot currently pay any dividends to us without the prior approval of the California Department of Insurance. Our guaranty of Sierra's credit facility puts your investment at risk. In August 2000, CII Financial, as a holding company, became a guarantor of Sierra's revolving credit facility, which at December 15, 2000 was fully drawn and had an outstanding balance of $185 million. The old junior subordinated debentures and the new senior subordinated debentures are subordinated to our guaranty of the credit facility debt. In the event of a default in payment on our old junior subordinated debentures, Sierra's senior lenders would have the right to receive payment in full by us on our guaranty of Sierra's credit facility prior to any payment being made on the old debentures. On December 15, 2000, Sierra amended and restated its credit facility. Prior to this amendment, Sierra was not in compliance with some of the credit facility's financial covenants. We have significant indebtedness which has and could continue to adversely affect our business operations. CII Financial, as a holding company, has a significant amount of outstanding indebtedness. Upon consummation of the exchange offer, we will have up to $232,059,000 of senior indebtedness, consisting of the new senior subordinated debentures, the credit facility guaranty and the demand promissory note held by an affiliate. As a result, we will remain highly leveraged following the exchange offer. This high leverage will restrict our flexibility. Significant geographic and industry concentration may adversely affect our business. Our current business is concentrated geographically and by industry. For the nine months ended September 30, 2000, approximately 77% of our direct written premiums were in California, 8% were in Colorado and 7% were in Nevada. Policyholders whose primary business is construction account for approximately 32% of our premiums. As a result of this geographic and industry concentration, the economic condition of these areas and of the construction industry will have a significant effect on our operating results. We may experience adverse loss development on prior accident years. In both 1999 and 2000 we were required to increase reserves for losses incurred in prior accident years. For the year ended December 31, 1999, we increased reserves related to losses on prior accident years by a net amount of $9.9 million. For the nine months ended September 30, 2000, we increased reserves related to losses on prior accident years by a net amount of $20.2 million. A significant portion of this adverse loss development was related to the 1996 through 1998 accident years and was primarily attributable to increased severity of claims in California. The average cost per claim under our workers' compensation policies has increased each year since 1995. Two of the factors increasing the costs of claims are medical inflation and, in California, adverse court decisions related to medical control of claims. The California workers' compensation industry has been adversely affected by higher claim severity, and adverse loss development on prior years' incurred losses. We cannot assure you that we will not be required to make additional increases in our loss reserves for prior year incurred losses or that any such losses will not have a material impact on our results of operations or financial position. If our reinsurers do not perform their obligations, we would experience significant losses and profitability would be adversely affected. In the ordinary course of our business we reinsure our losses with several reinsurers. Reinsurance does not, however, relieve us of our obligation to policyholders. As of September 30, 2000, we had over $211 million of reinsurance receivables from our reinsurers. A single reinsurer accounts for approximately 87.6% of this amount. Should these reinsurance companies not perform their obligations to reimburse us for losses paid by us under the direct policies, we would experience significant losses and our profitability would be adversely affected. We have reduced our reinsurance coverage, which will expose us to greater risk of ultimate loss. For policies issued after June 30, 2000, our reinsurance coverage has a much higher retention of liability, and covers claims in excess of $250,000 per occurrence, compared to our former retention that had a maximum of $17,000 per occurrence. As a result, we must pay a substantially higher portion of each claim before we have recourse to our reinsurers. This exposes us to greater risk of ultimate loss. The competitive environment in California has and could continue to adversely affect our profitability. For the nine months ended September 30, 2000, approximately 77% of our direct written premiums were in California. There has been intense price competition in California since that state replaced its minimum rate law with an open rating premium law in 1995. While workers' compensation rates have risen in California during 2000, the premiums charged remain lower than those charged prior to the 1995 change in law. This price competition has affected and could continue to affect our profitability. Many of our competitors are larger and have significantly greater resources than us. The open rating environment in Nevada scheduled for July 1, 2001 could adversely affect our profitability. For the nine months ended September 30, 2000, approximately 7% of our direct written premiums were in Nevada. Nevada is scheduled to change to an open rating environment from a minimum rating environment beginning July 1, 2001. After the introduction of open rating in California, premium rates were reduced. As a result, premium revenues and operating profits became uncertain due to increased price competition and the risk of incurring losses. Although we intend to underwrite each account taking into consideration the insured's risk profile, prior loss experience, loss prevention plans and other underwriting considerations, we cannot assure you that we will be able to operate profitably in the Nevada workers' compensation industry in the open rating environment. A rating downgrade from insurance rating agencies could adversely affect us. A downgrade of our insurance subsidiaries' rating by A.M. Best or Fitch could have a material adverse effect on our business, financial condition and results of operations. In the event we default on our debentures, our subsidiaries' rating may be downgraded. Regulations and regulatory development could increase our costs and adversely affect our financial condition and operations. Our insurance subsidiaries are subject to extensive regulation by the California and Texas Departments of Insurance, and are also subject to regulation in each additional jurisdiction in which they become licensed to transact business. These regulations could increase our costs and limit our ability to react to changes in the marketplace or take advantage of new opportunities in a timely manner. In addition, because insurance regulations are designed primarily for the protection of policyholders rather than stockholders or creditors, these regulations could impede our creditors' ability to fully enforce their rights. Changes in regulation could further increase our costs. Our failure to comply with these regulations could result in various regulatory actions including oversight of our insurance subsidiaries or other actions which could adversely affect our operations and our ability to service our debt. The nature and extent of such regulations varies from jurisdiction to jurisdiction, but typically involves: o standards of solvency and minimum amounts of capital and surplus which must be maintained; o limits on types and amounts of investments; o restrictions on the size of risks which may be insured by a single company; o licensing of insurers and their agents; o required deposits of securities for the benefit of policyholders; o approval of policy forms; o establishment of statutory reporting practices and the form and content of statutory financial statements; o establishment of methods for setting statutory loss and expense reserves; o review, and in some instances, prior approval of premium rates; o limits on transactions among insurers and their affiliates; o approval of all proposed changes of control; o approval of dividends; o setting and collecting guarantee fund assessments; and o required filing of annual and other reports with respect to the financial condition and operation of insurers. In addition, state regulatory examiners perform periodic financial and underwriting examinations of insurers. We cannot predict the impact of changes that may be made by the National Association of Insurance Commissioners. In recent years, the insurance regulatory framework has been subject to increased scrutiny by the National Association of Insurance Commissioners, or the NAIC, state legislatures and insurance regulators and the United States Congress. The NAIC is a voluntary organization of state regulators. Its principal mission is to encourage uniformity in state regulation of insurance through the drafting of model laws and the continuing refinement of insurance accounting practices and reporting procedures. None of the NAIC's pronouncements has any legal effect unless enacted by individual states. The NAIC is currently engaged in a project to codify statutory accounting practices that is likely to change the definition of what constitutes prescribed versus permitted statutory accounting practices and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements. At this time, we are unable to predict how such initiative may affect our insurance subsidiaries' statutory financial statements or how insurance rating agencies will interpret or react to any such changes. No assurance can be given that future legislative or regulatory changes resulting from such activities will not adversely affect us. If we are unable to maintain and improve our management information system, our operations would be adversely affected. Our management information system is critical to our current and future operations. The information gathered and processed by our management information system assists us in, among other things, pricing our product, invoicing and collecting our premiums, processing and paying our claims and vendor invoices and providing us with information to manage our business. In the past we have encountered some difficulty with replacing or enhancing our systems. If our systems were to fail or if we were unable to expand or enhance the capability of our systems, our business would be adversely affected. Our operating results could be affected by factors which are beyond our control. In the workers' compensation insurance business, changes in economic conditions can lead to reduced premium levels due to lower payrolls and to increased claims due to the tendency of workers who are laid off to submit workers' compensation claims. Changes in market interest rates can affect the amount of interest income that we can earn on our investment portfolio, as well as the amount of realized and unrealized gains or losses on specific holdings within our investment portfolio. Legislative and regulatory changes can also cause the operating results of our workers' compensation insurance businesses to vary. We are controlled by Sierra. All of CII Financial's common stock is owned by Sierra. Sierra thus is able to elect our board of directors and thereby indirectly control our policies and those of our subsidiaries, including mergers, sales of assets and similar transactions. The interests of Sierra may not be the same as the interests of holders of our debentures. Shares of our common stock and shares of common stock of our subsidiaries may from time to time be pledged, subject to certain regulatory requirements, to secure obligations of Sierra or its affiliates. CII Financial has guaranteed Sierra's obligations under its fully drawn $185 million senior secured credit facility. Risks relating to our debentures You may not be able to trade the debentures easily because there may be a limited market for them. The old junior subordinated debentures are not listed on any securities exchange or quoted on The Nasdaq Stock Market. Although we intend to list the new senior subordinated debentures on the New York Stock Exchange, we do not expect any active trading market for our debentures to exist. Accordingly, you may have difficulty selling your debentures after the expiration of the offer. To the extent that the old junior subordinated debentures are tendered and accepted in the exchange offer, the outstanding principal amount available for trading will be reduced, and consequently, any existing trading market for the remaining old junior subordinated debentures will likely become even more limited than it is now. The debentures are subordinated to our guaranty of Sierra's credit facility; in the event of a default, you may lose part or all of your investment. CII Financial, as a holding company, has guaranteed Sierra's credit facility, and both the old junior subordinated debentures and the new senior subordinated debentures will rank junior to our obligations under this guaranty, as well as any other senior debt we incur. As a result of such subordination, in the event of Sierra's liquidation or insolvency or a payment default with respect to its credit facility, our assets will be available to pay obligations on the debentures only after the credit facility has been paid in full. There may not then be sufficient assets remaining to pay amounts due on the debentures then outstanding. As of December 15, 2000, Sierra had approximately $185 million outstanding under its fully drawn credit facility. The terms of our debentures do not limit our ability to incur additional senior debt. The old junior subordinated debentures will rank junior to the new senior subordinated debentures. The old junior subordinated debentures will rank junior to the new senior subordinated debentures and to our guaranty of Sierra's credit facility and other senior debt. Risk Associated with the Exchange Offer You may not receive the exchange consideration you requested in the exchange offer. If holders of more than $19,500,000 aggregate principal amount of old junior subordinated debentures elect the cash option, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19,500,000 principal amount of old junior subordinated debentures for cash and we will exchange the balance of the old junior subordinated debentures we receive for new senior subordinated debentures. All holders who elect the cash option will be permitted to sell the same fraction of their old junior subordinated debentures for cash. This fraction will equal $19,500,000, divided by the aggregate principal amount of all debentures tendered for cash by all holders. To receive the maximum amount of cash, you must tender all of your old junior subordinated debentures for the cash option. We will not determine whether the cash option for the exchange consideration has been oversubscribed until after the expiration of the exchange offer. You will not be able to withdraw your tender of old junior subordinated debentures at the time we make this determination even though it may affect the type of exchange consideration you will receive in the exchange offer. The exchange offer does not reflect any valuation of the old subordinated debentures. Our board of directors has made no determination that the exchange offer represents a fair valuation of the old subordinated debentures. We have not obtained a fairness opinion from any financial advisor about the fairness of the exchange offer to you or us. We cannot assure you that if you tender your old junior subordinated debentures you will receive more value than if you had chosen to keep them. We may not be able to fund the cash portion of the exchange consideration. We intend to fund the cash portion of the exchange consideration through a combination of dividends or other transfers from our California insurance subsidiaries and a loan from an affiliate. The insurance subsidiaries may not be permitted to declare and pay dividends or make other transfers to us unless the California Department of Insurance approves. We cannot assure you that we will receive this regulatory approval. Our affiliates are under no obligation to loan funds to us. If we are unable to obtain the cash required for this transaction, we will not be able to consummate the exchange offer. Sierra may not receive the consent of Sierra's lenders under its $185 million credit facility to the exchange offer. The consent of the lenders under Sierra's credit facility is required in order for us to consummate the exchange offer. We cannot assure you that Sierra will receive the lenders' consent. If the consent is not received, we will not be able to complete the exchange offer. SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS We have made forward-looking statements with respect to our financial condition, results of operations and business and on the expected impact of the exchange offer on our financial performance. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates" and similar expressions identify forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties, including those described under "Risk Factors" in this prospectus, that could cause actual results to differ materially from the results contemplated by the forward-looking statements. In evaluating the exchange offer, you should carefully consider the discussion of risks and uncertainties in the section entitled "Risk Factors" on page 9 of this prospectus. WHERE YOU CAN FIND ADDITIONAL INFORMATION We have filed a registration statement on Form S-4 under which we are registering the new senior subordinated debentures to be issued to our debenture holders in the exchange offer. This prospectus is a part of that registration statement. This prospectus does not contain all of the information in the registration statement and the exhibits and schedules to it. For further information with respect to us and our new senior subordinated debentures, we refer you to the registration statement and to the exhibits and schedules to the registration statement. Statements contained in this prospectus as to the contents of any contract or any other document referred to are not necessarily complete, and in each instance, we refer you to the copy of the contract or other document filed as an exhibit to the registration statement. Each of these statements is qualified in all respects by this reference. You may inspect copies of the registration statements without charge at the SEC's principal office in Washington, D.C., and copies of all or any part of the registration statement may be obtained from the Public Reference Section of the SEC, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of fees prescribed by the SEC. We do not currently file reports and information with the SEC. Upon completion of this offering, we will be subject to the information reporting requirements of the Securities Exchange Act of 1934 and we will file reports, and other information with the SEC. You may read and copy any reports, statements or other information that we file with the SEC at the SEC's public reference rooms at the following locations: Public Reference Room New York Regional Office Chicago Regional Office 450 Fifth Street, N.W. 7 World Trade Center Citicorp Center Room 1024 Suite 1300 500 West Madison Street Washington, D.C. 20549 New York, NY 10048 Suite 1400 Chicago, IL 60661-2511 Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms. These SEC filings are also available to the public from commercial document retrieval services and at the Internet worldwide web site maintained by the SEC at "http://www.sec.gov". Reports, proxy statements and other information concerning Sierra may also be inspected at the offices of the New York Stock Exchange, which is located at 20 Broad Street, New York, New York 10005. The old junior subordinated debentures are convertible into shares of Sierra common stock. Sierra has filed a registration statement on Form S-3 under which it registered the shares of Sierra common stock into which the old junior subordinated debentures are convertible. In addition, Sierra files annual, quarterly and special reports and other information with the SEC. Documents filed by Sierra with the SEC can be obtained as described above. The registration statement and Sierra's periodic filings under the Exchange Act are not incorporated by reference in this prospectus. RATIO OF EARNINGS TO FIXED CHARGES
Nine Months Ended September 30, For the year Ended December 31, 2000 1999 1999 1998 1997 1996 1995 (dollars in thousands) (dollars in thousands) Pre-tax (loss) income before discontinued operations and extraordinary gains $(14,007) $11,854 $7,095 $17,878 $10,813 $10,630 $9,083 Fixed Charges: Interest expense 2,717 2,751 3,706 4,301 4,091 4,123 4,868 Capitalized interest 0 130 130 0 0 0 0 Interest relating to rental expense (1) 704 632 867 438 438 542 491 ------ ------ ------ ------ ------ ------ ------ Total fixed charges 3,421 3,513 4,703 4,739 4,524 4,665 5,359 Earnings available for fixed charges $(10,586) $15,367 $11,798 $22,617 $15,342 $15,295 $14,442 Ratio of earnings to fixed charges (3.09x) 4.37x 2.51x 4.77x 3.39x 3.28x 2.69x
- ------------------------------------------------------------------------------ (1) The representative interest portion of rental expense was deemed to be one-third of all rental expense. Earnings were not sufficient to cover fixed charges during the first nine months of 2000 by $14,007,000; all other periods had sufficient income to cover charges. USE OF PROCEEDS The new senior subordinated debentures issued in connection with the exchange offer are only being issued in exchange for your old junior subordinated debentures. We will not receive any cash proceeds from the issuance of new senior subordinated debentures pursuant to the exchange offer. All old junior subordinated debentures accepted by us in the exchange offer will be canceled. CAPITALIZATION The following table sets forth as of September 30, 2000: o our actual capitalization; and o our capitalization adjusted to reflect the tender of all $47,059,000 aggregate principal amount of old junior subordinated debentures in the exchange offer and full subscription of the cash option, so that owners tendering outstanding old junior subordinated debentures will receive, in the aggregate, $10,237,500 in cash and $27,559,000 principal amount of new senior subordinated debentures under the exchange offer. We intend to fund a portion of the cash consideration of the exchange offer, as well as interest and expenses, through a loan from an affiliate evidenced by a demand promissory note, which we refer to as the affiliate note. The amount of this loan will be determined prior to the expiration of the exchange offer. For purposes of this table, we have assumed that the amount of the affiliate note will be $5.0 million. To the extent that old junior subordinated debentures are not validly tendered or accepted in the exchange offer, the amount set out below in the "pro forma" column for the new senior subordinated debentures and the affiliate note, depending on the election of the debenture holder, may decrease and the amount set out below in the "pro forma" column for the old junior subordinated debentures would increase. In addition, it is possible that the cash option will not be fully subscribed. In that event, the amount set below in the "pro forma" column for the new senior subordinated debentures would increase and the amount of the affiliate note may decrease. This information should be read in conjunction with our consolidated financial statements and notes thereto which are included elsewhere in this prospectus.
September 30, 2000 Historical Pro forma (dollars in thousands, except share data) Total debt: New senior subordinated debentures (1)............. 0 $36,822 Old junior subordinated debentures................. $47,059 - Notes payable-affiliates .......................... - 5,000 Other debt......................................... - - ----------- ------------ Total debt....................................... 47,059 41,822 ------------------ ---------- Stockholder's equity:................................ Common stock, no par value; 1,000 shares authorized; 100 shares issued and outstanding 3,604 3,604 - --------------------------------------------------------- 64,450 64,450 Additional paid-in capital......................... Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments ................................... (8,651) (8,651) Accumulated deficit ................................. (889) (889) ------------- ---------- Total stockholder's equity....................... 58,514 58,514 ----------- ----------- Total capitalization............................. $105,573 $100,336 ========= =========
(1) New senior subordinated debentures will have an accounting book value of $36,821,500, which includes a deferred gain of $9,262,500. This premium will be amortized over the life of the senior subordinated debentures. - ------------------------------------------------------------------------------ THE EXCHANGE OFFER This section of the prospectus describes the proposed exchange offer. While we believe that the description covers the material terms of the exchange offer, this summary may not contain all of the information that is important to you. You should read this entire document and the other documents we refer to carefully for a more complete understanding of the exchange offer. Terms of the Exchange Offer Upon the terms and subject to the conditions of the exchange offer set forth in this prospectus and in the accompanying letter of transmittal, you can choose to exchange your old junior subordinated debentures for: o $1,000 in principal amount of new senior subordinated debentures for each $1,000 in principal amount of old junior subordinated debentures that you tender; or o $525 in cash for each $1,000 in principal amount of the old junior subordinated debentures that you tender, up to a maximum of $19,500,000 aggregate principal amount of old junior subordinated debentures as described below. We will pay in cash accrued and unpaid interest on all old junior subordinated debentures accepted in the exchange offer through, but not including, the date of acceptance. We are only offering to purchase a maximum of $19,500,000 aggregate principal amount of old junior subordinated debentures for cash. If holders of more than $19,500,000 aggregate principal amount of old junior subordinated debentures elect the cash option, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19,500,000 principal amount of old junior subordinated debentures for cash and we will exchange the balance of the old junior subordinated debentures we receive for new senior subordinated debentures. All holders who elect the cash option will be permitted to sell the same fraction of their old junior subordinated debentures for cash. This fraction will equal $19,500,000, divided by the aggregate principal amount of all debentures tendered for cash by all holders. The following table illustrates how new senior subordinated debentures and cash will be distributed in the aggregate under three scenarios, all of which assume that 100% of the old junior subordinated debentures are tendered, but each of which assumes that a different percentage of holders elects the cash option. The three scenarios are: first, that no old junior subordinated debentures are tendered for cash; second, that $19,500,000 of old junior subordinated debentures are tendered for cash; and third, that $47,059,000 of old junior subordinated debentures are tendered for cash.
Principal amount of Principal amount of new old junior senior subordinated subordinated Cash paid for old debentures issued for debentures tendered junior subordinated old junior subordinated for cash debentures debentures ----------------------- ----------------------- -------------------------- $ 0 $ 0 $47,059,000 $19,500,000 $10,237,500 $27,559,000 $47,059,000 $10,237,500 $27,559,000
We will not determine whether the cash option has been oversubscribed until after the expiration of the exchange offer. You will not be able to withdraw your tender of old junior subordinated debentures once we make this determination even though it may affect the type of exchange consideration you will receive in the exchange offer. We will publicly announce whether the cash option has been oversubscribed and the effect of any required proration of exchange consideration as soon as practicable after the expiration of the exchange offer. You do not have to choose the same option for all of the old junior subordinated debentures that you tender. You do not have to tender all of your old junior subordinated debentures to participate in the exchange offer. You may withdraw your tender of old junior subordinated debentures at any time before the expiration of the exchange offer. Our board of directors makes no recommendation to owners of the old junior subordinated debentures whether or not to tender their debentures in the exchange offer or as to the form of exchange consideration to elect. In addition, we have not authorized anyone to make a recommendation on our behalf regarding the exchange offer. Owners of the old junior subordinated debentures must make their own decision whether to tender their old junior subordinated debentures in the exchange offer and as to the form of exchange consideration to elect. Principal Differences between the Old Junior Subordinated Debentures and the New Senior Subordinated Debentures The terms of our old junior subordinated debentures and our new senior subordinated debentures are described in more detail in the sections headed "Description of Debentures." The principal differences are as follows: o The new senior subordinated debentures will rank senior in right of payment to any old junior subordinated debentures which are not tendered. o You will receive a higher rate of interest on the new senior subordinated debentures, which will pay 9% per annum, than on the old junior subordinated debentures, which pay 7 1/2% per annum. o The scheduled maturity date of the new senior subordinated debentures is September 15, 2006, which is five years later than September 15, 2001, the scheduled maturity date of the old junior subordinated debentures. o The new senior subordinated debentures will not be convertible into Sierra common stock. The old junior subordinated debentures are convertible into Sierra common stock at $39.398 per share. Period For Tendering Your Debentures Subject to applicable securities laws and the terms and conditions in this prospectus, we will accept for exchange any and all old junior subordinated debentures that are validly tendered and not withdrawn before 5:00 p.m., New York City time, on the expiration date of the exchange offer. However, we reserve the right to: o delay the acceptance of the old junior subordinated debentures for exchange; o terminate the exchange offer; o extend the expiration date and retain all old junior subordinated debentures that have been tendered, subject to the right of owners of old junior subordinated debentures to withdraw their tendered old junior subordinated debentures; o refuse to accept the old junior subordinated debentures and return all old junior subordinated debentures that have been tendered to us; or o waive any condition or otherwise amend the terms of the exchange offer in any respect. The rights we reserve in this paragraph are in addition to our right to terminate the exchange offer described under "Conditions to, and Amendment of, the Exchange Offer." If we make a material change in the terms of the exchange offer or the information concerning the exchange offer or waive a material condition to the exchange offer, we will disseminate additional exchange offer materials and extend the exchange offer to the extent required by law. In addition, we may, if we deem appropriate, extend the exchange offer for any other reason. If the consideration to be paid in the exchange offer is increased or decreased or the principal amount of old junior subordinated debentures subject to the exchange offer is decreased, the exchange offer will remain open at least 10 business days from the date we first give notice to you, by public announcement or otherwise, of that increase or decrease. In the case of an extension of the exchange offer, the announcement will be issued no later than 9:00 a.m., New York time, on the next business day after the previously scheduled expiration of the exchange offer. Without limiting the manner in which any public announcement may be made, we will have no obligation to publish, advertise or otherwise communicate any public announcement other than by issuing a release to the Dow Jones News Service. Market and Trading Information Regarding the Old Junior Subordinated Debentures The old junior subordinated debentures currently are traded over-the-counter. There is no established reporting system or trading market for trading in the old junior subordinated debentures. Accordingly, there is no practical way to determine the trading history of the old junior subordinated debentures. We believe that trading in the old junior subordinated debentures has been limited and sporadic. We believe that the trading market for the old junior subordinated debentures that remain outstanding after the exchange offer will be very limited. Acceptance for Exchange of Debentures Upon the terms and subject to the conditions of the exchange offer and applicable law, we will exchange the applicable exchange consideration for all old junior subordinated debentures validly tendered and not withdrawn under the exchange offer on or prior to the expiration of the exchange offer. This exchange will be made by our deposit of the exchange consideration with the exchange agent as soon as practicable after the expiration of the exchange offer so that the exchange consideration may be paid to you on the exchange date. The exchange agent will act as agent for you for the purpose of issuing the exchange consideration for the old junior subordinated debentures. Under no circumstances will interest on the exchange consideration be paid by us by reason of any delay on behalf of the exchange agent in making that exchange. We expressly reserve the right, in our sole discretion and subject to Rule 14e-l(c) under the Exchange Act of 1934, to delay acceptance for exchange of, or the exchange of, old junior subordinated debentures in order to comply, in whole or in part, with any applicable law or regulation. In all cases, the exchange agent will deliver the exchange consideration for old junior subordinated debentures accepted for exchange under the exchange offer only after timely receipt by the exchange agent of: o certificates representing your old junior subordinated debentures or timely confirmation of a book-entry transfer of your old junior subordinated debentures into the exchange agent's account at DTC; o a properly completed and duly executed letter of transmittal, or a manually signed facsimile thereof or, in the case of book-entry transfer, an "agent's message"; and o any other documents required by the letter of transmittal. For purposes of the exchange offer, validly tendered old junior subordinated debentures, or defectively tendered old junior subordinated debentures for which we have waived that defect, will be deemed to have been accepted for exchange by us if, as and when we give written notice thereof to the exchange agent. If the exchange offer is terminated or withdrawn, or the old junior subordinated debentures are not accepted for exchange, no exchange consideration will be paid or payable. If any tendered old junior subordinated debentures are not exchanged under the exchange offer for any reason, or certificates are submitted evidencing more old junior subordinated debentures than are tendered, those old junior subordinated debentures not exchanged will be returned, without expense, to you, or, in the case of old junior subordinated debentures tendered by book-entry transfer, those old junior subordinated debentures will be credited to the account maintained at DTC from which those old junior subordinated debentures were delivered, unless otherwise requested by you under the heading "Special Delivery Instructions" in the letter of transmittal, promptly after the expiration of the exchange offer or termination of the exchange offer. Procedures for Exchanging Debentures In order to receive the exchange consideration you must tender your old junior subordinated debentures under the exchange offer on or before its expiration. The method of delivery of old junior subordinated debentures and letters of transmittal, any required signature guarantees and all other required documents, including delivery through DTC and any acceptance of an agent's message transmitted through ATOP, is at your election and risk. Except as otherwise provided in the letter of transmittal, delivery will be deemed made only when actually received by the exchange agent. If delivery is by mail, we suggest that you use properly insured, registered mail with return receipt requested, and that the mailing be made sufficiently in advance of the expiration of the exchange offer. It is contemplated that our new senior subordinated debentures will be delivered in book-entry form through DTC. Accordingly, if you anticipate tendering other than through DTC, you are urged to promptly contact a bank, broker or other intermediary that has the capability to hold securities custodially through DTC, to arrange for the receipt of any new senior subordinated debentures to be delivered as part of the exchange consideration, and to obtain the information necessary in the letter of transmittal. The payment of any cash to you will be paid to you by the exchange agent. If you have any questions or need help in tendering your notes, please call the information agent whose address and phone number are on the back cover of this prospectus. Tenders of debentures. Your tender of old junior subordinated debentures, and subsequent acceptance by us, by one of the procedures set out below will constitute a binding agreement between us and you in accordance with the terms and subject to the conditions set forth in this prospectus, in the letter of transmittal and, if applicable, in the notice of guaranteed delivery. Tenders of debentures held in physical form. To effectively tender old junior subordinated debentures held in physical form: o you must properly complete and duly execute a letter of transmittal, or a manually signed facsimile thereof, and any other documents required by the letter of transmittal, and those documents must be received by the exchange agent at its address set out on the back cover of this prospectus; and o you must ensure that certificates representing those old junior subordinated debentures are received by the exchange agent at that address on or prior to the expiration of the exchange offer. Letters of transmittal and old junior subordinated debentures should be sent only to the exchange agent and should not be sent to us, the information agent or the dealer manager. If your old junior subordinated debentures are registered in the name of a person other than the signatory to the letter of transmittal, then, in order to tender those old junior subordinated debentures under the exchange offer, the old junior subordinated debentures must be endorsed or accompanied by an appropriate written instrument or instruments of transfer signed exactly as that name appears on the old junior subordinated debentures, with the signature on the old junior subordinated debentures or instruments of transfer guaranteed as provided below. Tender of debentures held through a custodian. If your old junior subordinated debentures are registered in the name of a broker, dealer, commercial bank, trust company or other nominee and if you wish to tender old junior subordinated debentures and deliver a letter of transmittal, you should contact that broker, dealer, commercial bank, trust company or other nominee promptly and instruct him or her or it to tender old junior subordinated debentures and deliver a letter of transmittal on your behalf. A letter of instructions is enclosed in the materials provided along with this prospectus which may be used by you in this process to instruct the registered holder to tender old junior subordinated debentures. If you wish to tender those old junior subordinated debentures yourself, you must, prior to completing and executing the letter of transmittal and delivering those old junior subordinated debentures, either make appropriate arrangements to register ownership of the old junior subordinated debentures in your name or follow the procedures described in the immediately preceding paragraph. The transfer of record ownership may take considerable time. Tender of debentures held through DTC. We have confirmed with DTC that the old junior subordinated debentures may be tendered using ATOP. DTC participants may electronically transmit their acceptance of the exchange offer by causing DTC to transfer their old junior subordinated debentures to the exchange agent using the ATOP procedures. In connection with the transfer, DTC will send an "agent's message" to the exchange agent. The agent's message states that DTC has received instructions from the participant to tender old junior subordinated debentures and that the participant agrees to be bound by the terms of the letter of transmittal. By using the ATOP procedures to tender old junior subordinated debentures, you will not be required to deliver a letter of transmittal to the exchange agent. However, you will be bound by its terms just as if you had signed it. Book-entry delivery procedures. The exchange agent will establish accounts with respect to the old junior subordinated debentures at DTC for purposes of the exchange offer within two business days after the date of this prospectus. Although delivery of old junior subordinated debentures may be effected through book-entry transfer into the exchange agent's account at DTC, the letter of transmittal, or a manually signed facsimile thereof, with any required signature guarantees, or an agent's message, in connection with a book-entry transfer, and any other required documents, must, in any case, be transmitted, to and received by the exchange agent at one or more of its addresses set out on the back cover of this prospectus on or prior to the expiration of the exchange offer in connection with the tender of those old junior subordinated debentures. Delivery of documents to DTC does not constitute delivery to the exchange agent. The confirmation of a book-entry transfer into the exchange agent's account at DTC as described above is referred to in this prospectus as a "book-entry confirmation." The term "agent's message" means a message transmitted by DTC to, and received by, the exchange agent and forming a part of the book-entry confirmation, which states that DTC has received an express acknowledgment from a DTC participant that such participant has received the letter of transmittal and agrees to be bound by the terms of the letter of transmittal. Signature guarantees. Signatures on all letters of transmittal must be guaranteed by a recognized participant in the Securities Transfer Agents Medallion Program, unless your tender of old junior subordinated debentures tendered are tendered: o by a registered holder of old junior subordinated debentures, or by a participant in DTC whose name appears on a security position listing as the owner of those old junior subordinated debentures, who has not completed any of the boxes entitled "Special Payment Instructions" or "Special Delivery Instructions" on the letter of transmittal; or o for the account of a member firm of a registered national securities exchange, a member of the National Association of Securities Dealers, Inc. or a commercial bank or trust company having an office or correspondent in the United States, which entities we refer to as "eligible institutions". If your old junior subordinated debentures are registered in the name of a person other than the signatory to the letter of transmittal or if old junior subordinated debentures not accepted for exchange or not tendered are to be returned to a person other than the registered holder, then the signature on the letter of transmittal accompanying the tendered old junior subordinated debentures must be guaranteed. See Instructions 1 and 5 of the letter of transmittal. Mutilated, lost, stolen or destroyed certificates. If you desire to tender old junior subordinated debentures, but the certificates evidencing those old junior subordinated debentures have been mutilated, lost, stolen or destroyed, you should contact us for information about the procedures for obtaining replacement certificates for old junior subordinated debentures at the following address or telephone number: 2716 North Tenaya Way, Las Vegas, Nevada 89128 or (702) 242-7040. Guaranteed delivery. If you want to tender old junior subordinated debentures under the exchange offer prior to the expiration of the exchange offer and, o your certificates representing those old junior subordinated debentures are not immediately available; o time will not permit your letter of transmittal, the certificates representing your old junior subordinated debentures and all other required documents to reach the exchange agent on or prior to the expiration of the exchange offer; or o the procedures for book-entry transfer, including delivery of an agent's message, cannot be completed on or prior to the expiration of the exchange offer, you may nevertheless tender your old junior subordinated debentures with the effect that tender will be deemed to have been received on or prior to the expiration of the exchange offer if all the following conditions are satisfied: o the tender is made by or through an eligible institution; o a properly completed and duly executed notice of guaranteed delivery or an agent's message with respect to guaranteed delivery that is accepted by us is received by the exchange agent on or prior to the expiration of the exchange offer as provided below; and o the certificates for the tendered old junior subordinated debentures, in proper form for transfer, or a book-entry confirmation of the transfer of those old junior subordinated debentures into the exchange agent's account at DTC as described above, together with a letter of transmittal, or manually signed facsimile thereof, that is properly completed and duly executed, with any signature guarantees and any other documents required by the letter of transmittal, or a properly transmitted agent's message, are received by the exchange agent within two business days after the date of execution of the notice of guaranteed delivery. The notice of guaranteed delivery may be sent by hand delivery, facsimile transmission or mail to the exchange agent and must include a guarantee by an eligible institution in the form set out in the notice of guaranteed delivery. Under no circumstances will interest be paid by us by reason of any delay in exchanging old junior subordinated debentures for the exchange consideration to any person using the guaranteed delivery procedures that results from this guaranteed delivery. The exchange consideration for old junior subordinated debentures tendered under the guaranteed delivery procedures will be the same as for old junior subordinated debentures delivered to the exchange agent on or prior to the expiration of the exchange offer, even if the old junior subordinated debentures to be delivered subject to the guaranteed delivery procedures are not so delivered to the exchange agent, and therefore exchange by the exchange agent on account of those old junior subordinated debentures is not made, until after the exchange date. Backup United States federal income tax withholding. To prevent backup federal income tax withholding you must provide the exchange agent with your current taxpayer identification number and certify that you are not subject to backup federal income tax withholding by completing the Substitute Form W-9 included in the letter of transmittal. Determination of validity. All questions as to the validity, form, eligibility, including time of receipt, and acceptance of any tendered old junior subordinated debentures subject to any of the procedures described above will be determined by us, in our sole discretion, which determination shall be final and binding. We reserve the right to reject any or all tenders of any old junior subordinated debentures that we determine not to be in proper form or if the acceptance for tender of those old junior subordinated debentures may, in the opinion of our counsel, be unlawful. We also reserve the right to waive any of the conditions of the exchange offer or any defect or irregularity in any tender of your old junior subordinated debentures, whether or not similar defects or irregularities are waived in the case of other holders of old junior subordinated debentures. Our interpretation of the terms and conditions of the exchange offer, including the letter of transmittal and the instructions thereto, will be final and binding. Neither we, the exchange agent nor any other person will be under any duty to give notification of any defects or irregularities in tenders or will incur any liability for failure to give any such notification. If we waive our right to reject a defective tender of old junior subordinated debentures, you will be entitled to the exchange consideration. Withdrawal of Tendered Old Junior Subordinated Debentures You may withdraw tenders of debentures at any time on or prior to the expiration of the exchange offer, but the exchange consideration shall not be payable in respect of old junior subordinated debentures so withdrawn. We will not determine whether the cash option for the exchange consideration has been oversubscribed until after the expiration of the exchange offer. You will not be able to withdraw your tender of old junior subordinated debentures at the time we make this determination even though it may affect the type of exchange consideration you will receive in the exchange offer. Tenders of old junior subordinated debentures may be validly withdrawn if the exchange offer is terminated without any old junior subordinated debentures being exchanged thereunder. In this case, the old junior subordinated debentures tendered under the exchange offer will be promptly returned to you. If we make a material change in the terms of the exchange offer or waive a material condition of the exchange offer, we will disseminate additional exchange offer materials and extend the exchange offer to the extent required by law. In addition, we may, if we deem appropriate, extend the exchange offer for any other reason. If the consideration to be paid in the exchange offer is increased or decreased or the principal amount of old junior subordinated debentures subject to the exchange offer is decreased, the exchange offer will remain open at least 10 business days from the date we first give notice to you, by public announcement or otherwise, of that increase or decrease. For a withdrawal of tendered old junior subordinated debentures to be effective, a written or facsimile transmission notice of withdrawal must be received by the exchange agent on or prior to the expiration of the exchange offer at its address set out on the back cover of this prospectus. Any such notice of withdrawal must: o specify the name of the person who tendered the old junior subordinated debentures to be withdrawn; o contain the description of the old junior subordinated debentures to be withdrawn and identify the certificate number or numbers shown on the particular certificates evidencing those old junior subordinated debentures, unless those old junior subordinated debentures were tendered by book-entry transfer, and the aggregate principal amount represented by those old junior subordinated debentures; and o be signed in the same manner as the original signature on the letter of transmittal by which those old junior subordinated debentures were tendered, including any required signature guarantees, or be accompanied by evidence sufficient to the exchange agent that the person withdrawing the tender has succeeded to the beneficial ownership of the old junior subordinated debentures. If the old junior subordinated debentures to be withdrawn have been delivered or otherwise identified to the exchange agent, a signed notice of withdrawal is effective immediately upon written or facsimile notice of that withdrawal even if physical release is not yet effected. Any permitted withdrawal of old junior subordinated debentures may not be rescinded, and any old junior subordinated debentures properly withdrawn will thereafter be deemed not validly tendered for purposes of the exchange offer. Withdrawn old junior subordinated debentures may, however, be re-tendered by again following one of the appropriate procedures described in this prospectus at any time on or prior to the expiration of the exchange offer. If we extend the exchange offer or if for any reason, whether before or after any old junior subordinated debentures have been accepted for tender, the acceptance for tender of old junior subordinated debentures is delayed or if we are unable to accept the tender of old junior subordinated debentures under the exchange offer, then, without prejudice to our rights under the exchange offer, tendered old junior subordinated debentures may be retained by the exchange agent on our behalf and may not be withdrawn, subject to Rule 14e-l(c) under the Exchange Act, which requires that an offeror pay the consideration offered or return the securities deposited by or on behalf of the investor promptly after the termination or withdrawal of a tender offer, except as otherwise provided in this section. All questions as to the validity, form and eligibility, including time of receipt, of notices of withdrawal will be determined by us, in our sole discretion, which determination shall be final and binding. Neither we, the exchange agent, the dealer manager, the information agent nor any other person will be under any duty to give notification of any defects or irregularities in any notice of withdrawal, or incur any liability for failure to give any such notification. Conditions to, and Amendment of, the Exchange Offer The exchange offer is subject to the conditions that: o we must receive valid tenders for at least 90% of the aggregate principal amount of the outstanding old junior subordinated debentures; o we must receive the consent of the lenders, under Sierra's $185 million senior secured credit facility, which has been guaranteed by us to our issuing the new senior subordinated debentures in the exchange offer; o we must receive the approval of the California Department of Insurance required for one or more of our subsidiaries to directly or indirectly fund all or part of the cash to be paid as the exchange consideration; o we must obtain sufficient cash to pay any cash consideration required to be paid as exchange offer consideration; and o the exchange offer complies with applicable laws and applicable interpretations of the staff of the SEC; o the new senior subordinated debentures must be approved for listing on the New York Stock Exchange; o no litigation has been instituted or threatened or law enacted that could prohibit the exchange offer, materially adversely affect our business or materially impair the benefits of the exchange offer; o no event has occurred affecting our business that could prohibit, prevent or significantly delay consummation of the exchange offer, or materially impair our contemplated benefits of the exchange offer; and o no tender or exchange offer for our equity securities or any business combination involving us has been proposed or announced or has occurred. Subject to satisfaction or waiver of the conditions, we will accept for exchange any and all old junior subordinated debentures that are validly tendered and not withdrawn before 5:00 p.m., New York City time, on the expiration date of the exchange offer. However, we reserve the right to: o delay the acceptance of your old junior subordinated debentures for exchange; o terminate the exchange offer; o extend the expiration date and retain all old junior subordinated debentures that have been tendered, subject to the right of owners of the old junior subordinated debentures to withdraw their tendered old junior subordinated debentures; o refuse to accept the old junior subordinated debentures and return all old junior subordinated debentures that have been tendered to us; or o waive any condition or otherwise amend the terms of the exchange offer in any respect. United States Federal Income Tax Consequences of the Exchange Offer You are referred to the discussion about the federal income tax consequences of the exchange offer under "United States Federal Tax Consequences". Tax matters are very complicated and the tax consequences of the exchange offer to you will depend on the facts of your own situation. You should consult your own tax advisor for a full understanding of the tax consequences to you of the exchange offer. Exchange Agent We have appointed Wells Fargo Bank Minnesota, N.A. as the exchange agent for the exchange offer of the old junior subordinated debentures. We have agreed to pay Wells Fargo Corporate Trust reasonable and customary fees for its services and will reimburse Wells Fargo Corporate Trust for its reasonable out-of-pocket expenses. All executed letters of transmittal and any other required documents should be sent or delivered to the exchange agent at the address set forth below. Questions and requests for assistance, requests for additional copies of this prospectus or of the letter of transmittal and requests for notices of guaranteed delivery should be directed to the exchange agent, addressed as follows: Wells Fargo Corporate Trust: By Registered & Certified Mail: WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations MAC N9303-121 PO Box 1517 Minneapolis, MN 55480 By Regular Mail or Overnight Courier: WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations MAC N9303-121 Sixth & Marquette Avenue Minneapolis, MN 55479 In Person by Hand Only: WELLS FARGO BANK MINNESOTA, N.A. 12th Floor - Northstar East Building Corporate Trust Services 608 Second Avenue South Minneapolis, MN By Facsimile (for Eligible Institutions only): (612) 667-4927 For Information or Confirmation by Telephone: (800) 344-5128 Delivery of a letter of transmittal to an address other than that for the exchange agent as set forth above or transmission of instructions via facsimile other than as set forth above does not constitute a valid delivery of a letter of transmittal. Dealer Manager We have retained Banc of America Securities LLC as our exclusive dealer manager in connection with the exchange offer. We will pay Banc of America Securities LLC a customary fee for its services. We have also agreed to reimburse Banc of America Securities LLC for its expenses and to indemnify it against certain expenses and liabilities, including liabilities under federal securities laws. These expenses are not included in the fees set forth above. Information Agent We have appointed D.F. King & Co., Inc., the information agent for the exchange offer of the old junior subordinated debentures. We have agreed to pay D.F. King reasonable and customary fees for its services and will reimburse D.F. King for its reasonable out-of-pocket expenses. Any questions concerning the exchange offer procedures or requests for assistance or additional copies of this prospectus or the letters of transmittal may be directed to the information agent at: D.F. King & Co., Inc. 77 Water Street New York, New York 10005 Banks and Brokers, call collect: (212) 269-5500 Others, call toll free: (800) 735-3591 Fees and Expenses We will bear the expenses of soliciting tenders for the exchange offer. We are making the principal solicitation by mail. However, we may make additional solicitations by telephone, facsimile, e-mail or in person by officers and regular employees of ours and those of our affiliates. In addition, we may make payments to brokers, dealers or others soliciting acceptance of the exchange offer. We will also pay the exchange agent reasonable and customary fees for its services and will reimburse it for its reasonable out-of-pocket expenses. We will pay the cash expenses to be incurred in connection with the exchange offer and are estimated in the aggregate to be approximately $1.6 million. Such expenses include fees and expenses of the exchange agent and trustee, accounting and legal fees and printing costs, among others. Payment of Solicitation Fee We will pay to soliciting dealers a solicitation fee of $2.50 per $1,000 of old junior subordinated debentures tendered, accepted for purchase and paid pursuant to the exchange offer, provided, that the aggregate solicitation fee paid to any one soliciting dealer shall not exceed $15,000. As used herein, a "soliciting dealer" is an entity covered by a letter of transmittal which designated its name as having solicited and obtained the tender, and is: o any broker or dealer in securities, excluding the dealer manager, which is a member of any national securities exchange or of the NASD; o any foreign broker or dealer not eligible for membership in the NASD which agrees to conform to the NASD's Rules of Fair Practice in soliciting tenders outside the United States to the same extent as though it were an NASD member; or o any bank or trust company. No such fee shall be payable to a soliciting dealer with respect to the tender of old junior subordinated debentures by a holder unless the letter of transmittal accompanying such tender designates such soliciting dealer. No such fee shall be payable to a soliciting dealer in respect of old junior subordinated debentures registered in the name of such soliciting dealer unless such old junior subordinated debentures are held by such soliciting dealer as nominee and such old junior subordinated debentures are being tendered for the benefit of one or more beneficial owners identified on the letter of transmittal. No such fee shall be payable to a soliciting dealer if such soliciting dealer is required for any reason to transfer the amount of such fee to a depositing holder (other than itself). No such fee shall be paid to a soliciting dealer with respect to old junior subordinated debentures tendered for such soliciting dealer's own account. No broker, dealer, bank, trust company or fiduciary shall be deemed to be the agent of us, DTC, the dealer manager or the information agent for purposes of the exchange offer. For all purposes noted in all materials related to the exchange offer, the term "solicit" shall be deemed to mean no more than "processing old junior subordinated debentures tendered" or "forwarding to customers materials relating to the exchange offer." We will also, upon request, reimburse soliciting dealers for reasonable and customary handling and mailing expenses incurred by them in forwarding materials relating to the exchange offer to their customers. Transfer Taxes Owners who tender their old junior subordinated debentures for exchange will not be obligated to pay any transfer taxes. If, however, o new senior subordinated debentures are to be delivered to, or issued in the name of, any person other than the registered owner of the old junior subordinated debentures; or o old junior subordinated debentures are registered in the name of any person other than the person signing the letter of transmittal; or o a transfer tax is imposed for any reason other than the exchange of new senior subordinated debentures for old junior subordinated debentures in connection with the exchange offer; then the amount of any transfer taxes, whether imposed on the registered owner or any other persons, will be payable by the tendering holder. If satisfactory evidence of payment of such taxes or exemption from them is not submitted with the letter of transmittal, the amount of such transfer taxes will be billed directly to the tendering holder. No Appraisal Rights You will not have any right to dissent and receive an appraisal of your old junior subordinated debentures in connection with the exchange offer. Listing We intend to list the new senior subordinated debentures on the New York Stock Exchange. However, we do not expect the new senior subordinated debentures to be listed until after 30 days following the consummation of the exchange offer. Accounting Treatment of the Exchange Offer The new senior subordinated debentures will be recorded at the carrying amount of the old junior subordinated debentures less cash consideration given, if any, and that amount will be used to determine the effective interest rate of the new senior subordinated debentures. Fractional Debentures We will issue new senior subordinated debentures in denominations of $1,000 and integral multiples of $1,000. Any fractional principal amount of new senior subordinated debentures which a registered holder is entitled to receive as exchange consideration will be paid in cash. "Blue Sky" Compliance We are making this exchange offer to all holders of old junior subordinated debentures. We are not aware of any jurisdiction in which the making of the exchange offer is not in compliance with applicable law. If we become aware of any jurisdiction in which the making of the exchange offer would not be in compliance with applicable law, we will make a good faith effort to comply with any such law. If, after such good faith effort, we cannot comply with any such law, the exchange offer will not be made to, nor will tenders of old junior subordinated debentures be accepted from or on behalf of, the holders of old junior subordinated debentures residing in such jurisdiction. BUSINESS General We are a holding company whose subsidiaries, California Indemnity Insurance Company, Commercial Casualty Insurance Company, Sierra Insurance Company of Texas and CII Insurance Company are primarily engaged in writing workers' compensation insurance in nine Western and Midwestern states. Substantially all of our assets and our operations are conducted through our subsidiaries. In addition, we have other smaller subsidiaries that we consider immaterial to our overall results. We were acquired by Sierra on October 31, 1995 in a transaction treated as a pooling of interests. However, our old junior subordinated debentures remain solely our obligation and Sierra has not guaranteed the payment of the debentures. Our subsidiaries write workers' compensation insurance in the states of California, Colorado, Nevada, Texas, Nebraska, Kansas, Missouri, New Mexico and Utah primarily through independent insurance agents and brokers, and have licenses in 33 states and the District of Columbia and applications pending for licenses in other states. California, Colorado and Nevada represented approximately 77%, 8% and 7%, respectively, of our direct written premiums for the nine months ended September 30, 2000. We focus on writing lower-severity classes of workers' compensation insurance for primarily small and mid-sized employers although we actively pursue accounts of all sizes. This strategy allows us to direct our managed care expertise to employers that may lack the in-house resources needed to manage costs effectively and to return injured employees to work safely and quickly. These techniques include the use of specialized preferred provider networks, utilization review by our board certified occupational medicine physician and the employment of nurse case managers, medical bill reviewers, and job developers to facilitate early return to work. In particular, our Return to Work, or RTW, Program has brought a large number of injured workers back to the job more quickly and at a lower cost than would have otherwise been possible. By focusing primarily on small and mid-sized employers, we seek to target under-served segments of the workers' compensation market and avoid the price competition associated with large accounts. As of September 30, 2000, we had 16,155 policies in force and an average policy size of approximately $11,700. The following table sets forth the percentages of our written premiums in force on June 30, 2000, December 31, 1999, and July 31, 1998 attributable to the listed risk classifications identified as the policy holders governing class:
June 30, 2000 Dec. 31, 1999 July 31, 1998 ----------------------- ---------------------- ----------------------- Construction 31.60% 28.41% 26.63% Manufacturing 15.61% 15.97% 14.69% Service Industry 12.81% 12.82% 12.27% Agriculture 11.93% 11.80% 11.39% Other (1) 28.05% 31.00% 35.02% ------ ------ ------ Total 100.00% 100.00% 100.00%
(1) Includes all other risk classifications insured by us, none of which accounted for more than 9.5% of our written premiums in force as of any of the above dates. Underwriting Prior to insuring a particular risk, we review, among other factors, the employer's prior loss experience and other pertinent underwriting information. Additionally, we determine whether the employer's employment classifications are among the classifications that we have elected to insure and if the amounts of the premiums for the classifications are within our guidelines. We review these classifications periodically to evaluate whether they are profitable. Of the approximately 550 employment classifications in California, we are willing to insure approximately two-thirds. The remaining classifications are either excluded by our reinsurance treaty or are believed by us to be too hazardous or not profitable. In addition, we increase our requirements for certain classifications to increase the likelihood of profitability. Once an employer has been insured by us, our loss control department may assist the insured in developing and maintaining safety programs and procedures to minimize on-the-job injuries and industrial health hazards. The safety programs and procedures vary from insured to insured. Depending upon the size, classifications and loss experience of the employer, our loss control department will periodically inspect the employer's places of business and may recommend changes that could prevent industrial accidents. In addition, severe or recurring injuries may also warrant on-site inspections. In certain instances, members of our loss control department may conduct special educational training sessions for insured employees to assist in the prevention of on-the-job injuries. For example, employers engaged in contracting may be offered a training session on general first aid and prevention of injuries from specific work exposures. Claims Our claims operation is organized into a centralized claims/managed care service office in Las Vegas, Nevada, and four regional claims service offices. Major claims, those of high severity, complex nature and/or which are expected to exceed applicable reinsurance retention levels, are handled directly, or supervised, by the reinsurance claims staff. Our approach to claims administration relies upon a high level of interaction with the injured worker and the insured to resolve claims in an efficient and cost effective manner. Claims personnel act as the contact point with the insured and refer the claim to the appropriate support services within our managed care and Return To Work, or RTW, divisions. We have sought to reduce medical and indemnity cost by minimizing litigation and litigation expense, returning workers to work safely and quickly, and having access to medical attention at competitive prices. We have sought to accomplish this by: o using statewide medical provider networks, the members of which have agreed to provide hospital and physician services at reduced fee schedules; o utilizing in-house medical bill review services which advise us of any excess charges submitted by providers; o facilitating early return to work and managing vocational rehabilitation costs; o improving customer service to allow for faster reporting; and o outsourcing legal defense. Use of Managed Care. We use managed care techniques to manage claim costs. Except where limited by law, our managed care strategy directs injured workers to preferred provider organizations, which we refer to as PPO's, to take advantage of rates negotiated by the PPO's with participating providers and to utilize doctors who understand the procedures and communication required to allow injured workers to return to work safely and quickly. This strategy has led us to spend substantially less on medical costs than otherwise payable under state established fee schedules. From 1995 to September 30, 2000, our use of PPO's as a percentage of total medical bills where a saving was achieved, known as "PPO penetration", increased from 25% to 50%. In addition to increasing PPO penetration we also increased the savings from state established fee schedules to 33% through September 30, 2000, from 22% of such schedules for 1995. Management of the medical portion of any claim assists the employer in managing the cost of the indemnity benefit. Our staff of nurses evaluates lost-time cases and directs the injured employee to preferred providers. We utilize a board certified occupational medicine physician as our medical director to provide prospective, concurrent, and retrospective review of inpatient admissions. The medical director can communicate directly with treating physicians to assist with the direction of appropriate and timely medical care. By requesting the treating provider to obtain authorization prior to the administration of medical care, we seek to receive medical justification for proposed treatments, which often leads to more accurate medical diagnoses. We have used the medical authorization process to reduce the costs associated with over-treating or under-treating by medical care providers. In-house Medical Bill Review. We use in-house medical bill reviewers to manage costs. By performing the bill review work in-house, we have increased our bill review savings as a percentage of state fee schedules from 25% for 1995 to 38% for the nine months ended September 30, 2000. Return to Work, or "RTW", Program. A critical component of our claims administration approach and our accompanying efforts to reduce indemnity costs is our RTW Program. The program assigns certain claims to a RTW technician, who contacts the injured worker's physician and employer to ascertain functional capacity restrictions and determines whether the employee can perform modified or temporary work. In an unmanaged environment, the doctor typically relies upon the injured worker's description of job duties and bases the medical impairment and disability status upon that subjective description. Such reliance on the worker's description can lead to increased amounts of lost time and, therefore, much higher indemnity payments by us. The RTW technician's task is to work with the doctor and the employer to formally define job duties and to compare those against functional capacity restrictions. This process allows the RTW technician to determine the extent of job disability and the need for vocational rehabilitation as required by the state. By being directly involved with the assessment process, we not only strive to obtain an objective disability diagnosis, but also provide a valuable service to our smaller insureds, who typically do not have formalized processes for return to work. Customer Service. Early claims reporting allows us to direct the injured worker to in-network medical care providers, to enroll those workers in the RTW program, and to reduce the chance of litigation. We have instituted a 24-hour per day, seven days per week, toll free "800" telephone number that allows employers to notify us of a potential claim as quickly as possible. Our customer service call center directs policyholders and injured workers to the nearest preferred health care facility and provides assistance to claims examiners by asking specific investigative questions which allow the examiner to make prompt claim decisions. The customer service representatives additionally answer questions relating to provider bill status, pharmacy authorization, and agent/employer requests for information. Legal Defense. In April 1997, we discontinued our in-house claims legal defense unit in Southern California and entered into a five-year contract with a law firm specializing in the defense of workers' compensation claims. This legal arrangement defines roles for the attorneys and claims personnel to maximize efficient handling of litigated claims. Competition Workers' compensation is a statutory system that requires an employer to provide its employees with medical care and other specified benefits for work-related injuries, even though the injuries may have resulted from the negligence or wrongs of a person, including the employee. Employers typically purchase workers' compensation insurance to provide these benefits. The benefits payable are generally established by statute. The California workers' compensation insurance industry is extremely competitive. Approximately 185 companies wrote workers' compensation insurance in California in 1999, including the State Compensation Insurance Fund, which is the largest writer in California. Many of these companies have been in business longer, have a larger volume of business, offer a more diversified line of insurance coverage, have greater financial resources and have greater distribution capability than us. We believe that the dominant competitor in the industry is the State of California Compensation Insurance Fund. We concentrate on insuring workers' compensation accounts in the small to medium-size range, where we compete primarily on the basis of service and where policyholder dividends are not a significant factor. Based on 1999 direct written premiums, we were the 13th largest writer of workers' compensation insurance in California, with a 2% market share. Our insurance subsidiaries are currently rated "B++" by A.M. Best. The following table provides an illustration of our subsidiary, California Indemnity Insurance Company, and the top 10 workers' compensation writers in the state of California for 1999: California Workers' Compensation Market For the Year Ended December 31, 1999 (dollars in millions)
Direct Written Insurer Premiums Market Share State Compensation Fund $ 1,244.7 21.6 Fremont Comp Insurance Group* 520.4 9.0 482.2 8.4 Superior National Insurance Group* Liberty Mutual Insurance 463.0 8.0 Fireman's Fund/Allianz 232.6 4.0 Kemper Insurance Companies 213.7 3.8 Farmers Insurance Group 184.6 3.2 Reliance Insurance* 184.1 3.2 Great American P&C 173.3 3.0 Legion Insurance Co. 173.0 3.0 California Indemnity Insurance Company 120.5 2.0
Source: California Workers' Compensation Institute Bulletin No. 00-15 * These three companies have significantly reduced their writings in California or announced their intent to do so. Fremont and Superior each had an "E" (under regulatory supervision) rating by A.M. Best as of December 10, 2000. Reliance had a "D" (poor) rating by A.M. Best as of December 10, 2000. Prior to 1995, California law set minimum premium rates. This minimum rate law was repealed by the California legislature with policies issued or renewed on or after January 1, 1995. From 1995 until the end of 1999, our pricing declined significantly as competitors sought to write more business by cutting their prices. Beginning in December 1999 we began achieving rate increases on renewing policies. This increasing rate trend has continued through September 2000. In other states in which we are currently writing business, competition for workers' compensation insurance is primarily driven by pricing, dividend plans and agents' commission. In these states, the National Council on Compensation Insurance, or NCCI, is usually the designated rating organization. The NCCI accumulates statistical information and recommends pure loss cost rates to each state's department of insurance who has final approval authority. We then add loss cost multipliers or expense loads to derive premium rates for each filed company. Rating plans in NCCI states are more "standardized" pricing models based upon plans (algorithms) developed by the NCCI and approved by departments of insurance. Both Colorado and Nevada have competitive and dominant state insurance funds who represent the major competition in their respective states. In Colorado, the state fund is Pennacol Insurance Company. In Nevada, it is Employers Insurance Company of Nevada, formerly a state fund but now a private mutual insurer. In addition to these two organizations, there are approximately 200 other companies competing for business in states outside of California. The major competitive tool in NCCI states is the use of participating policies, which grant policyholders' dividends, and policies with retrospective rated premium. We currently write participating policies in Colorado, Nevada, Missouri, Nebraska, New Mexico and Kansas. Nevada is scheduled to change to an open rating environment from a minimum rating environment beginning July 2001. Losses and Loss Adjustment Expenses Often, several years may elapse between the occurrence of a loss and the final settlement of the loss. To recognize liabilities for unpaid losses, we establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses for insured events. We also establish reserves for events that have been incurred but have not yet been reported to us, which we refer to as "incurred but not reported" or "IBNR". When a claim is reported, our claims personnel initially establish reserves on a case-by-case basis for the estimated amount of the ultimate payment. These estimates reflect the judgment of the claims personnel based on their experience and knowledge of the nature and value of the specific type of claim and the available facts at the time of reporting as to severity of injury and initial medical prognosis. Included in these reserves are estimates of the expenses of settling claims, including legal and other fees. Claims personnel adjust the amount of the case reserves as the claim develops and as the facts warrant. IBNR reserves are established for unreported claims and loss development relating to current and prior accident years. In the event that a claim that occurred during a prior accident year was not reported until the current accident year, the case reserve for such claim typically will be established out of previously established IBNR reserves for that prior accident year. The National Association of Insurance Commissioners requires that we submit a formal actuarial opinion concerning loss reserves with each statutory annual report. The annual report must be filed with each applicable state department of insurance on or before March 1 of the succeeding year. The actuarial opinion must be signed by a qualified actuary as determined by the California Insurance Commissioner. We retain the services of a qualified independent actuary to review our loss reserves. California Indemnity, Commercial Casualty, Sierra Insurance Company of Texas and CII Insurance Company all received an unqualified opinion from that actuary as of December 31, 1999. After our June 30, 2000 review of our loss reserves, we increased our loss reserves by a net of $20.2 million. We and an independent actuary test the adequacy of our reserves using generally accepted actuarial methods. Both paid loss and incurred loss methods are used to estimate the amount of the ultimate reserves. We also test our reserves by comparing our paid losses and incurred losses to similar data provided by the California Workers Compensation Insurance Rating Bureau for all California workers' compensation insurance companies. We review the adequacy of our reserves with our independent actuary periodically and consider external forces such as changes in the rate of inflation, the regulatory environment, the judicial administration of claims, medical costs and other factors that could cause actual losses and LAE to change. The actuarial projections include a range of estimates reflecting the uncertainty of projections. Management evaluates the reserves in the aggregate, based upon the actuarial indications and makes adjustments where appropriate. Our consolidated financial statements provide for reserves based on the anticipated ultimate cost of losses. The following table sets forth the number of claims reported to us for the nine month accident period ended September 30, 2000 and accident years ended December 31, 1999, 1998 and 1997, and related direct earned premiums and claims frequency, or the number of claims per million dollars of direct earned premium.
Nine months ended September 30, Year ended December 31, 2000 1999 1998 1997 Number of claims reported during the period ended 15,600 17,200 18,600 18,100 Direct earned premiums (in millions) 150.1 146.7 154.0 134.2 Claims frequency 103.9 117.2 120.8 134.8
- --------------------------------------------------------------------------- The following table sets forth, for the nine months ended September 30, 2000 and the years ended December 31, 1999, 1998, and 1997, the cumulative loss ratio net of reinsurance for each accident year or nine-month period and also shows the loss "development" for each of these accident periods' loss ratios.
Cumulative Loss Ratios Nine months ended Cumulative Loss Ratios September 30, Year ended December 31, Accident Year 2000 1999 1998 1997 1995 and prior 72.32% 72.05% 73.76% 76.60% 1996 93.22% 89.60% 85.72% 83.84% 1997 96.43% 90.42% 84.21% 79.18% 1998 85.87% 83.64% 77.45% 1999 66.11% 62.13% 2000 70.20%
- ------------------------------------------------------------------------------ The liabilities for losses and loss adjustment expense, which we refer to as LAE, are determined using loss evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of trends in claim severity and frequency and are continually reviewed and adjusted to reflect new experience and information, as it becomes known. Such adjustments, if any, are reflected in current operations. Notwithstanding the fact that the claims for which reserves are established may not be paid for many years, the reserves for losses and LAE payments are not discounted, except to calculate the liability for federal income taxes. The anticipated price or cost increases due to inflation are considered in estimating ultimate claim costs. Historical trends, adjusted to reflect anticipated changes in underwriting standards, policy provisions and general economic trends, provide the basis for predicting the severity of future claims. Actual developments are monitored and anticipated trends are modified, if necessary. The following table provides a reconciliation of beginning and ending liability balances for the nine months ended September 30, 2000 and 1999 and years ended December 31, 1999, 1998 and 1997. Reconciliation of Liability for Loss and Loss Adjustment Expenses (in thousands)
Nine months ended September 30, Year ended December 31, 2000 1999 1999 1998 1997 Net Beginning Loss and LAE Reserve $134,305 $174,467 $174,467 $181,643 $172,100 Net Provision for Insured Events Incurred in: Current Year 63,843 36,061 51,540 103,990 102,302 Prior Years 20,177 (1,248) 9,920 (9,643) (8,970) ------ ------- ----- ------- ------- Total Net Provision 84,020 34,813 61,460 94,347 93,332 ------ ------ ------ ------ ------ Net Payments for Loss and LAE Attributable to Insured Events Incurred In: Current Year 15,763 12,836 21,206 29,591 26,812 Prior Years 49,893 64,668 80,416 71,932 56,977 ------ ------ -------- -------- ------- Total Net Payments 65,656 77,504 101,622 101,523 83,789 ------ ------ ------- ------- ------- Net Ending Loss and LAE Reserve 152,669 131,776 134,305 174,467 181,643 Reinsurance Recoverable 189,233 81,367 110,089 37,797 21,056 ------- -------- ------- -------- -------- Gross Ending Loss and LAE Reserve $341,902 $213,143 $244,394 $212,264 $202,699 ======== ======== ======== ======== ========
The following table discloses our development of the liability for losses and LAE for the nine months ended September 30, 2000 and the ten years ended December 31, 1999. ANALYSIS OF LOSSES AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT (in thousands)
September Year ended December 31, 30, 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 Losses and LAE Reserve...... 341,902 $244,394 $212,264 $202,699 $187,776 $182,318 $190,962 $200,356 $178,460 $112,749 $ 67,593 Less Reinsurance Recoverables (1)......... 189,233 110,089 37,797 21,056 15,676 25,871 29,342 25,841 20,207 --------- --------- ---------- -------- ------ -------- -------- -------- ________ Net Loss and LAE Reserves... 152,669 134,305 174,467 181,643 172,100 156,447 161,620 174,515 158,253 Net Reserve Re-estimated as of (2) 1 Year Later................ 154,482 184,386 172,000 163,130 141,163 139,741 160,562 154,388 140,815 83,841 2 Years Later............... 201,265 173,596 146,987 132,193 125,279 141,100 147,167 142,447 96,011 3 Years Later............... 187,491 140,563 113,766 117,792 126,483 134,747 143,433 97,142 4 Years Later............... 146,692 102,652 102,955 122,517 132,193 137,143 97,942 5 Years Later............... 104,400 95,997 114,443 131,112 135,249 94,852 6 Years Later............... 96,530 112,284 127,258 135,299 93,561 7 Years Later............... 112,506 125,936 133,729 93,672 8 Years Later............... 126,163 132,696 92,851 9 Years Later............... 132,906 92,104 10 Years Later.............. 92,226 Cumulative Net Paid as of (2): 1 Year Later................ 49,893 80,416 71,933 56,977 45,731 44,519 50,210 50,360 57,611 39,118 2 Years Later............... 115,256 117,794 91,765 70,854 68,619 79,788 84,465 89,177 65,165 3 Years Later............... 137,737 113,054 83,674 80,645 94,865 104,569 108,849 76,988 4 Years Later............... 122,386 91,115 86,381 102,395 114,293 120,539 83,822 5 Years Later............... 94,557 89,601 106,012 119,462 126,100 87,618 6 Years Later............... 91,074 107,850 122,000 129,060 89,607 7 Years Later............... 108,785 123,291 130,649 90,721 8 Years Later............... 123,956 131,346 91,354 9 Years Later............... 131,744 91,598 10 Years Later.............. 91,745 Cumulative (Deficiency) Redundancy (2)........... (20,177) (26,799) (5,848) 25,408 52,047 65,090 62,009 32,090 (20,157) (24,633) Net Reserve................. 152,669 134,305 174,467 181,643 172,100 156,447 161,620 174,515 Reins. Recoverables......... 189,233 110,089 37,797 21,056 15,676 25,871 29,342 25,841 ------- --------- ------ --------- ------ -- ------ -- ------ ------- Gross Reserve............... $341,902 $244,394 $212,264 $202,699 $187,776 $182,318 $190,96 $200,356 ======== ======== ======== ======== ======== ======== ======== ======== Net Re-estimated Reserve......... 154,482 201,265 187,491 146,692 104,400 96,530 112,506 Re-estimated Reins. Recoverables............. 135,654 45,866 21,487 16,049 26,712 29,874 26,180 ------- -------- ------- -------- -------- -------- -------- Gross Re-estimated Reserve.................. 290,136 247,131 208,978 162,741 131,112 126,404 138,686 -------- -------- -------- ------- ------- ------- ------- Gross Cumulative (Deficiency) Redundancy............... $(45,742)$(34,867)$ (6,279) $ 25,035 $51,206 $ 64,558 $ 61,670 ========= ========= ========= ======== ======= ======== ========
(1) Amounts reflect reinsurance recoverable under prospective reinsurance contracts only. Reinsurance recoverables on unpaid losses and LAE are shown as an asset on the balance sheets at September 30, 2000 and December 31, 1999 and 1998. (2) The last amount in each column and the cumulative (deficiency) redundancy represent development through nine months ended September 30, 2000. Our average cost per claim has increased each year since 1995. The majority of our claims occur in California. The entire California workers' compensation industry has been adversely affected by higher claim severity. The average ultimate loss per indemnity claim for California increased 58% from accident year 1995 to accident year 1999, according to a published estimate of the California Workers Compensation Insurance Rating Bureau in October 2000. Two of the factors influencing this increase are medical inflation and adverse court decisions related to medical control of claimant's treatment. - ------------------------------------------------------------------------------- Unallocated loss adjustment expense reserves are established for the estimated costs related to the general administration of the claims adjustment process. We review the adequacy of our reserves on a periodic basis and consider external forces such as changes in the rate of inflation, the regulatory environment, the judicial administration of claims, medical costs and other factors that could cause actual losses and loss adjustment expenses to change. Reserves are reviewed with our independent actuary at least annually. The actuarial projections include a range of estimates reflecting the uncertainty of projections. Management evaluates the reserves in the aggregate, based upon the actuarial indications, and makes adjustments where appropriate. Our financial statements provide for reserves based on the anticipated ultimate cost of losses. Investments As of September 30, 2000, our bond and preferred stock portfolio is invested primarily in high quality investment grade securities, which represent approximately 98% of total bond and preferred stock investments. The total bond and preferred stock portfolio is comprised of approximately 32% in U.S. Treasury securities; approximately 33% in U.S. Government-sponsored Agency securities; approximately 6% in AAA-rated corporate bonds; approximately 20% in AA-rated corporate bonds; approximately 7% in A-rated corporate bonds; and approximately 2% in BAA-rated corporate bonds. In addition to our cash and cash equivalents, preferred stocks, and fixed income bond portfolio, other investments include mortgage loans with a book value of $16.5 million and a real estate limited partnership with a book value of $7.1 million. The mortgage loan investments are comprised of approximately $10.3 million in two commercial mortgages extended to Sierra and a subsidiary of Sierra; approximately $4.6 million in relocation mortgages extended to our current and former employees prior to the 1995 merger of Sierra and us; and approximately $1.6 million in commercial mortgages extended to third parties. The real estate limited partnership represents our interest in the partnership which owns our Las Vegas headquarters. Approximately $22 million of our investment assets as of September 30, 2000 are booked as "assets held to maturity" according to FAS 115. Assets held to maturity are carried at amortized cost; changes in the market value of these assets do not affect their book value for reporting purposes under accounting principles generally accepted in the United States of America. The following table reflects investments, interest earned thereon and the average annual yield on investments for the periods indicated:
Nine Months Ended September 30, Years Ended December 31, 2000 1999 1998 1997 (dollars in thousands) Total cash, cash equivalents and invested assets at end of period $231,604 $226,572 $283,509 $278,479 Net investment income including net realized gains and losses before taxes 10,757 15,395 20,229 17,361 Average annual yield on investment - ----------------------------------------------- portfolio (before realized gains and losses and taxes) 6.5% 6.2% 6.5% 6.2%
The following table sets forth information concerning the composition of our investment portfolio, at December 31, 1999:
Percent of Amount Portfolio Fixed maturities, at fair value: (dollars in thousands) U.S. government and government agencies $114,358 54.7 AAA 14,320 6.9 AA 43,145 20.7 A 13,395 6.4 Less than A 4,107 2.0 ----------- ------- Total fixed maturities, at fair value $189,325 90.7 Equity securities, at fair value 3,486 1.7 Mortgage loans receivable 9,375 4.5 Real estate partnership 6,559 3.1 ----------- ------- Total investments $208,745 100.0 ======== =====
The following table sets forth the contractual maturity profile of our debt and mortgage loan investments at December 31, 1999:
Fair Value Percent of Maturity Amount Portfolio - -------- ------ --------- (dollars in thousands) One year or less $14,441 7.3 More than one year, through five years 51,085 25.7 More than five years, through ten years 15,112 7.6 More than ten years, through fifteen years 18,408 9.3 More than fifteen years 99,654 50.1
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. Reinsurance Our insurance subsidiaries purchase reinsurance to reduce our liability on individual policies and claims and catastrophic losses. As of September 30, 2000 we had over $211 million of reinsurance receivables from our reinsurers. A single reinsurer accounts for approximately 87.6% of this amount. Substantially all of the receivables are due from reinsurers rated A+ by A.M. Best. Effective July 1, 1998, all claims with dates of injury occurring on or after that date are reinsured under a quota share and excess of loss agreement with one A+ rated reinsurer, referred to as "low level reinsurance." The low level reinsurance provides quota share protection for 30% of the first $10,000 of each loss, and excess of loss protection of 75% of the next $40,000 of each loss, and 100% of the next $450,000 on a per occurrence basis. The maximum net loss retained on any one claim ceded under this treaty is $17,000. This agreement continued until June 30, 2000, when we executed an option for a twelve month extension relating to the run-off of policies in force as of June 30, 2000. In addition to the low-level reinsurance, effective January 1, 2000 we entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2003. The reinsurer has a limited ability to cancel this treaty on each anniversary of inception during that period. Effective July 1, 2000, we entered into a reinsurance contract that provides $250,000 of coverage for workers' compensation claims in excess of $250,000 per occurrence. The contract is in effect for claims occurring on policies incepting July 1, 2000 and thereafter. The reinsurer has the ability to cancel the treaty if written notice is provided 90 days prior to each anniversary of inception. Marketing Our insurance policies are sold primarily through independent insurance agents and brokers, who may also represent other insurance companies. We believe that independent insurance agents and brokers choose to market our insurance policies because of the quality of service that we provide, the commissions we pay and the price of the insurance product. We employ full-time employees as marketing representatives to make personal contacts with agents and brokers, to maintain regular communication with them, to advise them of our services and products, and to recruit additional agents and brokers. We currently have relationships with approximately 900 agents and brokers and pay our agents and brokers commissions based on a percentage of the gross written premium produced by such agents and brokers. In 2001, we anticipate a reduction in the number of agents resulting from more stringent volume and profitability standards we imposed. We maintain standard commission plans that vary by state for our agents and brokers. In addition to the standard commission plans, agents and brokers may be eligible to receive additional commissions in certain instances. Commissions, including additional commissions if any, are negotiated on an individual policy basis. No one agent or broker accounted for more than 1.7% of our total premiums in force on September 30, 2000, and no one policy accounted for more than 0.6% of our total premiums in force on September 30, 2000. Our top 10 agents and brokers accounted for 12.2% of our total premiums in force September 30, 2000. From time to time, we advertise and participate in insurance trade association functions to maintain existing relationships and develop new ones. Geographic Distribution of Premiums and Policy The following tables set forth information concerning the percentages of premiums and policies in force with us by geographic area as of September 30, 2000, and as of December 31, 1999, 1998, and 1997. In force premiums are the total estimated annual premiums of all policies in force at a point in time.
September 30, December 31, 2000 1999 1998 1997 ---- ---- ---- ---- Percent of premiums in force: California 77% 80% 83% 83% Nevada 8 4 0 0 Colorado 8 8 8 10 Other States 7 8 9 7 ------------------ ------------ ------------ ------------ ------------------ ------------ ------------ ------------ Total 100% 100% 100% 100% ================== ============ ============ ============ ================== ============ ============ ============ Total premiums in force (in thousands): $189,557 $154,963 $132,789 $128,840 Percent of policies in force: California 74% 79% 80% 84% Nevada 7 3 0 0 Colorado 7 6 6 6 Other States 12 12 14 10 ------------------ ------------ ------------ ------------ ------------------ ------------ ------------ ------------ Total 100% 100% 100% 100% ================== ============ ============ ============ ================== ============ ============ ============ Total policies in force 16,155 15,485 12,624 11,779
- ------------------------------------------------------------------------------- Government Regulation and Recent Legislation We are subject to extensive governmental regulation and supervision in each state in which we conduct workers' compensation business. The primary purpose of such regulation and supervision is to provide safeguards for policyholders and injured workers rather than protect the interests of shareholders or creditors. The extent and form of the regulation may vary, but generally has its source in statutes that establish regulatory agencies and delegate to the regulatory agencies broad regulatory, supervisory and administrative authority. Typically, state regulations extend to such matters as licensing companies; restricting the types or quality of investments; requiring triennial financial examinations and market conduct surveys of insurance companies; licensing agents; regulating aspects of a company's relationship with its agents; restricting use of some underwriting criteria; regulating premium rates, forms and advertising; limiting the grounds for cancellation or nonrenewal of policies; solicitation and replacement practices; and specifying what might constitute unfair practices. In the normal course of business, we and the various state agencies that regulate our activities may disagree on interpretations of laws and regulations, policy wording and disclosures or other related issues. These disagreements, if left unresolved, could result in administrative hearings and/or litigation. We attempt to resolve all issues with the regulatory agencies, but are willing to litigate issues where we believe we have a strong position. The ultimate outcome of these disagreements could result in sanctions and/or penalties and fines assessed against us. Currently, there are no litigation matters pending with any department of insurance. State holding company acts also regulate changes in control of insurance holding companies, such as the transactions and dividends between an insurance company and its parent or affiliates. Although the specific provisions vary, holding company acts generally prohibit a person from acquiring a controlling interest in an insurer unless the insurance authority has approved the proposed acquisition pursuant to applicable regulations. In many states, including California, where the insurance subsidiaries are incorporated, "control" is presumed to exist if 10% or more of the voting securities of the insurance holding company are owned or controlled by one person or entity. In addition, the insurance authority may find that "control" in fact does or does not exist where one person or entity owns or controls either a lesser or greater amount of securities. The holding company acts also impose standards on certain transactions with related companies and individuals which include, among other requirements, that all transactions are to be fair and reasonable and that transactions exceeding specified limits receive prior regulatory approval. Typically, states mandate participation in insurance guaranty associations, which assess solvent insurance companies in order to fund claims of policyholders of insolvent insurance companies. Under this arrangement, insurers can be assessed up to 1%, or 2% in certain states, of premiums written for workers' compensation insurance in that state each year to pay losses and LAE on covered claims of insolvent insurers. In California and certain other states, insurance companies are allowed to recoup such assessments from policyholders while several states allow an offset against premium taxes. The California Insurance Guarantee Association has issued an assessment as a result of the insolvency of the insurers owned by Superior National Insurance Group. The assessment is 1% of 1999 written premium to be paid in two installments on December 31, 2000 and June 30, 2001. The payments of approximately $1.2 million will be recouped during 2001 and 2002 through assessments to policyholders. It is likely that Guarantee Fund assessments related to this insolvency will continue. Besides state insurance laws, we are subject to general business and corporation laws, federal and state securities laws, consumer protection laws, fair credit reporting acts and other laws regulating the conduct and operation of our subsidiaries. Dividends Our insurance subsidiaries are restricted by state law as to the amount of dividends that can be declared and paid to us. Moreover, insurance companies domiciled in California and Texas generally may not pay extraordinary dividends without providing the state insurance commissioner with 30 days' prior notice, during which period the commissioner may disapprove the payment. An "extraordinary dividend" is generally defined as a dividend whose fair market value together with that of other dividends or distributions made within the preceding 12 months exceeds the greater of ten percent of the insurer's surplus as of the preceding December 31 or the income of such insurer for the 12-month period ending on the preceding December 31. In addition, our insurance subsidiaries may not pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year exceeds the amount shown as unassigned funds (reduced by any unrealized gains included in such amount) on the insurer's statutory statement as of the previous December 31. California Indemnity, which is our only direct subsidiary, cannot currently pay any dividends to us without the prior approval of the California Department of Insurance. We are not in a position to assess the likelihood of obtaining future approval for the payment of dividends other than those specifically allowed by law in each of our subsidiaries' state of domicile. No prediction can be made as to whether any legislative proposals relating to dividend rules in the domiciliary states of our subsidiaries will be made or adopted in the future, whether the insurance departments of such states will impose either additional restrictions in the future or a prohibition on the ability of our regulated subsidiaries to declare and pay dividends or as to the effect of any such proposals or restrictions on our regulated subsidiaries. Deposits and Other Requirements Our insurance subsidiaries are required by state regulatory agencies to maintain certain deposits for the benefit of policyholders or claimants and must also meet certain net worth and reserve requirements. Our insurance subsidiaries have assets on deposit for the benefit of policyholders in various states totaling $152,356,000 at September 30, 2000. Legal Proceedings We are subject to various claims and other litigation in the ordinary course of our business. Such litigation includes workers' compensation claims by injured workers and by providers for payment for medical services rendered to injured workers. In the opinion of our management, the ultimate resolution of pending legal proceedings is not expected to have a material adverse effect on our financial condition. Employees At September 30, 2000, we had a total of 404 full-time equivalent employees, which we refer to as FTE's, grouped into underwriting, claims, marketing and administrative functions. With the completion of our 1997-1998 restructuring and the commencement of Nevada operations in 1999, 157.5 of our FTE's are located at the headquarters in Las Vegas, while 143.3 work at the Pleasanton, California office, and 63 work at the Burbank, California office. In addition, we have full-service branch offices in Denver, Colorado and Dallas, Texas, which employ 20 and 16 FTE's respectively. We have two FTE's in Reno, Nevada and two FTE's in Gladstone, Missouri. Facilities Our principal executive offices and the Las Vegas, Nevada branch office are comprised of 52,231 square feet of office space leased through December 31, 2008. Our Northern California branch office, comprised of approximately 34,975 square feet of office space leased through October 31, 2002, is located in Pleasanton, California. Our Southern California branch office, comprised of 23,250 square feet of office space leased through September 30, 2003, is located in Burbank, California. We also lease space in other locations where we have operations and believe our facilities are adequate for our current needs. SELECTED FINANCIAL AND OTHER DATA The table below presents our selected consolidated financial information for the periods indicated and at the end of these periods. The consolidated financial statement information as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998 and 1997 was derived from our consolidated financial statements included elsewhere in this prospectus. These financial statements were prepared in accordance with accounting principles generally accepted in the United States of America, and were audited by Deloitte & Touche LLP. The consolidated financial information at December 31, 1997 and for the year ended December 31, 1996 was derived from our unaudited consolidated financial statements for that year and the consolidated financial information for the year ended December 31, 1995 was derived from our audited consolidated financial statements for that year. The consolidated financial statement information at September 30, 2000 and for the nine months ended September 30, 2000 and 1999 has been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The unaudited consolidated financial statements have been prepared by us on a basis consistent with the audited financial statements and included all normal recurring adjustments necessary for a fair presentation of the information set forth therein. Operating results for the nine months ended September 30, 2000 are not necessarily indicative of the results that will be achieved for future periods, including the entire year ending December 31, 2000.
Nine Months Ended September 30, Year Ended December 31, (dollars in (dollars in thousands) thousands) 2000 1999 1999 1998 1997 1996 1995 Income Statement Data: Direct written premiums $153,034 $106,291 $148,824 $153,914 $135,580 $126,724 $94,953 Net written premiums $93,857 $60,833 $85,097 $134,147 $130,597 $121,555 $90,926 Net earned premiums $90,951 $58,254 $82,955 $134,274 $129,197 $120,951 $90,584 Net investment income and net realized gains and losses 10,757 11,901 15,395 20,229 17,361 18,689 14,454 Other revenue 0 0 0 0 0 0 3,547 Total revenues 101,708 70,155 98,350 154,503 146,558 139,640 108,585 Total costs and expenses 115,715 58,301 91,255 136,625 135,745 129,010 99,502 (Loss) income from continuing operations before federal income taxes, discontinued operations, and extraordinary gain (14,007) 11,854 7,095 17,878 10,813 10,630 9,083 Federal income tax (benefit) expense (4,902) 4,815 3,602 4,166 272 (896) (750) (Loss) income from continuing operations before discontinued operations and extraordinary gain (9,105) 7,039 3,493 13,712 10,541 11,526 9,833 Net loss from discontinued operations 0 0 0 0 0 0 (6,600) Extraordinary gain from debt extinguishment, net of tax 654 0 111 48 2 58 0 Net (loss) income ($8,451) $7,039 $3,604 $13,760 $10,543 $11,584 $3,233 Combined Ratios: GAAP Combined Ratio: Loss ratio 92.38% 59.76% 74.08% 70.26% 72.24% 72.69% 59.72% Underwriting expense ratio(1) 28.59% 35.61% 31.45% 28.45% 29.67% 30.54% 44.75% Combined ratio 120.97% 95.37% 105.53% 98.71% 101.91% 103.23% 104.47% Statutory Combined Ratio: Loss ratio 96.32% 61.07% 78.73% 71.03% 72.24% 72.69% 59.72% Underwriting expense ratio 30.10% 37.53% 32.48% 28.92% 29.56% 30.48% 40.89% Combined ratio 126.42% 98.60% 111.21% 99.95% 101.80% 103.17% 100.61% Balance Sheet Data: Total cash, cash equivalents and $231,604 $238,864 $226,572 $283,509 $278,479 $261,846 $244,396 invested assets Total assets 492,852 380,766 404,338 379,880 343,022 315,895 303,151 Total debt 47,059 51,196 50,498 51,251 54,467 54,497 56,800 Total liabilities 434,338 309,669 338,285 305,933 285,452 270,975 260,977 Total stockholder's equity 58,514 71,097 66,053 73,947 57,570 44,920 42,174
- ----------------------------------- =============================================================================== (1) Includes policyholders'dividend ratio of 1.83% for the nine months ended September 30, 2000. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ---------------------------------------------------------------------------- You should read the following discussion in conjunction with the consolidated financial statements of CII Financial and the related notes, which appear elsewhere in this prospectus and Annex 1 to this prospectus which contains a glossary of terms. Any forward-looking statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this prospectus need to be considered in connection with the Risk Factors discussed earlier in this prospectus. - ---------------------------------------------------------------------------- Our operating results are primarily the results of our workers' compensation insurance subsidiaries and consist of underwriting profit/loss, net investment income, net realized gains/losses, other income/expense, interest expense on the old junior subordinated debentures, and income taxes. Results of Operations for the Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999 Our income before taxes decreased by $25.9 million for the nine months ended 2000 compared to 1999. The major components of the change were: o $32.7 million increase in net earned premiums; o $0.9 million decrease in investment income; o $49.2 million increase in loss and loss adjustment expenses; o $2.9 million increase in policy acquisition costs; and o $2.4 million increase in general, administrative and other expenses. Revenues: Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 45% for the nine months ended September 30, 2000 compared to 1999. The increase was largely due to a larger amount of written premiums resulting from production growth and higher premium rates. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums increased by 44% due primarily to growth in California and Nevada. Partially offsetting the growth in direct written premiums was an increase in premiums ceded to reinsurers, which increased by 30%. The growth in ceded reinsurance premiums was lower than the growth in direct written premiums primarily due to the expiration of one of our reinsurance agreements on July 1, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded. The following table shows a comparison of direct written premiums, by state, for the nine months ended September 30, 2000 and 1999: Nine Months Ended September 30, 2000 % of total 1999 % of total (dollars in millions) California $117.6 76.9% $ 86.5 81.4% Colorado 12.4 8.1 9.1 8.6 Nevada 11.3 7.4 0.8 0.7 Texas 5.6 3.6 5.5 5.2 Other States 6.1 4.0 4.4 4.1 Total $153.0 100.0% $106.3 100.0% - ------------------------------------------------------------------------------- As shown in the preceding table, our largest premium state, California, had the largest increase in written premiums. For the nine months ended September 30, 2000, we have obtained an average premium rate increase on renewing policies of approximately 25%. The market-pricing environment in California has become more favorable since 1999 in reaction to industry-wide losses in the workers' compensation line, increased reinsurance costs and competitors retreating from the market. In Nevada, we began writing premiums on July 1, 1999, which was the first date private carriers were allowed to issue workers' compensation policies in the state. Premiums in force are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies in force at a point in time. Total inforce premiums increased by 36% to $189,557,000 at September 30, 2000. Total inforce premiums have dropped slightly (.05%) from its highest point in the last twelve months which was in August 2000. This indicates a potential slowing trend in premiums written, especially in California, due largely to business lost because of the higher premium rate increases we have been trying to obtain. The number of inforce policies at September 30, 2000 has also dropped by 1.3% from its highest point in the last twelve months, which was also August 2000. Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio as we reinsured a significant amount of losses to the reinsurer. However, the ceded premiums we paid the reinsurer reduced the cash available for investment and temporarily created negative cash flow for us. The $900,000 or 7% reduction in net investment income for the nine months ended September 30, 2000, compared to the prior period, is due to a reduction in investments primarily because of higher ceded premiums paid to reinsurers in 2000. We had net realized losses of $460,000 for the nine months ended September 30, 2000 compared to net realized losses of $174,000 for the prior period. We have tried to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. Losses and Loss Adjustment Expenses: The $49.2 million increase in losses and loss adjustment expenses, which we refer to as LAE, is attributable to the following reasons: o Approximately $19.5 million of the increase is related to our premium growth. o We recorded $20.2 million of net adverse loss development for prior accident years. The net adverse development recorded in 2000 for the prior accident years was primarily attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. o We are establishing a higher loss and LAE ratio for the 2000 accident year, which has resulted in an increase of approximately $8.3 million. The higher loss and LAE ratio is due in part to the net adverse loss development we recorded in the fourth quarter of 1999 of $9.9 million and to the lower premium rates on policies written in 1999. o The remaining difference is due to the expiration of the low level reinsurance policy on June 30, 2000. We have a higher risk exposure on policies effective after that date, which results in a higher amount of net incurred loss and LAE. Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies in force as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. As a percentage of net earned premiums, the loss and LAE ratio for the nine months ended September 30, 2000 was 92.4% compared to 59.8% for 1999. The 2000 loss ratio was significantly impacted by the $20.2 million net adverse development, which represents 22.2% of net earned premiums. In addition, the expiration of the low level reinsurance agreement is resulting in a higher loss and LAE ratio on policies effective after June 30, 2000 as we are keeping more of the losses. Underwriting Expenses: Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $2.9 million for the nine months ended September 30, 2000 compared to 1999 is primarily attributable to the increase in net earned premiums. Other underwriting expenses increased by $0.7 million for the nine months ended September 30, 2000 compared to 1999 due to higher personnel costs to service the increase in premium growth. As a percentage of net earned premiums, the underwriting expense ratio was 28.6% in 2000 compared to 35.6% in 1999. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, smaller growth in personnel expenses and lower agents' commissions and allowances. General, Administrative and Other Expenses: Included in this income statement line item are other underwriting expenses of $15.7 million for the nine months ended September 2000 compared to $15.0 million for the prior year period. Also included are policyholders' dividends of $1.7 million for the nine months ended September 30, 2000 compared to nil in 1999. The majority of the dividends are for Nevada participating policies and represent 1.8% of net earned premiums. In addition, in 2000, we wrote-off capitalized costs of $3.0 million on an information system software project that was cancelled because the vendor was unable to fulfill its contractual obligations. Combined Ratio: The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 121.0% for the nine months ended September 30, 2000 compared to 95.4% for the same period in 1999. The increase was primarily due to a higher loss and LAE ratio of 32.6 percentage points, offset slightly by a decrease in the underwriting expense ratio of 8.8 percentage points and a new policyholders' dividends ratio of 1.8 percentage points. The increase in the loss and LAE ratio was due to: o net adverse loss development of $20.2 million, which represents 22.2% of net earned premiums, on prior accident years recorded in 2000 compared to no loss development for the nine months ended 1999; and o higher loss and LAE ratio on the 2000 accident year, which represents 9.1% of net earned premiums. The higher loss and LAE ratio is due in part to the net adverse loss development we recorded in the fourth quarter of 1999 of $9.9 million and to the lower premium rates on policies written in 1999. Income Taxes: For the nine months ended September 30, 2000, we recorded a tax benefit of $4.9 million compared to a tax provision of $4.8 million in the prior year period. The effective tax rate was 35% for the 2000 period compared to 41% for the 1999 period. The decrease in the effective tax rate was due to deferred income tax valuation allowances recorded in 1999. Results of Operations for the Year ended December 31, 1999 Compared to the Year Ended December 31, 1998 Our income before taxes decreased by $10.8 million for the year ended December 31, 1999 compared to 1998. The major components of the change were: $51.3 million decrease in net earned premiums; $2.5 million decrease in investment income; $2.4 million decrease in net realized gains; $32.9 million decrease in loss and loss adjustment expenses; and $12.9 million decrease in policy acquisition costs. Revenues: Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue decreased by 36% for the year ended December 31, 1999 compared to 1998 and was due to a significant reduction in net earned premiums. In addition, negative cash flows from operations resulted in lower net investment income. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums decreased by $5.1 million or 3% due primarily to lower prices for workers' compensation insurance in California. The increase in ceded reinsurance premiums of $44.0 million was primarily due to the low level reinsurance agreement, which is discussed below. The following table shows a comparison of direct written premiums, by state, for the year ended December 31, 1999 and 1998: Year Ended December 31, 1999 % of total 1998 % of total (dollars in millions) California $120.5 80.9% $129.3 84.0% Colorado 12.3 8.3 12.0 7.8 Texas 7.2 4.8 8.1 5.3 Nevada 2.6 1.8 0.0 0.0 Other States 6.2 4.2 4.5 2.9 Total $148.8 100.0% $153.9 100.0% Our largest premium state, California, also had the largest decrease in written premiums due in large part to increasing price competition. The market-pricing environment in California became less favorable at the end of 1998 due to some competitors using reinsurance as a way of reducing premium rates to gain market share. We began writing workers' compensation insurance in Nevada on July 1, 1999, the first date private insurance carriers were allowed to issue workers' compensation policies in the state. - -------------------------------------------------------------------------------- Premiums in force are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies in force at a point in time. Although direct premium writings decreased for the year ended December 31, 1999 compared to 1998, total inforce premiums at December 31, 1999 increased by 17% to $155.0 million. This indicates an upward trend in premium growth, especially in California, in the latter part of 1999. The number of inforce policies at December 31, 1999 also increased by 23% to 15,485. Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio as we reinsured a significant amount of losses to the reinsurer. However, the ceded premiums we paid the reinsurer reduced the cash available for investment and temporarily created negative cash flow for us. The negative cash flow created by the low level reinsurance agreement was the primary reason for the lower net investment income of $2.5 million. We had net realized losses of $381,000 for the year ended December 31, 1999 compared to net realized gains of $2.0 million in 1998. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. In 1998, we sold some of our investments in debt securities and realized some gains. Losses and Loss Adjustment Expenses: The $32.9 million decrease in the losses and LAE is attributable to the following reasons: o Due to the low level reinsurance agreement, our reinsurer is at risk for more of our losses and LAE on policies in force at July 1, 1998. This agreement reduced the dollar amount of losses and LAE for the year ended December 31, 1999 by approximately $70 million. o We recorded $9.9 million of net adverse loss development for prior accident years in the fourth quarter of 1999 compared to net favorable loss development of $9.6 million in 1998. The net adverse development recorded in 1999 was primarily attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. However, the number of reported claims per $1 million of earned premium, or claims frequency, did not significantly change when compared to our historical patterns. The net favorable loss development recorded in 1998 was due to lower than expected loss and LAE payments. o The amount of direct losses and LAE reserves (i.e., before deducting reinsurance recoveries) recorded in 1999 were higher by approximately $22 million due to the trend in higher claim severity. This was partially offset by an increase in excess reinsurance recoverable of $4.5 million. In 1998, we recorded favorable loss development and this trend was factored into the loss ratio to record the 1999 accident year reserves. Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998. We also had excess of loss reinsurance agreements that covered 100% of the losses above $500,000 to $100 million. As a percentage of net earned premiums, the loss and LAE ratio for year ended December 31, 1999 was 74.1% compared to 70.3% for 1998. The increase is due to the following: o The $9.9 million of net adverse loss development for prior accident years recorded in the fourth quarter of 1999 compared to favorable loss development of $9.6 million in 1998 accounts for an increase in the loss and LAE ratio of approximately 19 percentage points. o The additional amounts of ceded losses and LAE due to the low level reinsurance agreement have reduced the net loss and LAE ratio by approximately 11 percentage points. o The remainder of the difference is due to the lower direct reserves that were established on the 1999 accident year. Underwriting Expenses: Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to underwriting and marketing departments. Policy acquisition costs decreased by $12.9 million or 67% for the year ended December 31, 1999 compared to 1998. The decrease was all due to a ceding commission of $14.7 million received on the low level reinsurance agreement as a partial reimbursement of our expenses. Partially offsetting the ceding commissions were higher commissions paid to agents and brokers in order to remain competitive in the market place. Other underwriting expenses increased by $.6 million in 1999 compared to 1998 due to higher personnel costs to service the increase in premium growth. As a percentage of net earned premiums, the underwriting expense ratio was 31.5% in 1999 compared to 28.4% in 1998. The improvement in the expense ratio was largely due to the ceding commissions. General, Administrative and Other Expenses: The increase in this income statement line item was primarily due to other underwriting expenses of $19.6 million for the year ended December 31, 1999 compared to $19.0 million for 1998. Combined Ratio: The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 105.5% for the year ended December 31, 1999 compared to 98.7% for 1998. The increase was due to a higher loss and LAE ratio of 3.8 percentage points and a higher underwriting expense ratio of 3.1 percentage points. The increase in the 1999 year loss and LAE ratio was primarily due to net adverse loss development of $9.9 million, which represents 11.9% of 1999 net earned premiums, whereas the 1998 year had favorable loss development of $9.6 million, which represented 7.1% of 1998 net earned premiums. The change in loss development was partially offset by additional amounts of ceded losses and LAE under the low level reinsurance agreement. The increase in the underwriting expense ratio was primarily due to the lower net earned premium base in 1999. Income Taxes: For the year ended December 31, 1999, we recorded a tax provision of $3.6 million compared to a tax provision of $4.2 million in 1998. The effective tax rate was 50% for 1999 compared to 23% for 1998. The increase in the effective tax rate for 1999 was due to deferred income tax valuation allowances recorded in 1999 for CII Financial whereas the 1998 rate benefited from a reduction in the deferred income tax valuation allowance from the use of net operating loss carryforwards of California Indemnity. The California Indemnity net operating loss carryforwards were completely used in 1998. Results of Operations for the Year Ended December 31, 1998 Compared to the Year Ended December 31, 1997 Our income before taxes increased by $7.1 million for the year ended December 31, 1998 compared to 1997. The major components of the change were: $5.1 million increase in net earned premiums; $1.5 million increase in investment income; $1.4 million increase in net realized gains; and $1.0 million increase in loss and loss adjustment expenses. Revenues: Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by $7.9 million or 5% for the year ended December 31, 1998 compared to 1997. The increase was largely due to higher net earned premiums of $5.1 million. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums increased by $18.3 million or14% due primarily to increased premium growth in California. Ceded reinsurance premiums also increased by $14.8 million and were primarily due to the low level reinsurance agreement, which is discussed below. The following table shows a comparison of direct written premiums, by state, for the year ended December 31, 1998 and 1997: Year Ended December 31, 1998 % of total 1997 % of total (dollars in millions) California $129.3 84.0% $113.1 83.4% Colorado 12.0 7.8 12.8 9.4 Texas 8.1 5.3 6.3 4.6 Other States 4.5 2.9 3.4 2.6 Total $153.9 100.0% $135.6 100.0% ================================================================================ Our largest premium state, California, had the largest increase in written premiums due in large part to premium growth from writing more policies that occurred in the first half of 1998. The market-pricing environment in California became less favorable at the end of 1998 due to some competitors using reinsurance as a way of reducing premium rates to gain market share. Premiums in force are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies in force at a point in time. Although total inforce premiums at December 31, 1998 increased by 3% to $132.8 million from December 31, 1997, there was a downward trend in the last half of 1998. Total inforce premiums increased in the first half of 1998 from $128.8 million at January 1, 1998 to a high of $142.8 million in July 1998 and declined in the last half of 1998 due to escalating price competition in California. Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio as we reinsured a significant amount of losses to the reinsurer. However, the ceded premiums we paid the reinsurer reduced the cash available for investment and temporarily created negative cash flow for us. Our first payment to the reinsurer was not made until the end of December 1998. Thus, the timing of this payment did not reduce our net investment income in 1998 the increase in our investment income was related to the increase in our investment portfolio throughout most of 1998. In 1998, we had net realized gains of $2.0 million for the year ended December 31, 1998 compared to net realized gains of $.6 million in 1997. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. In 1998 and 1997, we sold some of our investments in debt securities and realized some gains. Losses and Loss Adjustment Expenses: The $1.0 million net increase in the losses and LAE was primarily attributable to premium growth, which increased losses and LAE by $16.2 million. This increase was substantially reduced by the effects of the low level reinsurance agreement which reduced the dollar amount of losses and LAE in 1998 by approximately $21.0 million. Changes in excess reinsurance resulted in an increase in losses and LAE of $5.9 million. Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998. We also had excess of loss reinsurance agreements that covered 100% of the losses above $500,000 to $100 million. As a percentage of net earned premiums, the loss and LAE ratio for year ended December 31, 1998 was 70.3% compared to 72.2% for 1997. The reduction was primarily due to the effects of the low level reinsurance agreement. In addition, we also had net favorable loss development on prior accident years of $9.6 million compared to net favorable loss development of $9.0 million in 1997. The net favorable loss developments were primarily attributable to lower than expected loss and LAE payments. Underwriting Expenses: Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to underwriting and marketing departments. Policy acquisition costs decreased by $.6 million. The increase in policy acquisition costs that would normally accompany an increase in related premium revenues was substantially offset by a ceding commission of approximately $3.9 million. We received a ceding commission on the low level reinsurance agreement as a partial reimbursement of our expenses. Other underwriting expenses increased by $0.5 million or 3% for the year ended December 31, 1998 compared to 1997. As a percentage of net earned premiums, the underwriting expense ratio was 28.4% in 1998 compared to 29.7% in 1997. The decrease in the expense ratio was largely due to the ceding commission received on the low level reinsurance agreement. General, Administrative and Other Expenses: The increase in this income statement line item was primarily due to other underwriting expenses of $19.0 million for the year ended December 31, 1998 compared to $18.5 million for 1997. Combined Ratio: The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 98.7% for the year ended December 31, 1998 compared to 101.9% for 1997. The decrease was primarily due to a lower loss and LAE ratio of 2.0 percentage points and a lower underwriting expense ratio of 1.2 percentage points. The decrease in the 1998 year loss and LAE ratio was primarily due to the low level reinsurance agreement and net favorable loss development of $9.6 million, which represents 7.1% of 1998 net earned premiums. The 1997 year had net favorable loss development of $9.0 million, which represented 7.0% of 1997 net earned premiums. The decrease in the underwriting expense ratio was primarily due to the ceding commission received on the low level reinsurance agreement of $3.9 million. Income Taxes: For the year ended December 31, 1998, we recorded a tax provision of $4.2 million compared to a tax provision of $0.3 million in 1997. The effective tax rate was 23% for 1998 compared to 2% for 1997. Both the 1998 and 1997 effective tax rates were less than the statutory rate primarily due to reductions in the deferred income tax valuation allowance from the use of net operating loss carryforwards of California Indemnity. Liquidity and Capital Resources We had negative cash flows from operating activities of $2.3 million for the nine months ended September 30, 2000 and $29.5 million for the year ended December 31, 1999. Our negative cash flow for the 2000 period was largely due to a net loss of $8.5 million and an increase in reinsurance recoverable on paid and unpaid losses of $79.7 million, which were partially offset by an increase in loss and LAE reserves of $97.5 million. Our negative cash flow for the 1999 year was primarily due to a net increase in reinsurance recoverable on paid and unpaid losses of $73.4 million offset by an increase in loss and LAE reserves of $32.1 million, an increase in deferred income taxes of $5.9 million and net income of $3.6 million. The increases in reinsurance recoverable were primarily due to the low level reinsurance agreement. The increases in the loss and LAE reserves were due to premium growth as well as adjustments related to net adverse development on prior accident years recorded in 2000 of $20.2 million and $9.9 million in 1999. Our net cash provided by investing activities was $9.9 million for the nine month 2000 period and $24.8 million for the year ended 1999. Capital expenditures in 2000 were $0.8 million and $4.2 million in the year ended 1999. Due to the negative cash flows from operations, we had to sell some of our investments. Our net cash flows from financing activities were a negative $5.1 million for the nine month 2000 period and negative $0.6 million for the year 1999. The negative cash flows from financing activities for both periods were a result of our repurchase of old junior subordinated debentures in the open market. In September 1991, we issued the old junior subordinated debentures. The old junior subordinated debentures bear interest at 7 1/2% per annum, which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 25.382 shares of common stock of our ultimate parent company, Sierra Health Services, at a conversion price of $39.398 per share. Unamortized issuance costs of $362,000 are included in other assets on the balance sheet and are being amortized over the life of the old junior subordinated debentures. The old junior subordinated debentures are junior subordinated obligations of CII Financial, Inc. only and are not guaranteed by Sierra. Sierra has a bank credit facility with outstanding borrowings of $185 million at September 30, 2000. Sierra was in default of certain financial covenants at June 30, 2000. In consideration of the banks granting a waiver of compliance, in August 2000, CII Financial, the holding company, became a guarantor of the Sierra credit facility debt. The guaranty of the bank debt ranks senior to the old junior subordinated debentures. The waivers expired on October 31, 2000 and Sierra received a notice of default from the banks on November 8, 2000. The credit facility was amended and restated on December 15, 2000. CII Financial is a holding company and its only significant assets are its investment in California Indemnity Insurance Company. Of the cash and cash equivalents held at September 30, 2000, approximately $231 million were designated for use only by the regulated insurance companies. Funds can only be transferred by the insurance subsidiaries to CII Financial in accordance with applicable regulations. CII Financial has a limited source of cash and is dependent upon dividends paid by California Indemnity. The payment of stockholders' dividends is regulated by the California Insurance Code. Currently, California Indemnity is prohibited from making any dividend payments to CII Financial without prior approval of the California Department of Insurance. Sierra advanced $365,000 to us in order to enable us to make our September 15, 2001 interest payment on the old junior subordinated debentures. Sierra's amended and restated bank credit facility will restrict Sierra from making any future advances to us. Therefore, we have no readily available source of cash with which to pay the old junior subordinated debentures when they mature on September 15, 2001. Since our acquisition by Sierra in October 1995, we have paid dividends to Sierra totaling $2.6 million. Sierra has also contributed $3.7 million to us by purchasing in the open market old junior subordinated debentures and contributing them to us. Inflation Inflation can be expected to affect our operating performance and financial condition in several aspects. Inflation can reduce the market value of our investment portfolio; however, we try to manage our investment portfolio to minimize unplanned sales. Inflation can adversely affect the portion of loss and LAE reserves that relate to hospital and medical expenses, although some medical expenses are established by statute. Loss reserves related to indemnity benefits for lost wages are not directly affected by inflation as these amounts are established by statute. We do not believe that inflation has had a material effect on our results of operations. Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 clarifies existing accounting principles related to revenue recognition in financial statements. We are required to comply with the provisions of SAB 101 in the quarter ending December 31, 2000. Based upon the current nature of our operations, we do not believe that SAB 101 will have any impact on our results of operations. In June 1998, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended, which is effective for fiscal years beginning after June 15, 2000. SFAS 133 establishes additional accounting and reporting standards for derivative instruments and hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position. This statement also defines and allows companies to apply hedge accounting to its designated derivatives under certain instances. It also requires that all derivatives be marked to market on an ongoing basis. This applies whether the derivatives are stand-alone instruments, such as warrants or interest rate swaps, or embedded derivatives, such as call options contained in convertible debt investments. Along with derivatives, in the case of qualifying hedges, the underlying hedge items are also to be marked to market. These market value adjustments are to be included either in the income statement or other comprehensive income, depending on the nature of the hedged transaction. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over the counter market. In cases where derivatives relate to financial instruments of non-public companies, or where quoted market prices are otherwise not available, such as for derivative financial instruments, fair value is based on estimates using present value or other valuation techniques. Based on our understanding of SFAS 133, we do not believe that we have any derivative instruments and do not have any hedging activities. The majority of our investments are held by our insurance subsidiaries, which are regulated as to the types of investments they may hold. Quantitative and Qualitative Disclosures About Market Risk At December 31, 1999, we had $226.6 million in cash, cash equivalents and invested assets. Our invested assets consist of debt securities of $190.3 million, of which $165.3 million were classified as available-for-sale and $25.0 million was classified as held-to-maturity. These investments are substantially investment grade securities. Our investment policies emphasize return of principal and liquidity and are focused on fixed returns that limit volatility and risk of principal. Our primary market risk associated with our investment portfolio is interest rate risk. Assuming interest rates were to increase by a factor of 1.1, the net hypothetical loss in fair value of shareholder's equity related to financial instruments would approximately be $6.1 million after tax. This would represent approximately 9% of shareholder's equity. We believe that if interest rates were to increase by this amount, it would not have a material impact on our future earnings or cash flows as it is unlikely that we would need or choose to substantially liquidate our investment portfolio. The effect of interest rate risk on potential near-term net income, cash flow and fair value was determined based on commonly used sensitivity analyses. The models project the impact of interest rate changes on a wide range of factors, including duration and prepayment. Fair value was estimated based on the net present value of cash flows or duration estimates, assuming an immediate 10% increase in interest rates. MANAGEMENT Directors and Executive Officers The following table sets forth information concerning our directors and executive officers. - ------------------------------------------------------------------------------- Name Position Age - ------------------------------------------------------------------------------- Paul H. Palmer Director 39 Frank E. Collins Director 46 Kathleen M. Marlon President, Chief Executive Officer, 42 Chairman and Director John F. Okita Chief Financial Officer 52 Robert G. Riordan Vice President, Region II 48 Robert L. Selli Vice President, Region I 59 David M. Sonenstein General Counsel and Secretary 53 - ------------------------------------------------------------------------------- Paul H. Palmer, Director. Mr. Palmer is the vice president of finance, chief financial officer and treasurer of Sierra. He was promoted to these offices in 1998. Prior to this, he was assistant vice president of Sierra from May 1996, corporate controller from November 1994 and director of finance when he joined Sierra in 1993. Prior to joining Sierra, Mr. Palmer was an audit manager at Deloitte & Touche LLP (formerly Touche Ross) in Las Vegas and California from 1988 to 1993. Mr. Palmer is a certified public accountant with an MBA and masters in accounting from Brigham Young University. He is a member of the American Institute of Certified Public Accountants, the Nevada State Society of Certified Public Accountants and the California State Society of Certified Public Accountants. Frank E. Collins, Director. Mr. Collins joined Sierra in 1986 as general counsel and secretary. In 1997 he was appointed executive vice president. From 1981 to 1986, Mr. Collins was employed by Blue Cross and Blue Shield of Kansas City, originally as staff legal counsel and in early 1986 as associate general counsel. Mr. Collins also served as counsel for the Missouri Division of Insurance from 1979 to 1981, where he was responsible for providing legal advice on insurance- and HMO-related regulatory issues. Mr. Collins received his Juris Doctor in 1979 from the University of Missouri at Kansas City school of law and is a member of the Missouri Bar Association. Kathleen M. Marlon, President, Chief Executive Officer, Chairman and Director. Ms. Marlon joined Sierra in March 1986. In 1990, she became president and chief operating officer of Sierra Healthcare Options, Inc., a start-up subsidiary of Sierra. In February 1996, Ms. Marlon became our president and chief executive officer. In December 2000, Ms. Marlon became our chairman. Prior to joining Sierra, Ms. Marlon held technical and management positions for six years with Delphi Systems and Quality Systems. Ms. Marlon received her Bachelor of Science in Accounting from the University of Southern California in 1980. Ms. Marlon has successfully completed the CPA exam and Property & Casualty and Health licensing exams and holds a F.L.M.I. designation. Ms. Marlon is married to Anthony M. Marlon's nephew. Anthony M. Marlon is the chairman and chief executive officer of Sierra. John F. Okita, Chief Financial Officer. Mr. Okita has served in this capacity since he started his employment with us in April 1992 until September 1999 and from June 2000 to present. In September 1999, Mr. Okita left us to become the corporate controller of Sierra, a position he still holds. In June 2000 he returned to us as our chief financial officer. Mr. Okita is a certified public accountant and a licensed attorney and has over twenty years of property-casualty insurance industry experience. Prior to joining us, Mr. Okita was in private tax and financial consulting practice. Mr. Okita served in several financial executive capacities at Fremont Insurance Group between 1980 and 1990. Prior to that, Mr. Okita was employed by Coopers & Lybrand from 1975 and audited both property-casualty and life insurance companies. Mr. Okita received his Bachelor of Science in Business Administration from California State University at Los Angeles and his Juris Doctor from Loyola Law School. Robert G. Riordan, Senior Vice President, Field Operations. Mr. Riordan was promoted to this position in May 1997 after having served as director of field operations since November 1993. He was vice president of Northern California operations for USA Casualty Company from November 1991 until joining Sierra in 1993. Prior to USA Casualty, Mr. Riordan had held various underwriting, marketing and financial reporting positions with Fireman's Fund Insurance Companies since 1976. Mr. Riordan attended Steubenville College where he received a Bachelor of Science degree in business administration. Robert L. Selli, Vice President, Underwriting. Mr. Selli was promoted in November 1997 after serving as director of underwriting since December 1996. Mr. Selli has served as Northern California Underwriting Manager and key member of our California Open Rating Task Force since he joined us in January 1994. Prior to that time, Mr. Selli held various underwriting management and marketing positions with Fireman's Fund Insurance Company and Zurich American since entering the industry in 1967. Mr. Selli attended San Francisco State University where he received a Bachelor of Arts degree in economics. David M. Sonenstein, General Counsel and Secretary. Mr. Sonenstein has served as general counsel since joining us in August 1997 and as secretary since early 1999. Mr. Sonenstein served as vice president and associate general counsel of Fireman's Fund Insurance Company, from 1991 to 1997. He started his employment with Fireman's Fund as Associate Counsel in 1979. Mr. Sonenstein was in private practice from 1972 to 1979. Mr. Sonenstein graduated from Claremont Men's College with a Bachelor of Arts degree and received his Juris Doctor in 1972 from Hastings College of Law. Executive Compensation The following table sets forth information with respect to the compensation paid by us for the year ended December 31, 1999 to our chief executive officer and to each of our four next most highly compensated executive officers:
SUMMARY COMPENSATION TABLE Name of Individual Or Number Of Persons In Capacities in Cash Compensation All Other Group Which Served Bonus Compensation Kathleen M. Marlon President, Chief $214,291 $78,733 $25,457 (1) Executive Officer Richard E. Dobson Chief Legal Officer 225,715 47,800 13,115 John F. Okita Chief Financial 126,912 66,698 21,487 Officer Robert G. Riordan Senior Vice 139,445 30,047 10,907 President, Field Operations David M. Sonenstein General Counsel 124,214 27,583 13,342
______________ (1) Includes $15,451 of compensation resulting from split-dollar insurance policies purchased in 1997, calculated based on regulations of the SEC. The regulations require compensation to be calculated on the assumption that most of the premiums paid by us represent a long-term, no-interest loan to the executive. This assumption results in high compensation expense being shown in early years of the expected life of each policy and lower expense in later years, while in fact the cash surrender value of such a policy to the executive is very low in the early years and higher only in the late years. Compensation of Directors The directors are our employees or employees of Sierra and receive no additional compensation for their service on our board. Employment Agreements Our subsidiary, California Indemnity Insurance Company, has entered into a three-year employment agreement with Kathleen M. Marlon, its chief executive officer. Under the agreement, Ms. Marlon may voluntarily terminate employment upon 60 days' notice. California Indemnity may terminate her employment, with or without cause, in accordance with California Indemnity's usual policies and procedures. The employment agreement provides that, in the event of a termination by California Indemnity without cause, a severance payment will be paid in the amount of 12 months' salary to Ms. Marlon. The agreement also provides that, a disability must continue for at least six months before California Indemnity may terminate her employment. In the event of a change in control not approved by the board of directors of California Indemnity, or if a change in control is approved by the board but within two years thereafter Ms. Marlon is terminated without cause, demoted, provided reduced compensation or required to relocate, Ms. Marlon will be entitled to receive a payment equal to a multiple of two times her salary and target annual incentive. In addition, if "golden parachute" excise taxes apply to compensation paid by California Indemnity, California Indemnity will provide a gross-up payment sufficient to cause the after-tax value of the compensation and the gross-up payment to Ms. Marlon to be the same as if no such excise had applied. The employment agreement contemplates annual adjustments in compensation based on job duties, performance goals and objectives and other reasonable standards deemed appropriate by California Indemnity. The agreement restricts Ms. Marlon's use and disclosure of confidential information, interference with California Indemnity's business relationships, and competition with California Indemnity, including a prohibition, for a one-year period following any termination of employment, on her working for a competitor which operates in California, Nevada, or Texas. Stock Options Our executive officers participate in Sierra's stock option plan. The following table contains information concerning the grants by Sierra of stock options to acquire Sierra common stock to the named executives during fiscal year 1999:
OPTION/SAR GRANTS IN FISCAL YEAR 1999 Individual Grants (1) Number of % of Total Potential Realizable Securities Options/SARs Value at Assumed Underlying Granted to Exercise or Annual Rates of Stock Options/SARs Employees in Base Price Expiration Price Appreciation for Granted (#) 1999 ($/Share) Date Option Terms 5% ($) 10% ($) Kathleen M. Marlon 75,000 (2)(3) 47% 8.00 10/12/05 $204,057 $462,937 Richard E. Dobson -0- N/A N/A N/A N/A N/A John F. Okita 10,000 (2)(3) 6% 8.00 10/12/05 27,208 61,725 Robert G. Riordan 7,500 (3)(4) 5% 6.6875 12/30/05 31,543 79,936 David M. Sonenstein 7,500 (3)(4) 5% 6.6875 12/30/05 31,543 79,936
- ------------- - ------------------------------------------------------------------------------- (1) All options were granted at an exercise price equal to the fair market value of Sierra common stock on the option grant date. The exercise price may be paid by the optionee in cash or by check, except that Sierra's stock plan committee may, in its discretion, allow such payment to be by surrender of unrestricted shares of Sierra common stock (at their fair market value on the date of exercise), or by a combination of cash, check and unrestricted shares. (2) These options were granted on October 13, 1999 and vest and are exercisable at the rate of 20% per year starting with the first anniversary date of the grant and will expire not later than six years after grant. (3) All awards were non-qualified stock options granted pursuant to Sierra's 1995 long-term incentive plan. No stock appreciation rights were granted with the above awards. Upon a change of control of Sierra, as defined in the 1995 Plan, the vesting of the options will be automatically accelerated, provided, however, that Sierra's stock plan committee may exclude a change of control transaction from the foregoing provisions and permit the option to continue to vest in accordance with its original terms. In addition, the options shown above will terminate and may no longer be exercised if the respective optionee ceases to be an employee or director of Sierra or one of its affiliates, except certain post-termination exercise periods are permitted in the case of death, disability, or other involuntary termination except for a termination for "cause." The options together with certain gains realized upon exercise of the options during a specified period will be subject to forfeiture if the optionee engages in certain acts in competition with Sierra or one of its affiliates, misuses proprietary information of Sierra or one of its affiliates, or fails to assist Sierra or one of its affiliates in litigation. Cashless withholding to satisfy tax obligations may be permitted by Sierra's stock plan committee. (4) These options were granted on December 31, 1999 and vest and are exercisable at the rate of 20% per year starting with the first anniversary date of the grant and will expire not later than six years after grant. Option Exercises and Holdings The following table provides information with respect to the named executives concerning the exercise of Sierra stock options during the fiscal year ended December 31, 1999 and unexercised Sierra stock options held as of December 31, 1999: Aggregated Option/SAR Exercises in Fiscal 1999 and Year-End Option Values
Number of Securities Value of Underlying Unexercised Unexercised In-the-Money Options/SARs at Options/SARs at Shares FY-End (#) FY-End ($) Acquired on Value Exercisable/ Exercisable/ Exercise (#) Realized ($) Unexercisable Unexercisable (1) Kathleen M. Marlon -0- -0- 46,963 / 105,537 -0- / -0- Richard E. Dobson (2) -0- -0- 36,825 / 5,675 -0- / -0- John F. Okita -0- -0- 43,215 / 15,625 -0- / -0- Robert G. Riordan -0- -0- 11,671 / 21,234 -0- / -0- David M. Sonenstein -0- -0- 1,700 / 10,550 -0- / -0-
- -------------- - ------------------------------------------------------------------------------- (1) Based on the closing price of Sierra common stock on December 31, 1999, which was $6.6875, minus the exercise price of the option. (2) Mr. Dobson's right to acquire stock pursuant to his options terminated on August 28, 2000. CII Financial's Supplemental Executive Retirement Plans Certain of our executive officers were participants in the CII Financial, Inc. Supplemental Executive Retirement Plan, or the SERP Plan, and the CII Financial, Inc. Supplemental Senior Executive Retirement Plan, or the Senior SERP Plan. These plans were effective as of January 1, 1990 and the SERP Plan was amended and restated April 24, 1993. When we were acquired by Sierra in October 1995, both plans were frozen as to any new contributions, participants, and accrued benefits. The Senior SERP Plan had only one participant, Mr. Joseph G. Havlick, who at that time was our chief executive officer. Of the eight participants in the SERP Plan, only Mr. Okita remains an officer of CII Financial. Our Board of Directors appoints a committee to administer both plans. Participation in both plans was limited to the executives, officers and employees selected by our chief executive officer and approved by our board of directors. The criteria used to determine participation in either plan was the participant's position, past contributions and anticipated contributions to our future success. The committee determined the benefit amount that would be paid at the participant's normal retirement age. The initial benefit amount was discretionary and was adjusted based on the participant's employment service years from the date of participation. Participants were given credit for employment prior to the plans' effective date of January 1, 1990. Under the SERP Plan, the benefit amount was also adjusted based on whether a participant retired at, prior to, or after, normal retirement age. Benefit amounts under both plans are paid in equal monthly installments over a 10-year period. Both plans also provide for a benefit payable over a 10-year period if a participant dies while still employed by us. Mr. Okita's annual benefits under the SERP Plan are $300. Sierra's Supplemental Executive Retirement Plan Ms.Kathleen Marlon participates in Sierra's Supplemental Executive Retirement Plan II (the "Supplemental Plan II"), which provides retirement benefits for selected executive officers. Under the Supplemental Plan II, each executive selected for participation generally will be entitled to receive annual payments, following retirement, disability, and certain other terminations of employment, for a 15-year period, equal to 2.5% of their "final average compensation" (as defined) for each year of service credited to the executive up to 20 years, reduced by an amount equal to the annualized payout over a 15-year period that would be payable to the executive as a result of Company contributions under the 401(k) Plan and the Deferred Compensation Plan (but not reduced for social security payments or other offsets). An executive's right to benefits under the Supplemental Plan II vests when five years of service have been credited or earlier upon the executive's death or disability or upon occurrence of a change in control (defined in the same way as under other compensatory plans). Upon the death of the executive, benefits will be payable for the 15-year period to the executive's beneficiary. Benefits will begin after retirement at or after age 65, a termination at or after age 55 and ten years of credited service, or a termination due to disability, and benefits will begin, in the case of other terminations (except a termination for "cause," as defined) prior to a change in control, at the later of termination or the date the executive would have completed ten years of service but for the termination. The following table shows the approximate amounts of annual retirement income that would be payable under the Supplemental Plan II to executives covered by it based on various assumptions as to final average compensation and years of service, assuming benefits are paid out over 15 years: Estimated Annual Benefits Based on Credited Years of Service
Final Average Compensation 5 Years 10 Years 15 Years 20 Years 30 Years $200,000 $23,366 $46,732 $70,099 $92,465 $93,465 400,000 45,225 90,450 135,675 180,900 180,900 600,000 67,837 135,675 203,512 271,350 271,350
- -------------------------------------------------------------------------------- Final average compensation generally means the average of the three highest years of compensation out of the last five years, with compensation being generally the amounts reported as salary and bonus in the Summary Compensation Table. Ms. Marlon has 14 years of credited service under the Supplemental Plan II. An additional year of service will be credited in the event of a termination within six years after a change in control, and the year of service for the year of the change in control will be deemed completed at the time of the change in control. An executive's or beneficiary's benefits are payable in a lump sum in certain circumstances, including following a change in control. No other executives of CII Financial participate in Sierra's Supplemental Executive Retirement Plan II. CERTAIN TRANSACTIONS We intend to finance all or a portion of the cash consideration in the exchange offer, together with interest and expenses, with a loan from one of our affiliates. We will not be able to determine the amount of cash needed until the expiration of the exchange offer. Our affiliates have no obligation to advance these funds to us. However, in the event the loan is made, the indebtedness will be represented by a demand promissory note issued to the affiliate bearing interest at a rate equal to the then current interest rate on Sierra's credit facility. This affiliate note will rank senior to both the old junior subordinated debentures and the new senior subordinated debentures. In August 2000, we, and some other subsidiaries of Sierra, became a guarantor of Sierra's obligations under its $185 million senior secured credit facility. For more information concerning this guaranty, see "Description of Other Indebtedness." Effective January 1, 1999, Sierra entered into separate but similar investment services agreements with California Indemnity Insurance Company, Commercial Casualty Insurance Company, Sierra Insurance Company of Texas and CII Insurance Company. Under these agreements Sierra manages the investments of the insurers. The management is, however, subject to the insurers' investment guidelines and the ultimate control of each insurer's board of directors. The management fee is a percentage of the total amount under management. The annual investment fees paid by the insurance companies in 1999 were approximately $335,000 and in 2000 were approximately $400,000. Effective January 1, 1999, Sierra and California Indemnity Insurance Company agreed that Sierra would furnish it services, including accounting, human resources, systems and other administrative services. The fee for the services is based on the lower of actual cost or fair market value. The services are subject to the ultimate control of California Indemnity Insurance Company's board of directors. The annual fees for these services were approximately $1,003,000 in 1999 and $1,200,000 in 2000. On March 31, 2000, California Indemnity Insurance Company loaned $7.4 million to Sierra, our sole stockholder. The loan was secured by a first trust deed mortgage on property at 4475 South Eastern Avenue in Las Vegas, Nevada. The loan is due April 1, 2005 with a right to accelerate on the part of the lender on or after April 1, 2001. The interest rate for the loan is 8% per annum and the loan to value was approximately 60%. Sierra Health Services has paid $441,000 as of November 30, 2000 in interest from the date of the loan. A sale of the 4475 South Eastern property to a real estate partnership is currently pending and expected to close in the near future. Under the terms of the purchase and sale agreement, the purchaser will be assuming the first trust deed mortgage with amended terms. The interest rate will be increased, the acceleration clause will be eliminated in consideration of additional fees, and the loan will be extendable up to two years under certain conditions for additional fees. Sierra, California Indemnity Insurance Company and Commercial Casualty Insurance Company are partners in a limited partnership called 2716 North Tenaya Way Limited Partnership. This partnership owns the building located at that address in Las Vegas, Nevada. The two insurers are limited partners in the partnership whereas Sierra Health Services is the general partner. The two limited partners own approximately 13.5% of the partnership each. They also lease a portion of the building from the partnership. The lease payments during 1999 for both companies were $1,168,000 and for this year to date were $1,160,000 as of November 30, 2000. A sale of the partnership to a third party is currently pending and expected to close in the near future. At closing, the net proceeds to the two limited partners will be approximately $8 million. Effective January 1, 1996, federal income taxes are calculated pursuant to a tax allocation agreement between Sierra and CII Financial. Income taxes are allocated on a separate return basis for each company and tax benefits are recorded only to the extent that an entity could recoup taxes paid in prior years. All of our directors are also executive officers of Sierra. PRINCIPAL STOCKHOLDERS Sierra owns 100% of our issued and outstanding capital stock. DESCRIPTION OF OTHER INDEBTEDNESS Sierra's credit facility is governed by an Amended and Restated Credit Agreement entered into by Sierra on December 15, 2000 with a syndicate of banks for which Bank of America, N.A., is the Administrative Agent and Issuing Bank. Other lenders include First Union National Bank, Deutsche Bank, AG, Credit Lyonnais, Bank One, N.A., Wells Fargo Bank, N.A., and Union Bank of California, N.A. Bank of America, N.A. is an affiliate of Banc of America Securities LLC, the dealer manager for the exchange offer. The new credit agreement amended Sierra's preceding credit agreement, which Sierra entered into in 1998. Sierra was not in compliance with the terms of the financial covenants in the preceding credit agreement and received a notice of default from its lenders on November 8, 2000 with respect to this non-compliance. As of December 15, 2000 Sierra was in compliance with the covenants under the Amended and Restated Credit Agreement. We have irrevocably and unconditionally guaranteed all obligations under this credit facility. Revolving Loans The new credit agreement provides Sierra with a revolving credit facility of $185 million. The proceeds from revolving loans under the revolving credit facility may be used for general working capital and general corporate purposes. As of December 15, 2000 the facility was fully drawn. The available amounts which Sierra can borrow under the credit facility will be reduced by specified amounts, on certain dates. If the total amount of outstanding loans exceeds the availability under the credit facility, as reduced, Sierra will be required to immediately prepay 100% of the excess amount. Under certain additional circumstances, Sierra would be required to make prepayments of the loans, and the amount available to Sierra under the revolving credit facility would be reduced. For example, 80% of any excess cash flow that Sierra has in each year must be applied to a repayment of the loans and a reduction of the amount available under the revolving credit facility. In addition, if Sierra or a subsidiary of Sierra (other than an HMO subsidiary and certain other subsidiaries) engages in an asset sale or a sale and leaseback transaction (with the exception of certain assets specified in the new credit agreement), 80% of the cash proceeds (net of certain expenses) must be applied to a repayment of the loans and a reduction of the amount available under the revolving credit facility. Similarly, 80% of the cash proceeds (net of certain expenses) of certain equity issuances by us or any of our subsidiaries and 100% of the cash proceeds (net of certain expenses) of a debt issuance by Sierra (excluding us) must be applied to a repayment of the loans and a reduction in the amount available under the revolving credit facility. The credit facility terminates on September 30, 2003. On that date, Sierra will be required to repay the aggregate principal amount of the revolving loans outstanding. Interest Under the credit facility, revolving loans bear interest at the applicable margin plus the greater of: o 0.5% per annum above the latest federal funds rate; or o the per annum prime lending rate of Bank of America, N.A. The applicable margin is initially 1.75%. However, the applicable margin may be increased or decreased in certain circumstances. Fees In connection with the credit facility, Sierra will pay certain customary fees, including agents' fees, commitment fees, and amendment fees. Covenants Subject to normal qualifications and exceptions, Sierra has certain covenants that, among other things, will restrict the ability of Sierra and its subsidiaries, including CII Financial, to dispose of assets, incur indebtedness, pay dividends, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and which otherwise restrict certain corporate activities. In addition, under the senior credit facility Sierra will be required to comply with specified financial ratios, as defined in the credit agreement, including minimum interest coverage ratios and leverage ratios. Events of Default The credit facility may be terminated before September 30, 2003 upon the occurrence of any event of default. Upon the occurrence of an event of default, with certain limitations, Sierra's obligations under the new credit agreement which are at that time outstanding may become accelerated. Events of default under the credit facility consist of customary specified events. A default in payment on our debentures would constitute an event of default. A bankruptcy proceeding or other similar event involving us would also constitute an event of default. Security The payment and performance of Sierra's obligations under the credit facility are secured by: o liens on substantially all of Sierra's assets and the assets of Sierra's subsidiaries, other than CII Financial and Sierra's other regulated subsidiaries; o a guaranty of Sierra's obligations thereunder by each of Sierra's subsidiaries, including CII Financial, but excluding our insurance subsidiaries and Sierra's other regulated subsidiaries; and o other collateral arrangements, subject to pledge agreements, the security agreements, deeds of trust, and similar arrangements between Sierra, Sierra's subsidiaries, and the lending banks. UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS We have set out below our unaudited pro forma consolidated financial statements. The unaudited pro forma consolidated balance sheet as of September 30, 2000 has been prepared on the basis that the exchange offer as described below had occurred on September 30, 2000. The unaudited pro forma consolidated statement of operations for the nine months ended September 30, 2000 have been prepared as if the exchange offer had occurred on January 1, 2000. We have assumed the exchange of $47,059,000 in principal amount of old junior subordinated debentures for $10,237,500 in cash and $27,559,000 in principal amount of new 9% senior subordinated debentures. You should read this information with the accompanying notes and our consolidated financial statements, which are included in this prospectus. The accompanying pro forma consolidated financial statements do not purport to represent what our results of operations would have been had such transactions and events occurred on the dates specified, or to project our results of operations for any future period or date. The pro forma adjustments are based on available information and certain adjustments that our management believes are reasonable. In the opinion of our management, all adjustments have been made that are necessary to present fairly the unaudited pro forma consolidated data. NOTES TO UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET SEPTEMBER 30, 2000 The accompanying unaudited pro forma consolidated balance sheet reflects the following adjustments: (a) Payment of the outstanding accrued interest on the old junior subordinated debentures as of September 30, 2000 of $145,000. (b) Payment of $1,600,000 in capitalizable debt issuance costs to be amortized over the term of the new senior subordinated debentures. (c) A $5,000,000 loan from Sierra to the CII Financial evidenced by the affiliate note. (d) An exchange of $27,559,000 aggregate principal amount of the old junior subordinated debentures for new senior subordinated debentures in the aggregate principal amount of $27,559,000 with a deferred gain of $9,262,500 to be amortized over the term of the new senior subordinated debentures. (e) $19,500,000 aggregate principal amount of old junior subordinated debentures retired in exchange for a $10,238,000 cash payment. CII FINANCIAL, INC. AND SUBSIDIARIES UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET SEPTEMBER 30, 2000 (In thousands, except for share data)
Historical Adjustments Pro forma ASSETS Cash, cash equivalents and invested assets: Cash and cash equivalents $19,408 $(6,982) (a),(b),(c),(e) $12,426 Debt securities, available for sale, at fair value 164,660 164,660 Debt securities, held-to-maturity, at amortized cost 22,154 22,154 Preferred stock, at fair value 1,732 1,732 Mortgage loans on affiliated real estate 10,261 10,261 Mortgage loans on non-affiliated real estate 6,281 6,281 Real estate limited partnership 7,108 7,108 Total cash, cash equivalents and invested assets ------------- ---------------- ------------ 231,604 (6,982) 224,622 Reinsurance recoverable 211,594 211,594 Premiums receivable (net of allowance of $1,134) 13,402 13,402 Investment income receivable 2,406 2,406 Deferred policy acquisition costs 2,732 2,732 Federal income taxes receivable 9,478 9,478 Deferred income taxes 15,984 15,984 Property and equipment, net 5,097 5,097 Other assets 555 1,600 (b) 2,155 TOTAL ASSETS ------------- ---------------- ------------ $492,852 $(5,382) $487,470 LIABILITIES Reserve for losses and loss adjustment expenses $341,902 $341,902 Unearned premiums 16,206 16,206 Ceded reinsurance premiums payable 7,424 7,424 Old junior subordinated debentures 47,059 $(47,059) (d),(e) 0 New senior subordinated debentures 36,822 (d) 36,822 Accounts payable and other accrued expenses 15,969 (145) (a) 15,824 Affiliate note 5,000 (c) 5,000 Payable to affiliates 2,487 2,487 Deferred tax liability 3,291 3,291 TOTAL LIABILITIES ------------- ---------------- ------------ 434,338 (5,382) 428,956 COMMITMENTS AND CONTINGENCIES STOCKHOLDER'S EQUITY Common Stock, no par value, 1,000 shares authorized; shares issued and outstanding - 100 3,604 3,604 Additional paid - in capital 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for (8,651) (8,651) sale-investments Accumulated deficit (889) (889) TOTAL STOCKHOLDER'S EQUITY ------------- ---------------- ------------ 58,514 0 58,514 TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $492,852 $(5,382) $487,470
=============================================================================== NOTES TO UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2000 The accompanying unaudited pro forma consolidated statement of operations reflects the following adjustments: (a) The elimination of the extraordinary gain from debt extinguishment assuming the exchange was consummated prior to our debt repurchases during the period. (b) Reduction of interest expense for the amortization of the deferred gain on the restructuring of the old junior subordinated debentures over the life of the new senior subordinated debentures. (c) A reduction of income taxes as a result of the pro forma adjustments at an assumed effective tax rate of 35%. CII FINANCIAL, INC. AND SUBSIDIARIES UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2000 (In thousands)
Historical Adjustments Pro forma REVENUES Direct written premiums $153,034 $153,034 Changes in direct unearned premiums (2,906) (2,906) Direct earned premiums 150,128 150,128 Less: premiums ceded 59,177 59,177 Net earned premiums 90,951 90,951 Net investment income 11,217 11,217 Net realized investment losses (460) (460) Total revenues 101,708 101,708 COSTS AND EXPENSES Losses and loss adjustment expenses 207,323 207,323 Reinsurance recoveries (123,303) (123,303) Net loss and loss adjustment expenses 84,020 84,020 Policy acquisition costs 8,606 8,606 General and administrative and other 17,372 17,372 Asset impairment 3,000 3,000 Interest expense 2,717 $(884) (b) 1,833 Total costs and expenses 115,715 (884) 114,831 LOSS BEFORE FEDERAL INCOME TAX BENEFIT AND EXTRAORDINARY GAIN (14,007) 884 (13,123) Federal income tax benefit (4,902) 310 (c) (4,592) LOSS BEFORE EXTRAORDINARY GAIN (9,105) 574 (8,531) Extraordinary gain from debt extinguishments (net of income taxes of $353) 654 (654) (a) 0 NET LOSS $(8,451) $(80) $(8,531)
=============================================================================== DESCRIPTION OF DEBENTURES Principal Differences Between Old Junior Subordinated Debentures and New Senior Subordinated Debentures The terms of the new senior subordinated debentures and the related indenture are identical in all material respects to the terms of the old junior subordinated debentures and the related indenture, except for: o The new senior subordinated debentures will rank senior in right of payment to any old junior subordinated debentures which are not tendered. o You will receive a higher rate of interest on the new senior subordinated debentures, which will pay 9% per annum, than on the old junior subordinated debentures, which pay 7 1/2% per annum. o The scheduled maturity date of the new senior subordinated debentures is September 15, 2006, which is five years later than September 15, 2001, the scheduled maturity date of the old junior subordinated debentures. o The new senior subordinated debentures will not be convertible into Sierra common stock. The old junior subordinated debentures are convertible into Sierra common stock at $39.398 per share. New Senior Subordinated Debentures We will issue the new senior subordinated debentures under an indenture between us and Wells Fargo Bank Minnesota, N.A., as trustee. A copy of the indenture substantially in the form in which it is to be executed is filed as an exhibit to the registration statement of which this prospectus is a part. The following description is a summary of the material provisions of the indenture relating to the new senior subordinated debentures and does not describe the indenture in its entirety. This summary is subject to and qualified by reference to all of the provisions in the indenture, including definitions of certain terms used in the indenture. We urge you to read the indenture because it, and not the summary description below, defines your rights. Copies of the indenture will be available for inspection at the Corporate Trust Offices of the trustee in Minneapolis, Minnesota. General. The new senior subordinated debentures will be limited to $47,059,000 aggregate principal amount. The new senior subordinated debentures will be subordinated obligations of CII Financial and will not be guaranteed by Sierra. The new senior subordinated debentures will be subordinate to all our senior indebtedness, including our guaranty of Sierra's credit facility and the affiliate note. However, the new senior subordinated debentures will rank senior to the old junior subordinated debentures. We are required to repay the principal amount of the new senior subordinated debentures in full on September 15, 2006. The new senior subordinated debentures will bear interest from the date of issuance, at the rate per annum of 9%. We will pay interest on the new senior subordinated debentures on March 15 and September 15 of each year, commencing on March 15, 2001, to the person in whose name the new debenture (or any predecessor debenture) is registered, subject to certain exceptions, at the close of business on March 1 or September 1, as the case may be, before each interest payment date. Principal of and interest on the new senior subordinated debentures will be payable and transfers will be registrable, at an office of the trustee or our office or agency maintained for such purpose in Minneapolis, Minnesota, provided that, at our option, payment of interest may be made by check mailed to the address of the person entitled thereto as it appears in the debenture register. Subordination of Debentures. The payment of principal, any premium and interest on the new senior subordinated debentures, including amounts payable on any redemption or repurchase, will be subordinated to the prior payment in full of all our senior debt. The new senior subordinated debentures will rank senior to the old junior subordinated debentures. Senior debt is defined in the indenture as the principal of, and interest on all our debt, whether outstanding on the date of the indenture or thereafter created, incurred, guaranteed or assumed, other than o the new senior subordinated debentures; o the old junior subordinated debentures; and o any debt which provides, or in respect of which any instrument creating or evidencing such debt or pursuant to which the same is outstanding provides, that such debt is not superior in right of payment to the new senior subordinated debentures. Debt is defined in the indenture to mean: o all debt which is (a) for money borrowed, (b) evidenced by a note, bond or similar instrument given in connection with the acquisition of any businesses, properties or assets of any kind, but excluding any other trade accounts payable or accrued liabilities arising in the ordinary course of business or (c) purchase money indebtedness with respect to the purchase of any real or personal property or any interest therein; o obligations under certain leases; o amendments, renewals, extensions, modifications and refundings of any debt or obligations referred to above; and o any debt or obligations referred to above in respect of which we are liable, contingently or otherwise, to pay or advance money or property as a guarantor, endorser or otherwise. In August 2000, we became a guarantor of Sierra's revolving credit facility, which at December 15, 2000 was fully drawn and had an outstanding balance of $185 million. The new senior subordinated debentures are subordinated to this guaranty of the credit facility debt. Our senior debt will also include the affiliate note. The terms of our debentures do not limit our ability to incur additional senior debt. Upon any payment or distribution of assets to creditors as a result of a liquidation, dissolution, winding up, reorganization for the benefit of creditors, marshalling of assets or any bankruptcy, insolvency or similar proceedings involving us, the holders of all senior debt will first be entitled to receive payment in full before you will be entitled to receive any payment on the new senior subordinated debentures. No such payment in respect of the new senior subordinated debentures may be made if there shall have occurred and be continuing a default in any payment with respect to any senior debt, or an event of default in respect to any senior debt resulting in acceleration of the maturity thereof, or if any judicial proceeding shall be pending with respect to any such default. If the new senior subordinated debentures are declared due and payable before their stated maturity, no payment may be made in respect of the new senior subordinated debentures unless and until all senior debt shall have been paid in full. By reason of such subordination, in the event of insolvency, our creditors who are holders of senior debt may recover more ratably than you will. The new senior subordinated debentures will be senior to the old junior subordinated debentures. The indenture will permit the trustee to become our creditor and to enforce its rights as a creditor, including rights as a holder of senior debt. Redemption. The new senior subordinated debentures will be redeemable upon not less than 25 nor more than 60 days' notice by mail at any time, in whole or in part, at our election, on or prior to September 15, 2001 at a redemption price equal to 100.75% of the principal amount together with accrued interest to the redemption date, or after September 15, 2001 at a redemption price equal to 100% of the principal amount together with accrued interest to the redemption date, subject to the right of holders of record on regular record dates to receive interest due on an interest payment date. Repurchase at Option of Holders Upon Change in Control. If a change in control as defined below occurs, you will have the right, at your option, to require us to repurchase all of your new senior subordinated debentures not previously called for redemption, or any portion of the principal amount thereof, that is equal to $1,000 or an integral multiple of $1,000. The price we are required to pay is 100% of the principal amount of the new senior subordinated debentures to be repurchased, together with accrued interest to the repurchase date. Such right may not be waived by our board of directors. Within 30 days after the occurrence of a change in control, we are obligated to mail to you notice of such change in control and of the repurchase right arising as a result thereof. We must also deliver a copy of this notice to the trustee and cause a copy of such notice to be published in a newspaper of general circulation in Los Angeles, California and in the Borough of Manhattan, The City of New York. To exercise the repurchase right, you must deliver to the trustee the new senior subordinated debentures with respect to which the repurchase right is being exercised, duly endorsed for transfer to us. We are required to repurchase the new senior subordinated debentures on the date that is 45 days after the date of our notice, which we refer to as the repurchase date. A change in control will be deemed to have occurred at the time after the new senior subordinated debentures are issued that any person, including any syndicate or group deemed to be a "Person" under Section 13(d)(3) of the Exchange Act, is or becomes the beneficial owner, directly or indirectly, through a purchase, merger or other acquisition transaction or series of transactions, of shares of our capital stock entitling such person to exercise 50% or more of the total voting power of all shares of our capital stock that are entitled to vote in elections of directors. For purposes of these provisions, whether a person is a "beneficial owner" will be determined in accordance with Rule l3d-3 promulgated by the SEC under the Exchange Act as in effect on the date of execution of the indenture. Merger and Consolidation. The indenture will provide that we may consolidate with or merge into any other corporation, or convey, transfer or lease its properties and assets substantially as an entirety to any person, provided that in any such case: o the successor corporation assumes by a supplemental indenture our obligations under the indenture; o immediately after giving effect to such transaction, no default will have occurred and be continuing; and o we deliver to the trustee an officer's certificate and an opinion of counsel stating that the terms of the indenture with respect to such event have been complied with. Upon compliance with these provisions by a successor corporation, we, except in the case of a lease, would be relieved of our obligations under the indenture and the new senior subordinated debentures. Modification of the Indenture. Modifications and amendments of the indenture may be made by us and the trustee with the consent of the holders of a majority in principal amount of the outstanding debentures. However, none of the following modifications or amendments may be made without your consent: o change the stated maturity date of the principal of, or any installment of interest on, the new senior subordinated debentures; o reduce the principal amount of, or interest on, any new debenture; o change the place or currency of payment on the new senior subordinated debentures; o impair your right to institute suit for the enforcement of any payment on the new senior subordinated debentures when due; o modify the provisions of the indenture with respect to the subordination of the new senior subordinated debentures in a manner adverse to you; or o reduce the percentage in principal amount of new senior subordinated debentures the consent of whose holders is required for modification or amendment of the indenture or for waiver of compliance with certain provisions of the indenture or for waiver of certain defaults. Events of Default, Notice and Waiver. The following are events of default under the indenture: o we fail to make a payment of interest on the new senior subordinated debentures when due, and this failure continues for 30 days; o we fail to make the payment of principal on the new senior subordinated debentures, when due; o we fail in the performance of any other covenant and this failure continues for 60 days after written notice, as provided in the indenture; o we default in respect of our indebtedness for money borrowed which results in acceleration of the maturity of $1,000,000 or more of indebtedness, if such acceleration is not rescinded or indebtedness discharged within 10 days after written notice to us, as provided in the indenture; and o certain events in bankruptcy, insolvency or reorganization involving us. If any event of default shall happen and be continuing, the trustee or the holders of 25% in principal amount of the outstanding new senior subordinated debentures may declare the debentures due and payable. However, after a declaration of acceleration has been made with respect to the new senior subordinated debentures, but before a judgment or decree based on acceleration has been obtained, the holders of a majority in principal amount of the outstanding debentures may, under certain circumstances, rescind and annul such acceleration. The indenture will provide that the trustee will be under no obligation, subject to the duty of the trustee during default to act with the required standard of care, to exercise any of its rights or powers under the indenture at the request or direction of any of the holders, unless such holders shall have offered to the trustee reasonable security or indemnity against the costs, expenses and liabilities which might be incurred by it in compliance with such request or direction. Subject to certain conditions, the holders of a majority in principal amount of the outstanding debentures will have the right to direct the time, method and place of conducting any proceeding for any remedy available to the trustee or exercising any trust or power conferred on the trustee. The holders of a majority in principal amount of the outstanding debentures may on behalf of the holders of all new senior subordinated debentures waive compliance by us with certain restrictive provisions of the indenture. The holders of a majority in principal amount of the outstanding debentures may on behalf of the holders of new senior subordinated debentures waive certain past defaults except a default in payment of the principal of, or premium, if any, or interest on any new debenture or in respect of a provision which under the indenture cannot be modified or amended without the consent of the holder of each outstanding debenture affected thereby. We will be required to furnish the trustee annually a statement as to any default by it in the performance of certain covenants in the indenture. Concerning the Trustee. The trustee may act as a depository for funds of, make loans, which may constitute senior debt, to and perform other commercial banking services for us in the ordinary course of business. Neither the trustee nor any of its affiliates currently performs any commercial banking services for us. Old Junior Subordinated Debentures The old junior subordinated debentures were issued under an indenture dated September 15, 1991. The indenture is a contract between us and Chase Manhattan Bank and Trust Company, National Association (as successor to Manufacturers Hanover Trust Company) as trustee. The following description is a summary of the material provisions of the indenture relating to the old junior subordinated debentures and does not describe the indenture in its entirety. This summary is subject to and qualified by reference to all of the provisions in the indenture, including definitions of certain terms used in the indenture. We urge you to read the indenture because it, and not the summary description below, defines your rights. Copies of the indenture will be available for inspection at the Corporate Trust Offices of the trustee in San Francisco, California. General. The old junior subordinated debentures are subordinated obligations of CII Financial and are not guaranteed by Sierra. The old junior subordinated debentures are subordinate to all our senior indebtedness, including the new senior subordinated debentures, our guaranty of Sierra's credit facility and the affiliate note. We are required to repay the principal amount of the old junior subordinated debentures in full to you on September 15, 2001. The old junior subordinated debentures bear interest, at the rate per annum of 7 1/2%. We pay interest on the old junior subordinated debentures on March 15 and September 15 of each year, to the person in whose name the old junior subordinated debenture (or any predecessor debenture) is registered, subject to certain exceptions, at the close of business on March 1 or September 1, as the case may be, before each interest payment date. Principal of, and premium, if any, and interest on the old junior subordinated debentures are payable and the old junior subordinated debentures are convertible and exchangeable and transfers are registrable, at an office of the trustee or our office or agency maintained for such purpose in San Francisco, California, provided that, at our option, payment of interest may be made by check mailed to the address of the person entitled thereto as it appears in the debenture register. Conversion Rights. You may, at your option, convert any portion of the principal amount of any old junior subordinated debenture that is an integral multiple of $1,000 into shares of Sierra common stock at any time prior to redemption, repurchase or maturity of the old junior subordinated debentures, at the conversion price of $39.398 per share. Your right to convert any old junior subordinated debentures called for redemption or to be repurchased will terminate at the close of business on the redemption date or the repurchase date, as the case may be, and will be lost if not exercised prior to that time. The conversion price is subject to adjustment in certain events, including: o dividends, and other distributions, payable in Sierra common stock on shares of Sierra capital stock; o the issuance to all stockholders of Sierra common stock of certain rights, options or warrants entitling them to subscribe for or purchase Sierra common stock at less than the then current market price per share; o subdivisions and combinations of Sierra common stock; o the distribution to all holders of Sierra common stock of evidences of debt securities of Sierra or of CII Financial, shares of any class of capital stock, cash or assets, including securities, but excluding any rights, options or warrants referred to above, excluding any dividend or distribution paid exclusively in cash, and excluding any dividend or distribution in Sierra common stock; o distributions to all holders of Sierra common stock of cash, excluding any cash that is distributed as part of a distribution referred to above, in an aggregate amount that together with the aggregate amount of certain other distributions, exceeds 10% of our market capitalization, being the product of the current market price per share of the Sierra common stock on the date fixed for shareholders entitled to receive such distribution and the number of shares of Sierra common stock outstanding on such date; and o tender offers made by us or any of our subsidiaries for all or any portion of Sierra common stock involving an aggregate consideration having a fair market value on the last time, which we refer to as the expiration time, tenders may be made pursuant to such tender offer that, together with the aggregate amount of certain other distributions, exceeds 5% of Sierra market capitalization on the expiration time, being the product of the current market price per share of the Sierra common stock on the expiration time and the number of shares of Sierra common stock outstanding, including any tendered shares, on the expiration time. In addition to the foregoing adjustments, we are permitted to make such reductions in the conversion price as we consider to be advisable in order that any event treated for United States federal income tax purposes as a dividend of stock or stock rights will not be taxable to the recipients. We will not be required to make adjustments in the conversion price of less than 1% of such price, but any adjustment that would otherwise be required to be made will be taken into account in the computation of any subsequent adjustment. In the case of certain consolidations or mergers to which we are a party or the transfer of substantially all of our assets, each old junior subordinated debenture then outstanding would, without your consent, become convertible only into the kind and amount of securities, cash and other property receivable upon such consolidation, merger or transfer by a holder of the number of shares of Sierra common stock into which such old junior subordinated debenture was convertible immediately prior to such consolidation, merger or transfer, assuming such holder of Sierra common stock failed to exercise any rights of election and received per share the kind and amount received per share by a plurality of the non-electing shares. Other than as set forth above, the conversion price is not subject to adjustment in the event of the sale of Sierra common stock at less than market value. If any such sale negatively affects the market price for Sierra common stock, the value of the old junior subordinated debentures may also be adversely affected. Fractional shares of Sierra common stock will not be issued upon conversion, and, in lieu thereof, we will pay cash to you based upon the market price of the Sierra common stock. At the close of business on a record date you will be entitled to receive the interest payable on the old junior subordinated debentures on the corresponding interest payment date notwithstanding the subsequent conversion thereof or our default in payment of the interest due on such interest payment date, subject to certain provisions applicable to defaulted interest. No payment or adjustment will be made upon conversion for interest accrued on the old junior subordinated debentures or for dividends on Sierra common stock issued on conversion. Therefore, old junior subordinated debentures surrendered for conversion during the period from the close of business on any record date to the opening of business on the corresponding interest payment date, except old junior subordinated debentures called for redemption, or to be repurchased, on such interest payment date or on a redemption date or a repurchase date within such period, must be accompanied by payment of an amount equal to the interest payable on the interest payment date. The holder of old junior subordinated debentures on a record date who converts old junior subordinated debentures on an interest payment date will receive the interest and need not include a payment for any such interest upon surrender of old junior subordinated debentures for conversion. Subordination of Debentures. The payment of principal, any premium and interest on the old junior subordinated debentures, including amounts payable on any redemption or repurchase, will be subordinated to the prior payment in full of all our senior debt. Senior debt is defined in the indenture as the principal of, and premium, if any, and interest on all our debt, whether outstanding on the date of the indenture or thereafter created, incurred, guaranteed or assumed, other than: o the old junior subordinated debentures; and o any debt which provides, or in respect of which any instrument creating or evidencing such debt or pursuant to which the same is outstanding provides, that such debt is not superior in right of payment to the new debentures. Debt is defined in the indenture to mean: o all debt which is (a) for money borrowed, (b) evidenced by a note, bond or similar instrument given in connection with the acquisition of any businesses, properties or assets of any kind, but excluding any other trade accounts payable or accrued liabilities arising in the ordinary course of business or (c) purchase money indebtedness with respect to the purchase of any real or personal property or any interest therein; o obligations under certain leases; o amendments, renewals, extensions, modifications and refundings of any debt or obligations referred to above; and o any debt or obligations referred to above in respect of which we are liable, contingently or otherwise, to pay or advance money or property as a guarantor, endorser or otherwise. In August 2000, we became a guarantor of Sierra's revolving credit facility, which at December 15, 2000 was fully drawn and had an outstanding balance of $185 million. The old junior subordinated debentures are subordinated to this guaranty of the credit facility debt. Our senior debt will also include the new senior subordinated debentures to be issued in the exchange offer and the affiliate note. The terms of our debentures do not limit our ability to incur additional senior debt. Upon any payment or distribution of assets to creditors as a result of a liquidation, dissolution, winding up, reorganization for the benefit of creditors, marshalling of assets or any bankruptcy, insolvency or similar proceedings involving us, the holders of all senior debt will first be entitled to receive payment in full before you will be entitled to receive any payment on the old junior subordinated debentures. No such payment in respect of the old junior subordinated debentures may be made if there shall have occurred and be continuing a default in any payment with respect to any senior debt, or an event of default in respect to any senior debt resulting in acceleration of the maturity thereof, or if any judicial proceeding shall be pending with respect to any such default. If the old junior subordinated debentures are declared due and payable before their stated maturity, no payment may be made in respect of the old junior subordinated debentures unless and until all senior debt shall have been paid in full. For purposes of the subordination provisions, the payment, issuance or delivery of cash, property or securities, other than our stock and certain subordinated securities, upon conversion of an old junior subordinated debenture, will be deemed to constitute payment on account of the principal of such old junior subordinated debentures. By reason of such subordination, in the event of insolvency, our creditors who are holders of senior debt may recover more ratably than you will. The old junior subordinated debentures are subordinate to the new senior subordinated debentures. The indenture permits the trustee to become our creditor and to enforce its rights as a creditor, including rights as a holder of senior debt. Redemption. The old junior subordinated debentures are currently redeemable upon not less than 25 nor more than 60 days' notice by mail at any time, in whole or in part, at our election, are currently at a redemption price equal to 100.75% of the principal amount together with accrued interest to the redemption date, subject to the right of holders of record on regular record dates to receive interest due on an interest payment date. Repurchase at Option of Holders Upon Change in Control. If a change in control as defined below occurs, you will have the right, at your option, to require us to repurchase all of your old junior subordinated debentures not previously called for redemption, or any portion of the principal amount thereof, that is equal to $1,000 or an integral multiple of $1,000. The price we are required to pay is 100% of the principal amount of the old junior subordinated debentures to be repurchased, together with accrued interest to the repurchase date. Such right may not be waived by our board of directors or by the board of directors of Sierra. At our option, instead of paying the repurchase price in cash, we may pay the repurchase price in Sierra common stock valued at 95% of the average of the closing prices of Sierra common stock for the five trading days ending on the third trading day preceding the repurchase date. We may only pay the repurchase price in Sierra common stock if such Sierra common stock is listed on a national securities exchange or quoted on the NASDAQ National Market System at the time of payment. Sierra has no obligation to issue shares in this event. Within 30 days after the occurrence of a change in control, we are obligated to mail to you notice of such change in control and of the repurchase right arising as a result thereof. We must also deliver a copy of this notice to the trustee and cause a copy of such notice to be published in a newspaper of general circulation in Los Angeles, California and in the Borough of Manhattan, The City of New York. To exercise the repurchase right, you must deliver to the trustee the old junior subordinated debentures with respect to which the repurchase right is being exercised, duly endorsed for transfer to us. We are required to repurchase the old junior subordinated debentures on the date that is 45 days after the date of our notice, which we refer to as the repurchase date. At least two trading days prior to the repurchase date, we must publish a notice in the manner described above specifying whether we will pay the repurchase price in cash or in Sierra common stock. A change in control will be deemed to have occurred at the time after the old junior subordinated debentures are issued that any person, including any syndicate or group deemed to be a "Person" under Section 13(d)(3) of the Exchange Act, is or becomes the beneficial owner, directly or indirectly, through a purchase, merger or other acquisition transaction or series of transactions, of shares of our capital stock entitling such person to exercise 50% or more of the total voting power of all shares of our capital stock that are entitled to vote in elections of directors. For purposes of these provisions, whether a person is a "beneficial owner" will be determined in accordance with Rule l3d-3 promulgated by the SEC under the Exchange Act as in effect on the date of execution of the indenture. However, a change in control will not be deemed to have occurred if either (a) the closing price per share of Sierra common stock for any five trading days within a period of 10 consecutive trading days ending immediately before the change in control shall equal or exceed 105% of the conversion price in effect on each of those trading days, or (b) all of the consideration (excluding cash payments for fractional shares) in the transaction or transactions constituting the change in control consists of shares of common stock traded on a national securities exchange or quoted on the NASDAQ National Market System and as a result of such transaction or transactions the old junior subordinated debentures become convertible solely into such common stock. Rule 13e-4 under the Exchange Act requires the dissemination of certain information to security holders in the event of an issuer tender offer and may apply in the event that the repurchase option becomes available to you. We will comply with this rule to the extent it applies at that time. Merger and Consolidation. The indenture provides that we may consolidate with or merge into any other corporation, or convey, transfer or lease its properties and assets substantially as an entirety to any person, provided that in any such case: o the successor corporation assumes by a supplemental indenture our and Sierra's obligations under the indenture, o immediately after giving effect to such transaction, no default will have occurred and be continuing, and o we deliver to the trustee an officer's certificate and an opinion of counsel stating that the terms of the indenture with respect to such event have been complied with. Upon compliance with these provisions by a successor corporation, we, except in the case of a lease, would be relieved of our obligations under the indenture and the old junior subordinated debentures. Modification of the Indenture. Modifications and amendments of the indenture may be made by us and the trustee with the consent of the holders of a majority in principal amount of the outstanding debentures. However, none of the following modifications or amendments may be made without your consent: o change the stated maturity date of the principal of, or any installment of interest on, the old junior subordinated debentures; o reduce the principal amount of, or any premium or interest on, any old junior subordinated debenture; o change the place or currency of payment on the old junior subordinated debentures; o impair your right to institute suit for the enforcement of any payment on the old junior subordinated debentures when due; o adversely affect your right to convert the old junior subordinated debentures into Sierra common stock; o modify the provisions of the indenture with respect to the subordination of the old junior subordinated debentures in a manner adverse to you; or o reduce the percentage in principal amount of old junior subordinated debentures the consent of whose holders is required for modification or amendment of the indenture or for waiver of compliance with certain provisions of the indenture or for waiver of certain defaults. Events of Default, Notice and Waiver. The following are events of default under the indenture: o we fail to make a payment of interest on the old junior subordinated debentures due, and this failure continues for 30 days; o we fail to make the payment of principal or premium, if any, on the old junior subordinated debentures, when due; o we fail in the performance of any other covenant and this failure continues for 60 days after written notice, as provided in the indenture; o we default in respect of our indebtedness for money borrowed which results in acceleration of the maturity of $1,000,000 or more of indebtedness, if such acceleration is not rescinded or indebtedness discharged within 10 days after written notice to us, as provided in the indenture; and o certain events in bankruptcy, insolvency or reorganization involving us. If any event of default shall happen and be continuing, the trustee or the holders of 25% in principal amount of the outstanding debentures may declare the old junior subordinated debentures due and payable. However, after a declaration of acceleration has been made with respect to the old junior subordinated debentures, but before a judgment or decree based on acceleration has been obtained, the holders of a majority in principal amount of the outstanding debentures may, under certain circumstances, rescind and annul such acceleration. The indenture will provide that the trustee will be under no obligation, subject to the duty of the trustee during default to act with the required standard of care, to exercise any of its rights or powers under the indenture at the request or direction of any of the holders, unless such holders shall have offered to the trustee reasonable security or indemnity against the costs, expenses and liabilities which might be incurred by it in compliance with such request or direction. Subject to certain conditions, the holders of a majority in principal amount of the outstanding debentures will have the right to direct the time, method and place of conducting any proceeding for any remedy available to the trustee or exercising any trust or power conferred on the trustee. The holders of a majority in principal amount of the outstanding debentures may on behalf of the holders of all old junior subordinated debentures waive compliance by us with certain restrictive provisions of the indenture. The holders of a majority in principal amount of the outstanding debentures may on behalf of the holders of old junior subordinated debentures waive certain past defaults except a default in payment of the principal of, or premium, if any, or interest on any old junior subordinated debenture or in respect of a provision which under the indenture cannot be modified or amended without the consent of the holder of each outstanding debenture affected thereby. We will be required to furnish the trustee annually a statement as to any default by it in the performance of certain covenants in the indenture. Concerning the Trustee. The trustee may act as a depository for funds of, make loans, which may constitute senior debt, to and perform other commercial banking services for us or for us in the ordinary course of business. The trustee is one of the lenders under Sierra's credit facility. BOOK-ENTRY SYSTEM-- THE DEPOSITORY TRUST COMPANY The new senior subordinated debentures will be evidenced by a global security initially deposited with The Depository Trust Company, or DTC, and registered in the name of Cede & Co., as DTC's nominee. Except as set forth below, the global security may be transferred only to another nominee of DTC or to a successor of DTC or its nominee. Holders of the new senior subordinated debentures may hold their interests in the global security directly through DTC or indirectly through organizations which are participants in DTC, called "participants". Transfers between participants will be affected in the ordinary way in accordance with DTC rules and will be settled in clearinghouse funds. The laws of some states require that some persons take physical delivery of securities in definitive form. As a result, holders may be unable to transfer beneficial interests in the global security to those persons. Holders that are not participants may beneficially own interests in the global security held by DTC only through participants or indirect participants, including banks, brokers, dealers, trust companies and other parties that clear through or maintain a custodial relationship with a participant. So long as Cede & Co., as the nominee of DTC, is the registered owner of the global security, Cede & Co. will be considered the sole holder of the global security for all purposes. Except as provided below, owners of beneficial interests in the global security will not: o be entitled to have certificates registered in their names; o be entitled to receive physical delivery of certificates in definitive form; and o be considered registered holders. We will make payments of interest on and principal of and the redemption or repurchase price of the global security to Cede & Co., the nominee for DTC, as the registered holder of the global security. We will make these payments by wire transfer of immediately available funds. Neither we, the trustee nor any paying agent will have any responsibility or liability for: o records or payments on beneficial ownership interests in the global security; or o maintaining, supervising or reviewing any records relating to those beneficial ownership interests. We have been informed that DTC's practice is to credit participants' accounts on the payment date. These payments will be made in amounts proportionate to participants' beneficial interests in the new senior subordinated debentures. Payments by participants to owners of beneficial interests in the new senior subordinated debentures represented by the global security held through participants will be the responsibility of those participants. We will send any redemption notices to Cede & Co. We understand that if less than all of the new senior subordinated debentures are being redeemed, DTC's practice is to determine by lot the amount of the holdings of each participant to be redeemed. We also understand that neither DTC nor Cede & Co. will consent or vote with respect to the new senior subordinated debentures. We have been advised that under its usual procedures, DTC will mail an "omnibus proxy" to us as soon as possible after the record date. The omnibus proxy assigns Cede & Co.'s consenting or voting rights to those participants to whose accounts the exchange notes are credited on the record date identified in a listing attached to the omnibus proxy. A person having a beneficial interest in new senior subordinated debentures represented by the global security may be unable to pledge that interest to persons or entities that do not participate in the DTC system, or to take other actions in respect of that interest, because that interest is not represented by a physical certificate. DTC has advised us that it is: o a limited purpose trust company organized under the laws of the State of New York; o a member of the Federal Reserve System; o a "clearing corporation" within the meaning of the Uniform Commercial Code, and o a "clearing agency" registered pursuant to the provisions of Section 17A of the Exchange Act. DTC was created to hold securities for its participants and to facilitate the clearance and settlement of securities transactions between participants through electronic book-entry changes to accounts of its participants. Some of the participants, together with other entities, own DTC. Indirect access to the DTC system is available to others such as banks, brokers, dealers and trust companies that clear through, or maintain a custodial relationship with a participant, either directly or indirectly. DTC is under no obligation to perform or continue to perform the above procedures. DTC may discontinue these at any time. If DTC is at any time unwilling or unable to continue as depository and a successor depository is not appointed by us within 90 days, we will cause new senior subordinated debentures to be issued in definitive form in exchange for the global security. UNITED STATES FEDERAL INCOME TAX CONSEQUENCES The following discussion summarizes the material United States federal income tax consequences to us and to United States holders of the exchange offer and of the acquisition, ownership and disposition of the new senior subordinated debentures. A United States holder is (1) an individual citizen or resident of the United States or (2) a corporation created or organized in or under the laws of the United States or any political subdivision thereof. This discussion does not purport to describe all of the tax considerations that may be relevant to a holder of old junior subordinated debentures. The following summary deals only with old junior subordinated debentures that are, and new senior subordinated debentures that will be, held as capital assets by United States holders, and does not deal with persons that are subject to special tax rules, such as: o dealers or traders in securities or currencies; o financial institutions or other United States holders that treat income in respect of the old junior subordinated debentures or new senior subordinated debentures as financial services income; o insurance companies; o tax-exempt entities; o persons holding old junior subordinated debentures or new senior subordinated debentures as a part of a straddles, conversion transaction or other arrangement involving more than one position; o persons that have a principal place of business or "tax home" outside the United States; or o persons whose "functional currency" is not the U.S. dollar. The discussion below is based upon the provisions of the United States Internal Revenue Code of 1986, as amended, and regulations, rulings and judicial decisions thereunder as of the date of this prospectus; any of these authorities may be repealed, revoked or modified, perhaps with retroactive effect, so as to result in United States federal income tax consequences different from those discussed below. Because United States tax consequences may differ from one holder to the next, the discussion set out below does not purport to describe all of the tax considerations that may be relevant to you and your particular situation. Accordingly, you are advised to consult your own tax advisor as to the United States federal, state, local and other tax consequences of the exchange offer and of the acquisition, ownership and disposition of new senior subordinated debentures. The statements of United States tax law set out below are based on the laws and interpretations in force as of the date of this prospectus, and are subject to any changes occurring after that date. Tax Consequences to Us A corporation will recognize cancellation of indebtedness income upon the satisfaction of its indebtedness for an amount that is less than the amount of the indebtedness. If the exchange offer is consummated, then we will realize ordinary income from (1) the payment of cash in satisfaction of the old junior subordinated debentures to the extent that the adjusted issue price, which is the stated principal amount, of the old junior subordinated debentures extinguished exceeds the amount of cash paid and (2) the exchange of new senior subordinated debentures for old junior subordinated debentures to the extent that the adjusted issue price of the old junior subordinated debentures exceeds the issue price of the new senior subordinated debentures exchanged therefor. As discussed more fully below, the issue price of a new senior subordinated debenture probably will equal the stated principal amount of the new senior subordinated debenture, in which case no cancellation of indebtedness income will arise from the exchange of new senior subordinated debenture for the old junior subordinated debenture. No assurance can be given in this respect, however, and it is possible that the issue price will equal the fair market value of the new senior subordinated debenture or of the old junior subordinated debenture exchanged therefor, in which case we would probably recognize cancellation of indebtedness income with respect to the exchange of new senior subordinated debentures for old junior subordinated debentures (See paragraph 3. under --Tax Consequences to United States Holders of the Exchange Offer--Exchange of New Senior Subordinated Debentures for Old Junior Subordinated Debentures--The Exchange). Tax Consequences to United States Holders of the Exchange Offer Your tax consequences will depend on the option that you select. The discussion under each of the headings below describes the tax consequences applicable to each option under the exchange offer: receiving cash in satisfaction of your old junior subordinated debentures, exchanging your old junior subordinated debentures for new senior subordinated debentures or continuing to hold your old junior subordinated debentures. Receipt of Cash for Old Junior Subordinated Debentures A United States holder that receives cash under the exchange offer will recognize gain or loss in an amount equal to the difference between (1) the amount of cash received and (2) the adjusted tax basis of the old junior subordinated debentures in the hands of the United States holder. Except as discussed below, the gain or loss recognized by a United States holder will be treated as capital gain or loss and will be long-term capital gain or loss if the old junior subordinated debentures have been held for more than one year. Gain recognized by a United States holder will be treated as ordinary income, to the extent of any market discount on the old junior subordinated debentures that has accrued during the period that the United States holder held the old junior subordinated debentures and that has not previously been included in income by the United States holder. A United States holder also will recognize ordinary income in an amount equal to the cash payments received as payment of the interest that has accrued on the old junior subordinated debentures. Exchange of New Senior Subordinated Debentures for Old Junior Subordinated Debentures The Exchange The exchange of new senior subordinated debentures for old junior subordinated debentures pursuant to the exchange offer may be treated as a taxable exchange or as a reorganization and recapitalization, within the meaning of Section 368(a)(1)(E) of the Internal Revenue Code. An exchange of new senior subordinated debentures for old junior subordinated debentures will be treated as a recapitalization only if both the old junior subordinated debentures and the new senior subordinated debentures are treated as "securities" for purposes of the reorganization provisions of the Internal Revenue Code. The term "securities" is not defined in the Internal Revenue Code or in the regulations promulgated thereunder. Under applicable administrative pronouncements and judicial decisions, as a general proposition, the original term of a debt instrument is the most important factor in determining whether the debt instrument is a security: debt instruments with an original term of at least ten years usually being considered securities and debt instruments with a term of five years or less usually not being considered securities. However, (1) the term of a debt instrument is not necessarily determinative, and other factors such as the degree of participation and continuing interest associated with the debt instrument may be relevant, (2) even under this simplified original-term test, the status of debt instruments with an original term of between five and ten years, such as the new senior subordinated debentures, is not clear, and (3) in any event, the applicable judicial decisions are not entirely consistent. Accordingly, there can be no assurance that the Internal Revenue Service (IRS) or a court will agree that the new senior subordinated debentures properly are treated as securities. If the new senior subordinated debentures that a United States Holder receives are not treated as securities then the exchange will be treated as a taxable transaction, rather than as a recapitalization. You are encouraged to consult your own tax advisor as to whether an exchange of new senior subordinated debentures for old junior subordinated debentures will be treated as a recapitalization. The exchange should have the following United States federal income tax consequences: 1. An exchanging United States holder of old junior subordinated debentures should realize gain or loss in an amount equal to the difference between (1) the issue price of the new senior subordinated debentures received and (2) the adjusted tax basis of the old junior subordinated debentures in the hands of the United States holder. The amount of gain or loss realized, as opposed to the amount of gain or loss recognized, does not depend on whether the exchange is treated as a taxable exchange or as a recapitalization. A United States holder also will recognize ordinary income in an amount equal to the cash payments received in satisfaction of interest that has accrued on the old junior subordinated debentures. 2. The issue price of the new senior subordinated debentures will depend upon whether the new senior subordinated debentures or the old junior subordinated debentures are "traded on an established market" at any time within the 60-day period ending 30 days after the issue date of the new senior subordinated debentures. For this purpose, a debt instrument is considered to be traded on an established market, if (1) the debt instrument is listed on a national securities exchange, an interdealer quotation system sponsored by a national securities association or a designated foreign exchange or board of trade, (2) the debt instrument is traded either on a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market, (3) the debt instrument appears on a "quotation medium, "which is a system of general circulation that provides a reasonable basis to determine fair market value by disseminating either recent price quotations of one or more identified brokers, dealers or traders or actual prices of recent sales transactions, or (4) price quotations for the debt instrument otherwise are readily available from dealers, brokers or traders. We do not believe that the old junior subordinated debentures have been traded on an established securities market. We will not list the new senior subordinated debentures on the New York Stock Exchange until after 30 days following the issue date of the new senior subordinated debentures, and we do not otherwise expect that the new senior subordinated debentures will be treated as traded on an established securities market within 30 days after their issue date, although no assurances can be made in this respect. 3. If neither the new senior subordinated debentures nor the old junior subordinated debentures are traded on an established market, then the issue price of the new senior subordinated debentures will be equal to their stated principal amount ($1000 per new senior subordinated debenture). If the new senior subordinated debentures are traded on an established market, then the issue price of the new senior subordinated debentures will be their fair market value on the issue date. If the old junior subordinated debentures are, and the new senior subordinated debentures are not, traded on an established market, then the issue price of the new senior subordinated debentures will be the fair market value on the issue date of the old junior subordinated debentures surrendered in exchange therefor. 4. If the exchange made by an exchanging United States holder is treated as a recapitalization, then gain or loss, if any, realized by the United States holder will not be recognized. 5. If the exchange made by an exchanging United States holder is treated as a taxable exchange, then gain, if any, realized by the United States holder will be recognized. Loss, if any, realized by the exchanging United States holder will be recognized only to the extent permitted under the wash sale rules of Section 1091 of the Internal Revenue Code. You are advised to consult your own tax advisor as to the potential application of the wash sale rules. 6. Except as discussed below, gain or loss recognized by an exchanging United States holder of old junior subordinated debentures will be treated as capital gain or loss. Gain recognized by an exchanging United States holder will be treated as ordinary income, to the extent of any market discount on the old junior subordinated debentures that has accrued during the period that the exchanging United States holder held the old junior subordinated debentures and that has not previously been included in income by the United States holder. An old junior subordinated debenture generally will be considered to have been acquired with market discount if the issue price of the old junior subordinated debenture at the time of acquisition exceeded the initial tax basis of the old junior subordinated debenture in the hands of the United States holder by more than a specified de minimis amount. Market discount accrues on ratable basis, unless the United States holder elects to accrue the market discount using a constant-yield method. If the exchange made by an exchanging United States holder is treated as a recapitalization, then any accrued market discount on the old junior subordinated debentures that is not recognized on the exchange will be transferred to the new senior subordinated debentures received. 7. If the exchange made by an exchanging United States holder is treated as a recapitalization, then the tax basis of the new senior subordinated debentures received in the hands of the United States holder will be equal to the adjusted tax basis of the old junior subordinated debentures transferred in the exchange. The holding period of the new senior subordinated debentures will include the holding period of the old junior subordinated debentures surrendered in the exchange. 8. If the exchange made by an exchanging United States holder is treated as a taxable exchange, then the tax basis of the new senior subordinated debentures received in the hands of the United States holder will be equal to their issue price. The holding period of the new senior subordinated debentures will not include the holding period of the old junior subordinated debentures surrendered in the exchange. Tax Treatment of the New Senior Subordinated Debentures Stated Interest Interest on a new senior subordinated debenture, other than interest that is not "qualified stated interest," will be taxable to a United States holder as ordinary interest income at the time that the interest is received or is accrued, in accordance with the United States holder's method of accounting for federal income tax purposes. In general, qualified stated interest is stated interest that is unconditionally payable at least annually at a single fixed rate during the entire term of a debt obligation. Original Issue Discount General. The new senior subordinated debentures probably will not be issued with original issue discount (OID). The amount of OID on a new senior subordinated debenture will be equal to the excess of (1) the stated redemption price at maturity of the new senior subordinated debenture over (2) the issue price of the new senior subordinated debenture, determined in the manner described above. The stated redemption price at maturity of a new senior subordinated debenture is the sum of all payments on the new senior subordinated debenture other than payments of qualified stated interest. If, as discussed above, the issue price of the new senior subordinated debentures is equal to their principal amount, then the new senior subordinated debentures would not be treated as issued with OID and the rest of the discussion under this heading "--Original Issue Discount" would not be applicable to the new senior subordinated debentures. If, on the other hand, the issue price of the new senior subordinated debentures is based on the fair market value of the new senior subordinated debentures or the old junior subordinated debentures, then the new senior subordinated debentures probably would be treated as issued with OID. Subject to the discussion below under "-Acquisition Premium," a United States holder of a new senior subordinated debenture issued with OID must include OID in income, as ordinary interest income, as it accrues, on a constant-yield basis, before the receipt of cash attributable to this income, and will be required to include in income increasingly greater amounts of OID over the life of the new senior subordinated debenture. The amount of OID includible in income by a United States holder is the sum of the daily portions of OID with respect to the new senior subordinated debenture for each day during the taxable year or portion of the taxable year on which the United States holder holds the new senior subordinated debenture, known as accrued OID. The daily portion is determined by allocating to each day in any "accrual period" a pro rata portion of the OID allocable to that accrual period. Accrual periods with respect to a new senior subordinated debenture may be of any length selected by the United States holder and may vary in length over the term of the new senior subordinated debenture, so long as (1) no accrual period is longer than one year and (2) each scheduled payment of interest or principal on the new senior subordinated debenture occurs on either the final or first day of an accrual period. The amount of OID allocable to an accrual period is equal to the excess of (1) the product of the adjusted issue price of the new senior subordinated debenture at the beginning of the accrual period and the yield to maturity of the new senior subordinated debenture, determined on the basis of compounding at the close of each accrual period and properly adjusted for the length of the accrual period, over (2) the sum of the payments of qualified stated interest on the new senior subordinated debenture that are allocable to the accrual period. The "adjusted issue price" of a new senior subordinated debenture at the beginning of any accrual period is the issue price of the new senior subordinated debenture, increased by the amount of accrued OID for all prior accrual periods and decreased by the amount of any payments previously made on the new senior subordinated debenture other than payments of qualified stated interest. The amount of OID allocable to an initial short accrual period may be computed using any reasonable method, if all other accrual periods other than a final short accrual period are of equal length. The amount of OID allocable to the final accrual period is the difference between the amount payable at the maturity of the new senior subordinated debenture and the new senior subordinated debenture's adjusted issue price as of the beginning of the final accrual period. In general, the effect of the OID provisions described above is that United States holders will realize interest income on the new senior subordinated debentures on a constant-yield basis over the term of the new senior subordinated debentures; United States holders generally will not realize additional income on the receipt of payments, other than payments of qualified stated interest, on the new senior subordinated debentures, even if those payments are denominated as interest. Acquisition Premium. A United States holder that acquires a new senior subordinated debenture for an amount less than or equal to the sum of all amounts payable on the new senior subordinated debenture after the acquisition date, other than payments of qualified stated interest, but in excess of its adjusted issue price (this excess being "acquisition premium") and that does not make the election described below under "Election To Treat All Interest As Original Issue Discount," is permitted to reduce the daily portions of OID includible in its income. The amount of this reduction is calculated by multiplying the daily portion of OID by a fraction, the numerator of which is the excess of the United States holder's adjusted tax basis in the new senior subordinated debenture immediately after its acquisition over the adjusted issue price of the new senior subordinated debenture, and the denominator of which is the excess of the sum of all amounts payable on the new senior subordinated debenture after the acquisition date, other than payments of qualified stated interest, over the adjusted issue price of the new senior subordinated debenture. The ability to reduce OID inclusions to reflect acquisition premium in the manner described above is specifically available to a United States holder (1) that acquires new senior subordinated debentures with OID pursuant to the exchange offer in a transaction treated as a recapitalization and (2) that realizes a loss on the exchange that it is not permitted to recognize under the recapitalization rules, with the consequence that its initial tax basis in the new senior subordinated debentures exceeds the adjusted issue price of those debentures. Election To Treat All Interest as Original Issue Discount. A United States holder may elect to include in gross income all interest that accrues on a new senior subordinated debenture using the constant-yield method described above under the heading "Original Issue Discount -General," with the modifications described below. For purposes of this election, interest includes stated interest, OID, market discount and de minimis market discount, as adjusted by any acquisition premium. In applying the constant-yield method to a new senior subordinated debenture with respect to which this election has been made, the issue price of the new senior subordinated debenture will equal the electing United States holder's adjusted basis in the new senior subordinated debenture immediately after its acquisition, the issue date of the new senior subordinated debenture will be the date of its acquisition by the electing United States holder and no payments on the new senior subordinated debenture will be treated as payments of qualified stated interest. This election generally will apply only to the new senior subordinated debenture with respect to which it is made and may not be revoked without the consent of the IRS. If the election to apply the constant-yield method to all interest on a new senior subordinated debenture is made with respect to a market discount debenture, then the electing United States holder will be treated as having made the election discussed below under "Market Discount" to include market discount in income currently over the life of all debt instruments held or thereafter acquired by the United States holder. Market Discount A new senior subordinated debenture will be considered to be a market discount debenture if the adjusted issue price of the new senior subordinated debenture at the time of acquisition exceeds the initial tax basis of the new senior subordinated debenture in the hands of the United States holder by more than a specified de minimis amount. If this excess is not sufficient to cause the new senior subordinated debenture to be a market discount debenture, this excess constitutes "de minimis market discount." In addition, as discussed above under "Exchange of New Senior Subordinated Debentures for Old Junior Subordinated Debentures-The Exchange," if a United States holder acquires new senior subordinated debentures pursuant to the exchange offer in an exchange treated as a recapitalization, then accrued market discount on an old junior subordinated debenture that is not taken into account in connection with the exchange will carry over to the new senior subordinated debenture received in exchange. Any gain recognized on the receipt of payments on or disposition of a market discount debenture will be treated as ordinary income to the extent that this gain does not exceed the accrued market discount on the new senior subordinated debenture. Alternatively, a United States holder of a market discount debenture may elect to include market discount in income currently over the life of the new senior subordinated debenture. This election shall apply to all debt instruments with market discount acquired by the electing United States holder on or after the first day of the first taxable year to which the election applies. This election may not be revoked without the consent of the IRS. A United States holder that makes the election described under "Original Issue Discount-Election To Treat All Interest as Original Issue Discount" will be deemed to have elected to include market discount in income currently. Market discount on a market discount debenture will accrue on a ratable basis unless the United States holder elects to accrue this market discount using a constant-yield method. This election shall apply only to the new senior subordinated debenture with respect to which it is made and may not be revoked without the consent of the IRS. A United States holder of a market discount debenture that does not elect, and is not deemed to have elected, to include market discount in income currently generally will be required to defer deductions for net direct interest expense with respect to the new senior subordinated debenture (defined for each taxable year as the excess of interest expense allocable to the new senior subordinated debenture over interest, including OID, includible in income in respect of the new senior subordinated debenture) in an amount not exceeding the accrued market discount on the new senior subordinated debenture until the maturity or disposition of the new senior subordinated debenture. Purchase, Sale and Retirement of New Senior Subordinated Debentures A United States holder's initial tax basis in a new senior subordinated debenture, determined in the manner described above under "Exchange of New Senior Subordinated Debentures for Old Junior Subordinated Debentures-The Exchange," will be increased by the amount of any OID or market discount included in the United States holder's income with respect to the new senior subordinated debenture and reduced by the amount of any payments on the new senior subordinated debenture other than payments of qualified stated interest. A United States holder generally will recognize gain or loss on the sale or retirement of a new senior subordinated debenture in an amount equal to the difference between the amount realized on the sale or retirement, other than amounts attributable to accrued but unpaid interest, which will be taxable as ordinary income, and the tax basis of the new senior subordinated debenture. Except to the extent described above under "-Market Discount," gain or loss recognized on the sale or retirement of a new senior subordinated debenture will be capital gain or loss and will be long-term capital gain or loss if the new senior subordinated debenture has been held for more than one year. Nonparticipation in the Exchange Offer A United States holder that does not participate in the exchange offer and instead retains its old junior subordinated debentures will not recognize any gain or loss as a result of the consummation of the exchange offer. LEGAL MATTERS The validity of our new senior subordinated debentures offered by this prospectus will be passed upon for us by Morgan, Lewis & Bockius LLP, New York, New York. EXPERTS The financial statements and related financial statement schedule of CII Financial, Inc. and subsidiaries as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, included in this prospectus have been audited by Deloitte & Touche LLP, independent auditors, as stated in their report appearing herein, and have been so included in reliance upon the reports of such firm given upon their authority as experts in accounting and auditing. A-2 A-1 ANNEX I GLOSSARY OF SELECTED INSURANCE TERMS The following terms when used in this Prospectus have the following meanings: Assume..............................To receive from a ceding company, all or a portion of a risk in consideration of a premium. Cede.................................To transfer to a reinsurer, all or a portion of a risk in consideration of a premium. Combined ratio..................... The sum of the loss ratio, the underwriting expense ratio and the policyholders' dividend ratio, expressed as a percentage. A combined ratio less than 100% indicates an underwriting profit. Direct written premiums......... Premiums written by an insurer before the assumption and cession of reinsurance. Loss ratio........................... The ratio arrived at by dividing the amount of losses and loss adjustment expenses by net earned premiums. Losses ........................... For workers' compensation insurance, payments and reserves needed to provide indemnity, medical and rehabilitation costs to injured workers. Loss adjustment expenses...... The expenses of settling claims, including legal, other fees and general expenses. Net earned premiums............ The portion of premiums applicable to the expired period of policies after the assumption and cession of reinsurance. Net written premiums............ Premiums retained by an insurer after the assumption and cession of reinsurance. Participating policy............... An insurance policy where the policyholders may receive a "dividend" which is a partial return of premium, after the policy period if, among other factors, the insured has had a favorable claims history during the period; that is, the policyholder "participates" in the savings resulting from a favorable claims history, among other factors. Policy acquisition costs......... Agents' and brokers' commissions, premium taxes, boards and bureau fees, marketing, underwriting and other direct expenses associated with acquiring and retaining business. Policyholders' dividend ratio... The ratio arrived at by dividing the amount of policyholders' dividends incurred by net earned premiums. Policyholders' surplus............ The sum remaining after all liabilities are subtracted from all assets, applying statutory accounting principles. This sum is regarded as financial protection to policyholders in the event an insurance company suffers unexpected or catastrophic losses. Quota share reinsurance......... A form of reinsurance in which the reinsurer assumes an agreed percentage of certain risks insured by the ceding insurer up to a specified amount, and shares premiums and losses proportionately. Reinsurance........................ An agreement whereby an original insurer remits a portion of the premium to a reinsurer as payment for the reinsurers assumption of a portion of the risk. Reinsurance can be effected by "treaties," where a reinsurance treaty automatically covers all risks of a defined category, amount and type, or by "facultative reinsurance." Facultative reinsurance is negotiated between an original insurer and the reinsurer on an individual, contract-by-contract basis. Reserves or loss reserves......... A balance sheet liability for unpaid losses representing estimates of amounts needed to pay reported and unreported claims and related loss adjustment expenses. Statutory accounting............... Recording transactions and preparing financial statements in accordance with the rules and procedures adopted by regulatory authorities, generally reflecting a liquidating, rather than a going concern, concept of accounting. Treaty.............................. See Reinsurance. Unassigned funds..................... The cumulative amount of retained net profits from insurance operations, or earned surplus including investment income, as determined under statutory accounting principles. Underwriting..................... The process whereby an insurer reviews applications submitted for insurance coverage and determines whether it will accept all or part, and at what premium, of the coverage being requested. Underwriting expenses............ The aggregate of policy acquisition costs and the portion of administrative, general and other expenses attributable to insurance operations. Underwriting expense ratio...... For generally accepted accounting principles ("GAAP"), the ratio arrived at by dividing the amount of GAAP underwriting expenses by net earned premiums. For statutory accounting basis, the ratio arrived at by dividing the amount of statutory underwriting expenses by net written premiums. Underwriting profit (loss)...... The amount of net income (loss) from insurance operations, exclusive of net investment or other income. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CII Financial, Inc. and Subsidiaries Page Management Report on Consolidated Financial Statements F-2 Report of Independent Auditors F-3 Consolidated Financial Statements for the Nine Months Ended September 30, 2000 and 1999 (unaudited), and the Years Ended December 31, 1999, 1998 and 1997: Consolidated Balance Sheets F-4 Consolidated Statements of Operations F-5 Consolidated Statements of Stockholder's Equity F-6 Consolidated Statements of Cash Flows F-7 Notes to Consolidated Financial Statements F-8 Supplemental Financial Statement Schedule F-22
MANAGEMENT REPORT ON CONSOLIDATED FINANCIAL STATEMENTS The management of CII Financial, Inc. is responsible for the integrity and objectivity of the accompanying consolidated financial statements. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment. The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against losses from unauthorized use or disposition. Management believes that for the year ended December 31, 1999, such systems and controls were adequate to meet the objectives discussed herein. The accompanying consolidated financial statements have been audited by independent certified public accountants, whose audits thereof were made in accordance with auditing standards generally accepted in the United States of America and included a review of internal accounting controls to the extent necessary to design audit procedures aimed at gathering sufficient evidence to provide a reasonable basis for their opinion on the fairness of presentation of the consolidated financial statements taken as a whole. Kathleen M. Marlon, Chairman and Chief Executive Officer John F. Okita Chief Financial Officer Report of Independent Auditors To the Board of Directors and Stockholder CII Financial, Inc. Las Vegas, Nevada We have audited the accompanying consolidated balance sheets of CII Financial, Inc. and Subsidiaries as of December 31, 1999 and 1998 and the related consolidated statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CII Financial, Inc. and Subsidiaries at December 31, 1999 and 1998 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States of America. Our audits were conducted for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The supplemental schedule listed in the index to the consolidated financial statements is presented for the purpose of additional analysis and is not a required part of the basic consolidated financial statements. This schedule is the responsibility of the management of CII Financial, Inc. Such schedule has been subjected to the auditing procedures applied in our audits of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects when considered in relation to the basic consolidated financial statements taken as a whole. /s/ DELOITTE & TOUCHE, LLP Las Vegas, Nevada December 21, 2000 CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except for share data)
September 30, December 31, 2000 1999 1998 ---- ---- ---- (Unaudited) ASSETS Cash, cash equivalents and invested assets: Cash and cash equivalents $ 19,408 $ 16,833 $ 22,114 Debt securities, available-for-sale, at fair value 164,660 165,296 185,644 Debt securities, held-to-maturity, at amortized cost 22,154 25,023 53,967 Preferred stock, at fair value 1,732 3,486 882 Mortgage loans on affiliated real estate 10,261 2,959 3,082 Mortgage loans on non-affiliated real estate 6,281 6,416 11,635 Real estate limited partnership 7,108 6,559 6,185 ---------- ---------- ---------- Total cash, cash equivalents and invested assets 231,604 226,572 283,509 -------- -------- -------- Reinsurance recoverable 211,594 131,862 58,424 Premiums receivable (net of allowances of $1,134 (unaudited), $1,134 and $1,278) 13,402 9,391 10,612 Investment income receivable 2,406 2,786 2,782 Deferred policy acquisition costs 2,732 2,378 1,804 Federal income taxes receivable 9,478 4,896 492 Deferred income taxes 15,984 17,344 15,929 Property and equipment, net 5,097 8,354 5,253 Other assets 555 755 1,075 ------------ ------------ ----------- TOTAL ASSETS $492,852 $404,338 $379,880 ======== ======== ======== LIABILITIES Reserve for loss and loss adjustment expenses $341,902 $244,394 $212,264 Unearned premiums 16,206 13,300 11,158 Ceded reinsurance premiums payable 7,424 9,321 8,739 Convertible subordinated debentures 47,059 50,498 51,251 Accounts payable and other accrued expenses 15,969 15,265 18,788 Payable to affiliates 2,487 2,768 2,105 Deferred tax liability 3,291 2,739 1,628 ---------- ---------- ---------- TOTAL LIABILITIES 434,338 338,285 305,933 -------- -------- -------- COMMITMENTS AND CONTINGENCIES STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; shares issued and outstanding - 100 3,604 3,604 3,604 Additional paid-in capital 64,450 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments (8,651) (12,200) (702) (Accumulated deficit) retained earnings (889) 10,199 6,595 ----------- ---------- ---------- TOTAL STOCKHOLDER'S EQUITY 58,514 66,053 73,947 ---------- ---------- --------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $492,852 $404,338 $379,880 ======== ======== ========
See the accompanying notes to consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands)
Nine Months Ended September 30, Year Ended December 31, 2000 1999 1999 1998 1997 ---- ---- ---- ---- ---- (Unaudited) (Unaudited) REVENUES Direct written premiums, gross $153,034 $106,291 $148,824 $153,914 $135,580 Changes in direct unearned premiums (2,906) (2,579) (2,142) 127 (1,400) ---------- ---------- ---------- ----------- ---------- Direct earned premiums, gross 150,128 103,712 146,682 154,041 134,180 Less: premiums ceded 59,177 45,458 63,727 19,767 4,983 --------- --------- --------- --------- ---------- Net earned premiums 90,951 58,254 82,955 134,274 129,197 Net investment income 11,217 12,075 15,776 18,241 16,781 Net realized investment (losses) gains (460) (174) (381) 1,988 580 ---------- ---------- ---------- ---------- ----------- Total revenues 101,708 70,155 98,350 154,503 146,558 ------- -------- -------- -------- -------- COSTS AND EXPENSES Loss and loss adjustment expenses 207,323 94,815 157,424 115,759 99,553 Reinsurance recoveries (123,303) (60,002) (95,963) (21,412) (6,221) -------- -------- --------- --------- ---------- Net loss and loss adjustment expenses 84,020 34,813 61,461 94,347 93,332 Policy acquisition costs 8,606 5,737 6,339 19,216 19,860 General and administrative and other 17,372 15,000 19,749 18,761 18,462 Asset impairment 3,000 Interest expense 2,717 2,751 3,706 4,301 4,091 --------- --------- ---------- ---------- ---------- Total costs and expenses 115,715 58,301 91,255 136,625 135,745 -------- -------- --------- -------- -------- (LOSS) INCOME BEFORE FEDERAL INCOME TAX (BENEFIT) EXPENSE AND EXTRAORDINARY GAIN (14,007) 11,854 7,095 17,878 10,813 Federal income tax (benefit) expense (4,902) 4,815 3,602 4,166 272 --------- --------- --------- ---------- ----------- (LOSS) INCOME BEFORE EXTRAORDINARY GAIN (9,105) 7,039 3,493 13,712 10,541 --------- -------- --------- --------- --------- Extraordinary gain from debt extinguishments (net of income taxes of $353 and $0 (unaudited), $59, $25, and $1) 654 111 48 2 ---------- ------------- ---------- ------------ ------------- NET (LOSS) INCOME $ (8,451) $ 7,039 $ 3,604 $ 13,760 $ 10,543 ======== ======= ======== ======== ========
See the accompanying notes to consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY (In thousands)
Accumulated (Accumulated Common Stock Additional Other Deficit) Total Number of Amount Paid-in Comprehensive Comprehensive Retained Stockholder's Shares Capital Income (Loss) Income (Loss) Earnings Equity ------------ --------- ----------- -------------- --------------- ------------- -------------- BALANCE, JANUARY 1, 1997 100 $3,604 $58,630 $ 303 $ (17,708) $44,829 Comprehensive income: Net income $10,543 10,543 10,543 Unrealized gain on available-for-sale investments, net of tax 949 949 949 Reclassification adjustment for gains included in net income (580) (580) (580) ---------- Comprehensive income $10,912 ======= Stock option activity 1,737 1,737 ------------ ------------------- ------------ ------------ -------- BALANCE, DECEMBER 31, 1997 100 3,604 60,367 672 (7,165) 57,478 Comprehensive income: Net income $13,760 13,760 13,760 Unrealized gain on available-for-sale investments, net of tax 614 614 614 Reclassification adjustment for gains included in net income (1,988) (1,988) (1,988) --------- Comprehensive income $12,386 ======= Capital contribution from parent 3,665 3,665 Stock option activity 418 418 ------------ -------------------- ------------ ------------ --------- BALANCE, DECEMBER 31, 1998 100 3,604 64,450 (702) 6,595 73,947 Comprehensive income: Net income $3,604 3,604 3,604 Unrealized loss on available-for-sale investments, net of tax (11,879) (11,879) (11,879) Reclassification adjustment for losses included in net income 381 381 381 --------- Comprehensive income $ (7,894) ------------ ---------------------------------- ========= ------------ BALANCE, DECEMBER 31, 1999 100 3,604 64,450 (12,200) 10,199 66,053 Comprehensive income: Net loss (unaudited) $(8,451) (8,451) (8,451) Unrealized gain on available-for-sale investments, net of tax (unaudited) 3,089 3,089 3,089 Reclassification adjustment for losses included in net income (unaudited) 460 460 460 --------- Comprehensive income (unaudited) $ (4,902) ========= Dividend paid to parent (unaudited) (2,637) (2,637) BALANCE, SEPTEMBER 30, 2000 (unaudited) 100 $3,604 $64,450 $ (8,651) $ (889) $58,514 === ====== ======= ======== ======= =======
See the accompanying notes to consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
Nine Months Ended September 30, Year Ended December 31, 2000 1999 1999 1998 1997 ---- ---- ---- ---- ---- (Unaudited) (Unaudited) CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $(8,451) $7,039 $3,604 $13,760 $10,543 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Extraordinary gain (1,007) (170) (73) (3) Depreciation and amortization 1,197 950 1,220 1,550 928 Provision for asset impairment 3,000 Provision for losses on premiums (144) (144) Change in assets and liabilities: Premiums receivable (4,011) 1,303 1,365 1,078 504 Investment income receivable 380 238 (3) 1,768 (820) Deferred policy acquisition costs (354) (773) (574) (3) 31 Payable to affiliates (281) 3,555 662 10,213 834 Reinsurance recoverable (79,732) (39,471) (73,438) (37,011) (5,634) Federal income taxes receivable (4,582) 2,650 (4,404) (697) (3,022) Deferred income taxes 5,887 (1,637) (2,044) Reserve for loss and loss adjustment expense 97,508 879 32,130 9,565 14,923 Unearned premiums 2,906 2,579 2,142 (127) 1,400 Accounts payable and other accrued expenses 704 (2,130) (3,523) 4,889 589 Ceded reinsurance premiums payable (1,897) (3,241) 582 7,843 (42) Other assets (7,633) 4,366 5,142 (13,988) (807) --------- --------- --------- -------- --------- Net cash (used in) provided by operating activities (2,253) (22,200) (29,522) (2,870) 17,380 --------- -------- -------- --------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (820) (4,011) (4,176) (4,395) (10,419) Purchase of available-for-sale investments (111,727) (159,576) (291,863) (682,334) (512,653) Proceeds from sales/maturities of available-for-sale investments 119,577 148,251 291,919 687,415 478,203 Purchase of held-to-maturity investments (1,499) (7,086) (7,133) (38,056) (7,776) Proceeds from maturities of held-to-maturity investments 4,366 30,980 36,077 18,087 4,872 ----- ------- ------- ------- ------ Net cash provided by (used in) investing activities 9,897 8,558 24,824 (19,283) (47,773) ------ ----- ------ ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of convertible subordinated debentures (2,432) (55) (583) (3,143) (27) Dividend to Sierra (2,637) Capital contribution 3,665 Stock option activity 418 1,737 -------------- -- ----------------------- --------- Net cash (used in) provided by financing activities (5,069) (55) (583) 940 1,710 ---------- ------------ ----------- ---------- --------- NET CHANGE IN CASH AND CASH EQUIVALENTS 2,575 (13,697) (5,281) (21,213) (28,683) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 16,833 22,114 22,114 43,327 72,010 -------- -------- -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $19,408 $ 8,417 $16,833 $22,114 $43,327 ======= ======== ======= ======= ======= SUPPLEMENTAL DISCLOSURES OF CASH FLOW DATA Cash paid during the year for interest (net of amount $3,713 $3,712 $3,724 $4,380 $4,088 capitalized) Cash paid during the year for income taxes 7 1,834 1,834 7,220 4,303
See the accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Business CII Financial, Inc. ("CII Financial") was incorporated in the State of California on September 15, 1988. On October 31, 1995 Sierra Health Services, Inc. ("Sierra") acquired CII Financial for approximately $76.3 million of common stock in a transaction accounted for as a pooling of interests. CII Financial is a holding company primarily engaging in writing workers' compensation insurance through its wholly-owned subsidiaries, California Indemnity Insurance Company ("California Indemnity"), Commercial Casualty Insurance Company ("Commercial Casualty"), CII Insurance Company ("CII Insurance") and Sierra Insurance Company of Texas ("Sierra Texas"). As used herein, the term "the Company" means CII Financial, Inc. and its subsidiaries, and the term "CII Financial" means CII Financial, Inc., exclusive of such subsidiaries. 2. Summary of Significant Accounting Policies Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. The consolidated financial statements of CII Financial include the accounts of all of its wholly-owned subsidiaries, California Indemnity, Commercial Casualty, Sierra Texas, CII Insurance, Sierra Insurance Agency, CII Leasing, Inc., Financial Assurance Company, Ltd. and CII Premium Finance Company. CII Leasing, Inc. and CII Premium Finance Company are both inactive subsidiaries. Unaudited Financial Statements. The accompanying unaudited balance sheet, as of September 30, 2000 and the consolidated statements of operations and of cash flows for the nine month periods ended September 30, 2000 and 1999, have been prepared in conformity with accounting principles generally accepted in the United States of America but do not contain all of the information and disclosures that would be required in a complete set of audited financial statements. They should, therefore, be read in conjunction with the audited consolidated financial statements and related notes thereto for the years ended December 31, 1999, 1998 and 1997. In the opinion of management, the accompanying unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial results for the interim periods presented. Premium Revenues. Revenue from workers' compensation premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Premiums written in excess of premiums earned are recorded as unearned premium revenue. Direct premiums earned but not billed at the end of each accounting period are estimated and accrued, and differences between such estimates and final billings are included in current operations. Accrued earned but unbilled premiums are included with premiums receivable. Revenue is shown net of premiums ceded to reinsurers. General and Administrative Expenses. Policyholder's dividends and management fees are included in general and administrative expenses. Deferred Policy Acquisition Costs. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed. Cash and Cash Equivalents. The Company considers cash and cash equivalents as all highly liquid instruments with an original maturity of three months or less at the time of purchase. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of these instruments. Investments. Available-for-sale debt securities and preferred stocks are stated at fair value with unrealized gains and losses recorded as a separate component of other comprehensive income (loss), net of deferred income taxes. Held-to-maturity debt securities are carried at amortized cost. The insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company, and its subsidiaries, are in compliance with the applicable minimum regulatory and capital requirements. Investment income is recognized when earned. Gains and losses on disposition are based on net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. The Company has an investment in a real estate limited partnership that is accounted for under the equity method. Under the equity method, original investments are recorded at cost and adjusted by the Company's share of earnings, losses and distributions. Property and Equipment. Property and equipment, consisting of buildings and leasehold improvements, furniture and fixtures, data processing equipment and vehicles, is stated at cost less accumulated depreciation. Depreciation is computed on a straight-line basis over periods ranging from 5 to 10 years with leasehold improvements depreciated over the term of the lease. Reinsurance. In the normal course of business, insurance companies seek to reduce the effects of events that may cause unfavorable underwriting results by reinsuring certain levels of risk in various levels of exposure with reinsurers. Amounts recoverable from the reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance receivables, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reserve for Loss and Loss Adjustment Expenses. The reserve for workers' compensation loss and loss adjustment expense ("loss and LAE") consists of estimated costs of each unpaid claim reported to the Company prior to the close of the accounting period as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations. The Company does not discount its loss and LAE reserves. Income Taxes. The Company accounts for income taxes using the liability method. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. The Company's temporary differences arise principally from certain net operating losses, accrued expenses, reserves for loss and LAE and depreciation. Federal income taxes are calculated pursuant to a tax allocation agreement between Sierra and the Company. Income taxes are allocated on a separate return basis for each company and tax benefits are recorded only to the extent that an entity could recoup taxes paid in prior years. Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of investments and accounts receivable. The Company maintains cash and cash equivalents and investments with various financial institutions. These financial institutions are located in many different regions, and Company policy is designed to limit exposure with any one institution. Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising the Company's customer base and their dispersion across many different industries. These customers are primarily located in the states in which the Company operates principally California, Colorado, Nevada and Texas. However, the Company is licensed and does business in several other states. The Company also has receivables from certain reinsurers. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance contracts with are rated A- or better by the A.M. Best Company. Recently Issued Accounting Standards. In June 1998, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended, which is effective for fiscal years beginning after June 15, 2000. SFAS 133 establishes additional accounting and reporting standards for derivative instruments and hedging activities. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position. This statement also defines and allows companies to apply hedge accounting to its designated derivatives under certain instances. It also requires that all derivatives be marked to market on an ongoing basis. This applies whether the derivatives are stand-alone instruments, such as warrants or interest rate swaps, or embedded derivatives, such as call options contained in convertible debt investments. Along with the derivatives, in the case of qualifying hedges, the underlying hedged items are also to be marked to market. These market value adjustments are to be included either in the income statement or other comprehensive income, depending on the nature of the hedged transaction. The fair value of financial instruments is generally determined by reference to market values resulting from trading on a national securities exchange or in an over the counter market. In cases where derivatives relate to financial instruments of non-public companies, or where quoted market prices are otherwise not available, such as for derivative financial instruments, fair value is based on estimates using present value or other valuation techniques. Based on management's understanding of SFAS 133, the Company does not believe that it has any derivative instruments and does not have any hedging activities. The majority of the Company's investments are held by insurance companies, which are regulated as to the types of investments they may hold. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 clarifies existing accounting principles related to revenue recognition in financial statements. The Company is required to comply with the provisions of SAB 101 in its quarter ending December 31, 2000. Based upon the current nature of the Company's operations, management does not believe that SAB 101 will have any impact on the Company's results of operations. Business Segment. As of December 31, 1999 the Company operated in a single business segment, workers' compensation insurance. Use of Estimates in the Preparation of Financial Statements. The preparation of the Company's financial statements requires management to make estimates and assumptions that affect the amounts of reported assets and liabilities, particularly loss and LAE reserves and incurred loss and LAE reported in the financial statements. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although reserves are established on the basis of a reasonable estimate, it is not only possible but probable that reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns and unanticipated inflationary trends affecting the services provided by the insurance contract. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results. 3. PROPERTY AND EQUIPMENT Property and equipment at December 31, consists of the following (in thousands):
1999 1998 -------- -- ---- Buildings and leasehold improvements $1,124 $ 974 Furniture, fixtures and equipment 3,003 2,936 Data processing equipment and software 3,560 3,154 Construction in progress 5,178 1,625 Less: accumulated depreciation (4,511) (3,436) ------ ------ Net property and equipment $8,354 $5,253 ======= ======
Depreciation expense in 1999, 1998 and 1997 was $1,075,000, $1,345,000 and $722,000, respectively. During the second quarter of 2000 the Company wrote-off capitalized costs of $3.0 million on an information system software project that was cancelled because the vendor was unable to fulfill its contractual obligations. 4. INVESTMENTS The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 1999 (in thousands):
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available-for-Sale: U.S. Government and its Agencies.......................................... $101,102 $122 $13,041 $ 88,183 Municipal Obligations......................................... 31,818 20 1,236 30,602 Corporate Bonds............................................... 32,907 45 1,730 31,222 Other......................................................... 17,908 2,619 15,289 Total Debt Securities......................................... 183,735 187 18,626 165,296 Preferred Stock............................................... 3,817 331 3,486 Total Available-for-Sale................................... $187,552 $187 $18,957 $168,782 Held-to-Maturity U.S. Government ======================================================================== and its Agencies.......................................... $9,782 $341 $ 708 $ 9,415 Municipal Obligations......................................... 5,558 64 55 5,567 Corporate Bonds............................................... 5,738 115 5,853 Other......................................................... 3,945 751 3,194 Total Held-to-Maturity...................................... $25,023 $520 $1,514 $ 24,029 The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 1998 (in thousands): Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value Available-for-Sale: U.S. Government and its Agencies.......................................... $78,071 $717 $1,189 $ 77,599 Municipal Obligations......................................... 23,585 145 227 23,503 Corporate Bonds............................................... 76,479 596 823 76,252 Other......................................................... 8,542 19 271 8,290 Total Debt Securities......................................... 186,677 1,477 2,510 185,644 Preferred Stock............................................... 931 9 58 882 Total Available-for-Sale.................................... $187,608 $1,486 $2,568 $186,526 Held-to-Maturity U.S. Government ======================================================================== and its Agencies.......................................... $15,492 $ 47 $ 483 $ 15,056 Municipal Obligations......................................... 6,300 319 6,619 Corporate Bonds............................................... 11,909 557 12,466 Other......................................................... 20,266 937 19,329 Total Held-to-Maturity...................................... $53,967 $ 923 $1,420 $ 53,470
=========================================================================== The contractual maturities of available-for-sale debt securities at December 31, 1999 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Amortized Estimated (in thousands) Cost Fair Value Due in one year or less....................................... $ 8,492 $ 8,485 Due after one year through five years......................... 38,414 37,688 Due after five years through ten years........................ 13,909 13,298 Due after ten years through fifteen years..................... 13,844 12,664 Due after fifteen years....................................... 109,076 93,161 --------- --------- Total.................................................... $183,735 $165,296 ======== ========
- ------------------------------------------------------------------------------ The contractual maturities of held-to-maturity debt securities at December 31, 1999 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations:
Amortized Estimated (in thousands) Cost Fair Value Due in one year or less....................................... $ 2,580 $ 2,611 Due after one year through five years......................... 9,565 9,585 Due after five years through ten years........................ 776 775 Due after ten years through fifteen years..................... 4,795 4,565 Due after fifteen years....................................... 7,307 6,493 --------- ----------- Total.................................................... $25,023 $ 24,029 ======= ========
- ---------------------------------------------------------------------------- Gross realized gains on investments for the nine months ended September 30, 2000 and the years ended December 31, 1999, 1998 and 1997 were $220,000 (unaudited), $261,000, $4,120,000 and $2,517,000, respectively. Gross realized losses on investments for the nine months ended September 30, 2000 and the years ended December 31, 1999, 1998 and 1997 were $680,000 (unaudited), $642,000, $2,132,000 and $1,937,000, respectively. Investment income, by major category of investments, is summarized as follows (in thousands):
Nine months ended September 30, Year Ended December 31, 2000 1999 1999 1998 1997 -------- -- ----- -- ----- -------- ------ (Unaudited) (Unaudited) Interest from debt securities $10,352 $10,962 $14,387 $17,175 $16,206 Dividend income from preferred stock 280 328 411 511 358 Mortgage interest 592 928 1,130 734 397 Other 42 ______ ----------- -------- -------------- Total investment income 11,266 12,218 15,928 18,420 16,961 Investment expenses 49 143 152 179 180 ----------- --------- ---------- ---------- ---------- Net investment income $11,217 $12,075 $15,776 $18,241 $16,781 ======= ======= ======= ======= =======
Of the total debt securities and cash equivalents, $152,356,000, $171,639,000 and $179,878,000, at fair value, were on deposit with regulatory authorities in compliance with certain legal requirements related to the insurance operations at September 30, 2000, December 31, 1999 and 1998, respectively. The Company holds certain mortgage notes on residential and commercial real estate. In connection with CII Financial's relocation of its principal executive offices to Pleasanton, California in July 1992, to retain key officers and other employees, the Company extended mortgage loans for the purchase of such employees' principal residences. The interest rate was reduced to a fixed rate of 3% per annum; the maturity date was fixed to March 2009; and each loan can be assumed, one time, by a qualified purchaser of the employee's residence. The interest rate, upon assumption, increases to 3.5% per annum. As of December 31, 1999 and 1998, the outstanding balances on employee relocation loans were $4,764,000 and $4,949,000, respectively. The Company also holds commercial mortgage loans, the majority of which are with Sierra affiliates. These loans are also first trust deeds and earn between 7% and 11 1/2% per annum. The Company has one mortgage loan with a non-affiliated third party which is currently in default; the principle balance outstanding was $1,633,000 at September 30, 2000. The property has been appraised at a value that exceeds book value. Interest income has not been accrued since the default date. The Company is currently litigating the priority of its lien on the property. The Company has made demand under its title insurance policy and will foreclose pending the outcome of the litigation on its claim. 5. Reinsurance The Company has reinsurance treaties in effect with unrelated entities. In 1999 and 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence are 100% reinsured. In 1997, workers' compensation claims between $350,000 and $60,000,000 per occurrence were 100% reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence were reinsured under quota share and excess of loss reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, the Company reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 and 100% of the next $450,000. The Company receives a 9.25% ceding commission from the reinsurer as a partial reimbursement of its operating expenses. The low level reinsurance agreement expired on June 30, 2000; however the Company opted to continue ceding premiums and losses under the low level agreement on a run off basis for all policies in force on June 30, 2000. Effective January 1, 2000 we entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2000. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 to $500,000 for policies issued after June 30, 2000. The low level reinsurance agreement at signing contained both retroactive and prospective reinsurance coverage and the Company has bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceed the amount paid for the retroactive coverage is reported as a deferred gain and amortized to income over the estimated remaining settlement period using the interest method. Any subsequent changes in estimated or actual cash flows related to the retroactive coverage are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income. During 1999, the Company recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $4,615,000. For the years ended December 31, 1999 and 1998, the Company amortized deferred gains of $3,850,000 and $1,038,000, respectively. At December 31, 1999 and 1998, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid loss and LAE was $110,089,000 and $37,797,000, respectively. At December 31, 1999 and 1998, the amount of reinsurance recoverable under the retroactive reinsurance contract was $14,842,000 and $18,710,000, respectively. The amount of reinsurance receivable for paid loss and LAE was $6,931,000 and $1,917,000 at December 31, 1999 and 1998, respectively. Such amortization is included in loss and loss adjustment expense on the accompanying consolidated statements of operations. Reinsurance contracts do not relieve the Company from its obligations to enrollees or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Substantially all of the reinsurance recoverables are due from reinsurers rated A+ by the A.M. Best Company. The following table provides workers' compensation prospective reinsurance information for the periods ended (in thousands):
Change in Recoveries Recoverable on Paid or Unpaid Premiums Loss / LAE Loss / LAE Ceded Nine Months Ended September 30, 2000 (Unaudited): Low level reinsurance carrier $36,180 $79,170 $56,732 Excess of loss reinsurance carriers 1,678 6,275 2,445 --------- --------- --------- Total $37,858 $85,445 $59,177 ======= ======= ======= Nine Months Ended September 30, 1999 (Unaudited): Low level reinsurance carrier $14,088 $40,191 $43,264 Excess of loss reinsurance carriers 2,578 3,145 2,194 --------- --------- --------- Total $16,666 $43,336 $45,458 ======= ======= ======= Year Ended December 31, 1999: Low level reinsurance carrier $21,941 $69,104 $60,702 Excess of loss reinsurance carriers 1,730 3,188 3,025 --------- --------- --------- Total $23,671 $72,292 $63,727 ======= ======= ======= Year Ended December 31, 1998: Low level reinsurance carrier $ 1,379 $19,664 $16,095 Excess of loss reinsurance carriers 3,292 (2,923) 3,672 -------- -------- --------- Total $ 4,671 $16,741 $19,767 ======= ======= ======= Year Ended December 31, 1997: Excess of loss reinsurance carriers $ 841 $ 5,380 $ 4,983 ======== ======== ======== 6. Loss and Loss Adjustment Expenses
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid loss and LAE. The loss estimates are subject to change in subsequent accounting periods and any change to the current reserve estimates would be accounted for in future results of operations. While management of the Company believes that current estimates are reasonable, significant adverse or favorable loss development could occur in the future.
Nine Months Ended September 30, (In thousands) Year Ended December 31, 2000 1999 1999 1998 1997 ---- -------- ---- ------- ------------ ---- ------- (Unaudited) (Unaudited) Net beginning loss and LAE reserve $134,305 $174,467 $174,467 $181,643 $172,100 -------- -------- -------- -------- -------- Net provision for insured events incurred in: Current year 63,843 36,061 51,541 103,990 102,302 Prior years 20,177 (1,248) 9,920 (9,643) (8,970) --------- --------- ---------- ----------- --------- Total net provision 84,020 34,813 61,461 94,347 93,332 --------- --------- --------- ---------- --------- Net payments for loss and LAE attributable to insured events incurred in: Current year 15,763 12,836 21,207 29,591 26,812 Prior years 49,893 64,668 80,416 71,932 56,977 --------- -------- --------- --------- --------- Total net payments 65,656 77,504 101,623 101,523 83,789 --------- -------- -------- -------- --------- Net ending loss and LAE reserve 152,669 131,776 134,305 174,467 181,643 Reinsurance recoverable 189,233 81,367 110,089 37,797 21,056 --------- --------- -------- --------- ---------- Gross ending loss and LAE reserve $341,902 $213,143 $244,394 $212,264 $202,699 ======== ======== ======== ======== ========
During the nine months ended September 30, 2000, the Company experienced net adverse development related to accident years 1999 and prior. Estimated loss and LAE incurred in accident years 1996 to 1998 have developed significantly in response to the continuation of increasing claim severity patterns on the Company's California book of business. Many workers' compensation insurance carriers in California are also experiencing high claim severity. For claims occurring on and after July 1, 1998, the Company has reinsured a percentage of the higher claim severity to its reinsurer under the Company's low level reinsurance agreement. The low level reinsurance agreement expired on June 30, 2000; however the Company opted to continue ceding premiums and losses under the low level agreement on a run off basis for all policies in force on June 30, 2000. Effective January 1, 2000 we entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2000. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 to $500,000 for policies issued after June 30, 2000. 7. Long Term Debt 7 1/2% Convertible Subordinated Debentures. The Company's long-term debt at December 31, 1999 and 1998 consists of convertible subordinated debentures with an outstanding balance of $50,498,000 and $51,251,000 respectively. In September 1991, the Company issued convertible subordinated debentures (the "Debentures") due September 15, 2001. The Debentures bear interest at 7 1/2% which is due semi-annually on March 15 and September 15. Each $1,000 in principal is convertible into 25.382 shares of Sierra common stock at a conversion price of $39.398 per share. Unamortized issuance costs of $362,000 and $509,000 at December 31, 1999 and 1998, are included in other assets on the consolidated balance sheets and are being amortized over the life of the Debentures. Accrued interest on the Debentures as of December 31, 1999 and 1998 was $1,099,000 and $1,117,000, respectively. The Debentures are redeemable in whole or in part, at a redemption price of 100.75% plus accrued interest. The Debentures are subordinated obligations of CII Financial only and were not assumed or guaranteed by Sierra. During the years ended December 31, 1999, 1998 and 1997, the Company repurchased $753,000, $3,216,000 and $30,000 respectively, of the debentures on the open market resulting in extraordinary gains of $170,000, $73,000 and $3,000 and a corresponding tax provision of $59,000, $25,000 and $1,000 in 1999, 1998 and 1997 respectively. The fair value of the Debentures at December 31, 1999 was $35,601,000, which was determined based on the estimated market price on December 31, 1999. The Debentures are scheduled to mature on September 15, 2001. CII Financial has limited sources of cash and borrowed approximately $365,000 from Sierra to make the September 15, 2000 interest payment. CII Financial is dependent upon dividends from its subsidiary, California Indemnity Insurance Company, to meet its debt payment obligations. Currently, California Indemnity cannot pay any dividends without prior approval by the California Department of insurance as it has no earned surplus and it may not have sufficient earned surplus from which to pay a dividend to CII Financial when the Debentures mature in 2001. Sierra has no obligation to lend any or enough funds to CII Financial to pay the Debentures when they mature. Accordingly, CII Financial does not expect to have readily available funds to pay the Debentures when they mature. The Company is exploring strategies regarding refinancing of the 7 1/2% subordinated convertible debentures including refinancing, extending the maturity date or exchanging the Debentures. There can be no assurances that CII Financial or Sierra will have the cash resources required to meet the obligations under the Debentures or that the Company will be able to successfully implement a strategy for refinancing of the Debentures. In December 2000, CII Financial commenced a proposed exchange offer to the holders of the 7 1/2% debentures to restructure the debt, extend the maturity date and reduce the overall debt of the Company. The offering proposed to exchange an amount of cash plus new subordinated debentures with a later maturity date. 8. Commitments and Contingencies Leases. The Company is the lessee under several operating leases most of which relate to office facilities and equipment. The rentals on these leases are charged to expense over the lease term and, where applicable, provide for rent escalations based on certain costs and price index factors. The following is a schedule, by year, of the future minimum lease payments under existing operating leases (in thousands):
Year Ending December 31, 2000............................................. $ 2,756 2001............................................. 2,617 2002............................................. 2,457 2003............................................. 1,661 2004............................................. 1,297 Thereafter....................................... 5,342 ---------- Total....................................... $ 16,130 ========
Rent expense totaled $2,602,000, $1,314,000 and $1,313,000 in 1999, 1998 and 1997, respectively. Guaranty of Sierra's Credit Facility Debt. At June 30, 2000, Sierra was not in compliance with certain financial covenants relating to its line of credit. The lenders provided Sierra with waivers effective June 30, 2000 and expiring October 31, 2000. In consideration for the banks granting one of the waivers, in August 2000, CII Financial became a guarantor of the Sierra credit facility debt. Should CII Financial be asked by the banks to perform on its guaranty, the Debentures would be subordinated to Sierra's credit facility debt. The waivers expired on October 31, 2000 and Sierra received a Notice of Default from the banks on November 8, 2000. No demand was made by the banks to perform on the guaranty and Sierra was able to amend its credit facility agreement on December 15, 2000. The new Sierra credit facility agreement expires on September 30, 2003. In the amended agreement, CII Financial continues to provide a guaranty of the debt in the event of a default by Sierra. Litigation and Legal Matters. The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. In the opinion of the Company's management, the ultimate resolution of pending legal proceedings should not have a material adverse effect on the Company's financial condition. 9. Federal Income Taxes A summary of the provision for income taxes for the years ended December 31, 1999, 1998 and 1997 is as follows (in thousands):
Year Ended December 31, 1999 1998 1997 (Benefit) provision for income taxes: Current tax on operating income ($2,286) $6,829 $3,045 Deferred tax on operating income 5,888 (2,663) (2,773) ------- ------ ----- Total tax on operating income 3,602 4,166 272 Current tax on extraordinary gain 59 25 1 ---------- --------- ---------- Total $3,661 $4,191 $ 273 ======= ====== ======
The following reconciles the difference between the 1999, 1998 and 1997 reported and statutory provision for income taxes:
1999 1998 1997 -- ------ -- ------ -- ---- Statutory rate 35% 35% 35% Tax preferred investments (6%) (2%) (4%) Change in valuation allowance 16% (11%) (34%) Other 5% 1% 5% ------- ------ ----- Provision for income taxes 50% 23% 2% ====== ===== =====
In 1991 and 1992, California Indemnity had taxable net operating losses ("NOLs") that were available to be carried forward to offset future taxable income. The deferred income tax asset related to these NOLs was fully reserved with a valuation allowance. In 1997 and 1998, California Indemnity had taxable operating income, which was partially offset by the NOLs, due to the separate return limitation year rules. The valuation allowances were reversed as the NOL was used and the NOLs were fully utilized in 1998. On a separate return basis, CII Financial has historically had taxable NOLs, including the three years ended December 31, 1999. The deferred income tax asset related to CII Financial's NOLs was fully reserved. Due to the smaller amount of taxable income at the insurance subsidiaries in 1999 compared to 1998, the effect of CII Financial's valuation allowance on the provision was greater compared to prior years. The tax effects of significant items comprising the Company's net deferred tax assets are as follows (in thousands):
1999 1998 ------ ---- Deferred tax assets: Loss and LAE reserves $ 1,956 $ 6,401 Accruals not currently deductible 1,128 1,374 Compensation accruals 616 754 Bad debt allowances 397 447 Loss carryforwards and credits 13,514 12,657 Unearned premiums 935 781 Deferred reinsurance gains 2,456 2,188 Unrealized investment losses 6,569 378 --------- --------- Total 27,571 24,980 Deferred tax liabilities: Deferred policy acquisition costs 832 631 Depreciation and amortization 1,255 454 Other 652 543 ---------- ---------- Total 2,739 1,628 Net deferred tax asset before valuation allowance 24,832 23,352 Valuation allowance (10,227) (9,052) ------- --------- Net deferred tax asset $14,605 $14,300 ======= =======
In lieu of state franchise and corporate income taxes, California Indemnity, Commercial Casualty, CII Insurance and Sierra Texas pay premium taxes based upon direct written premiums to the states in which they write business. Premium tax expense of $4,078,000, $4,228,000 and $3,730,000 is included in policy acquisition costs in the consolidated statements of operations for the years ended December 31, 1999, 1998 and 1997, respectively. 10. Dividend Restrictions - Insurance Subsidiaries Under California insurance company statutes and regulations, California Indemnity, Commercial Casualty and CII Insurance are restricted as to the amount of dividends they may pay on their common stock to their respective parent companies. Sierra Texas is regulated by Texas insurance statutes and regulations that are similar to California in terms of paying dividends. No dividends may be paid without at least ten business days prior notice to the Insurance Commissioner. Unless specially approved by the Insurance Commissioner prior to payment, dividends may be paid only out of accumulated earned surplus, excluding any earned surplus attributable to unrealized appreciation in assets or an exchange of assets. If a dividend or other distribution is contemplated which, along with all other dividends or distributions made within the preceding twelve months, exceeds the greater of 10% of the insurance company's policyholders' surplus as of the end of the prior calendar year or net income for such calendar year, at least 30 days prior notice to the Commissioner must be given, and no payment of the dividend or distribution may be made unless and until (i) the Commissioner has approved it or (ii) the 30 days have elapsed and the Commissioner has not disapproved the proposed payment. Net income and stockholder's equity of domestic insurance subsidiaries, as filed with regulatory authorities on the basis of statutory accounting practices, are summarized as follows (in thousands):
Nine Months Ended September 30, Year Ended December 31, 2000 1999 1998 1997 --------- --------- --------- ------- (Unaudited) Statutory net (loss) income for the period ended $ (7,185) $ 12,283 $ 20,877 $11,277 Statutory stockholder's equity at the period ended 106,078 118,278 116,580 96,061
Based on its financial position as of December 31, 1999, California Indemnity can pay $6,840,000 in shareholder dividends to CII Financial during 2000 without the prior approval of the California Insurance Commissioner. Commercial Casualty, CII Insurance and Sierra Texas can pay $1,686,000, $376,000 and $216,000, respectively to California Indemnity without prior approval of the applicable state insurance commissioner. CII Financial, Inc. paid dividends of $2,637,000, in March 2000, to Sierra. California Indemnity paid dividends to CII Financial of $6,800,000 and $6,000,000, during 2000 and 1999, respectively. During 1999, Commercial Casualty paid $1,700,000 in dividends to California Indemnity. Due notice was filed with the California Department of Insurance, and the payment was made after the expiration of the required waiting period in accordance with California Insurance regulations. The National Association of Insurance Commissioners adopted risk-based capital guidelines for property-casualty insurance companies whereby required statutory surplus would be based, in part, on a formula based risk assessment of the individual investments held in the insurance company's portfolio. The Company's risk-based capital results for the years ended December 31, 1999, 1998 and 1997 exceeded the minimum surplus required under the regulations. In March 1998, the NAIC adopted the Codification of Statutory Accounting Principals (the "Codification"). The codification, which is intended to standardize regulatory accounting and reporting for the insurance industry, becomes effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The state of California has indicated that it intends to require adoption of the Codification for the preparation of statutory financial statements. The Company has not finalized the quantification of the effects of the Codification on its statutory financial statements. 11. Employee Compensation and Benefit Plans Defined Contribution Plan. All employees who meet minimum requirements can participate in Sierra's defined contribution pension and 401(k) plan (the "Plan"). The Plan covers all employees who meet certain age and length of service requirements. For the years ended December 31, 1998 and 1997 and for the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS statute. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral and the maximum Company match is 6% of a participant's annual compensation, subject to Internal Revenue Service limits. The Plan does not require additional Company contributions. For the years ended December 31, 1999, 1998 and 1997, the Company expensed $601,000, $625,000 and $630,000, respectively, to this plan. Executive Retirement Plans. The Company offered key employees and officers a Supplemental Executive Retirement Plan and Supplemental Senior Executive Retirement Plan. Eligibility for participation in both plans was limited to officers and key employees selected and approved by the Board of Directors. These plans were terminated effective October 31, 1995, and there have been no further contributions. Pursuant to contractual obligations under the plans, the Company paid $250,000 to a former plan participant in each of the years ended December 31, 1999, 1998 and 1997. Employment Contracts. The Company currently has an employment contract with its Chief Executive Officer expiring December 2001. Minimum aggregate cash compensation obligations under this contract are $214,000 for both 2000 and 2001. Employee Stock Purchase Plan. The Company offers employee stock purchase plans through Sierra (the "Purchase Plan") whereby employees may purchase newly issued shares of stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan. Stock Option Plans. The Company offers several plans, through Sierra, that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of options, stock, and other stock-based awards. Awards are granted by a committee appointed by the Sierra Board of Directors. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of Sierra stock on the date of grant. Stock options generally vest at a rate of 20% - 25% per year. Options generally expire one year after the end of the vesting period. The tax benefit related to the exercise of options by Company employees is passed on to the Company by Sierra. This totaled $0, $418,000 and $1,737,000 for 1999, 1998 and 1997 respectively. 12. Other Related Party Transactions The Company entered into a management services agreement with Sierra effective January 1, 1999. The agreement provides investment, accounting, human resources, systems and other administrative services. The fee for the services is based on the lower of actual cost or fair market value. Management fee expense for 1999 totaled $1,338,000. The Company did not have a management agreement with Sierra prior to January 1, 1999. The Company purchases employee health insurance from its affiliates, Health Plan of Nevada, Inc., Sierra Health and Life Insurance Company, Inc. and Texas Health Choice, L.C. The Company paid $642,000, $528,000 and $498,000 to the aforementioned affiliates for years ended 1999, 1998 and 1997, respectively. The premiums paid to its affiliates were determined on an arms-length basis. At January 1, 1998, California Indemnity had an investment in real estate owned and occupied of $11,959,000. During the year, California Indemnity obtained a mortgage loan on this property in the amount of $5,000,000. In the fourth quarter of 1998, the property, net of the mortgage loan, with a book value of $8,442,000, which approximated fair value, was contributed to a real estate limited partnership of which Sierra is the general partner. California Indemnity agreed to adjust its partnership interest to approximate its occupancy. The adjustment resulted in Sierra purchasing a portion of California Indemnity's interests for $2,262,000. Simultaneously with the execution of the partnership agreement, California Indemnity contributed one-half of its adjusted interest into the limited partnership, valued at $3,092,000, to its wholly-owned subsidiary, Commercial Casualty. Together, California Indemnity and Commercial Casualty own limited partner interests totaling 27% of the limited partnership. These transactions were done to enable both companies to qualify for certain premium tax credits in the state of Nevada and were approved by the California Department of Insurance. As part of the transaction to form and fund the limited partnership, California Indemnity was released from any obligation directly under the mortgage loan. Concurrent with the sale of the real estate, California Indemnity entered into a rental agreement with the related partnership under which California Indemnity leases a portion of the transferred real estate. Rental expense under this agreement was approximately $1,168,000 and $270,000 in 1999 and 1998, respectively. In September 1998, California Indemnity refinanced a 15-year mortgage note of an affiliated real estate partnership. Sierra is the majority owner of the partnership. The note is secured by a first deed of trust and pays interest at 7% per annum. The loan to value ratio was approximately 68%. In March 2000, California Indemnity financed a $7,400,000 five-year mortgage note to Sierra. The note is secured by a first deed of trust and earns quarterly interest payments at 8.75% per annum beginning April 1, 2000 until April 1, 2005, when the unpaid principal balance is due and payable in full. The note is callable in April 2001. 13. Quarterly Results of Operations (Unaudited) The following table sets forth the unaudited data regarding operations for each quarter of the nine months ended September 30, 2000, and the years ended December 31, 1999 and 1998. In the opinion of management, such unaudited data includes all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the information presented. The Company's operating results for any quarter are not necessarily indicative of the operating results for any future period. Nine months ended September 30, 2000 (in thousands):
3rd Quarter 2nd Quarter 1st Quarter Net earned premiums $38,263 $27,344 $25,344 Net investment income 3,817 3,571 3,369 --------- ---------- --------- Total revenues 42,080 30,915 28,713 Costs and expenses 40,832 48,957 25,926 -------- ---------- -------- Income (loss) before income tax and extraordinary gain 1,248 (18,042) 2,787 Federal income tax provision (benefit) 437 (6,492) 1,153 ---------- ---------- --------- Income (loss) before extraordinary gain 811 (11,550) 1,634 Extraordinary gain, net of tax 93 485 76 ----------- ------------ ---------- Net income (loss) $ 904 $(11,065) $ 1,710 ========= ======== ======= Year ended December 31, 1999 (in thousands): 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter Net earned premiums $24,705 $21,860 $18,470 $17,920 Net investment income 3,490 3,788 3,944 4,173 --------- --------- -------- -------- Total revenues 28,195 25,648 22,414 22,093 Costs and expenses 32,952 21,451 18,641 18,211 ------- -------- ------- ------- (Loss) income before income tax and extraordinary gain (4,757) 4,197 3,773 3,882 Federal income tax (benefit) provision (1,212) 1,679 1,535 1,600 -------- -------- -------- -------- (Loss) income before extraordinary gain (3,545) 2,518 2,238 2,282 Extraordinary gain, net of tax 109 1 1 ---------- --------- ----------- ----------- Net (loss) income $ (3,436) $ 2,518 $ 2,239 $ 2,283 ======== ======= ======= ======= Year ended December 31, 1998 (in thousands): 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter Net earned premiums $24,308 $40,162 $36,978 $32,826 Net investment income 4,511 5,445 5,540 4,733 -------- -------- -------- -------- Total revenues 28,819 45,607 42,518 37,559 Costs and expenses 22,946 40,901 37,896 34,882 ------- ------- ------- ------- Income before income tax and extraordinary gain 5,873 4,706 4,622 2,677 Federal income tax provision (benefit) 4,192 (25) (1) ______ ------- ---------- ----------- Income before extraordinary gain 1,681 4,731 4,623 2,677 Extraordinary gain, net of tax ______ 45 3 ______ ---------- ----------- Net income $ 1,681 $ 4,776 $ 4,626 $ 2,677 ======= ======= ======= =======
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS - Parent Company Only (In thousands, except share data)
September 30, December 31, 2000 1999 1998 ---- ---- ---- ASSETS (Unaudited) Cash and cash equivalents $ 83 $ 857 $ 481 Equity in net assets of subsidiaries 104,512 115,002 125,945 Property and equipment, net 1,216 1,621 2,209 Net due from affiliates 936 Other assets 314 568 1,051 ------------ ------------ ----------- TOTAL ASSETS $107,061 $118,048 $129,686 ======== ======== ======== LIABILITIES AND STOCKHOLDER'S EQUITY Convertible subordinated debentures $ 47,059 $ 50,498 $ 51,251 Net payable to affiliates 251 3,217 Accrued interest payable 111 1,099 1,117 Accounts payable and accrued expenses 1,377 147 154 ----------- ----------- ------------ TOTAL LIABILITIES 48,547 51,995 55,739 ---------- --------- ---------- STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; shares issued and outstanding - 100 3,604 3,604 3,604 Additional paid-in capital 64,450 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments of subsidiaries (8,651) (12,200) (702) (Accumulated deficit) retained earnings (889) 10,199 6,595 ----------- ---------- ----------- TOTAL STOCKHOLDER'S EQUITY 58,514 66,053 73,947 ---------- ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY $107,061 $118,048 $129,686 ======== ======== ========
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENT OF OPERATIONS - Parent Company Only (In thousands)
Nine Months Ended September 30, Year Ended December 31, 2000 1999 1999 1998 1997 ---- ---- ---- ---- ---- (Unaudited) (Unaudited) REVENUES Net investment income $ 38 $ 1 $ 25 $ 118 Realized gains on investments 294 Other 707 $ 840 1,084 1,323 435 -------- -------- -------- -------- -------- Total revenues 745 840 1,085 1,348 847 --------- --------- -------- -------- -------- EXPENSES Interest expense 2,725 2,882 3,707 3,997 4,088 General and administrative 523 620 765 897 568 -------- -------- --------- --------- -------- Total expenses 3,248 3,502 4,472 4,894 4,656 ------- ------- -------- -------- ------- Equity in undistributed (loss) earnings of subsidiaries (7,239) 9,701 7,141 17,309 14,062 ------ ------- ----- ------ ------ (LOSS) INCOME BEFORE FEDERAL INCOME TAX (BENEFIT) EXPENSE AND EXTRAORDINARY GAIN (9,742) 7,039 3,754 13,763 10,253 Federal income tax (benefit) expense (637) 261 51 (288) -------- ------------ --------- ---------- --------- (LOSS) INCOME BEFORE EXTRAORDINARY GAIN (9,105) 7,039 3,493 13,712 10,541 -------- ------- -------- ------- -------- Extraordinary gain from debt extinguishments (net of income taxes of $353, $0, $59, $25 and $1) 654 111 48 2 ---------- ------------ --------- ---------- ------------ NET (LOSS) INCOME $(8,451) $7,039 $3,604 $13,760 $10,543 ======= ====== ====== ======= =======
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENT OF CASH FLOWS - Parent Company Only (In thousands)
Nine Months Ended September 30, Year Ended December 31, 2000 1999 1999 1998 1997 ---- ---- ---- ---- ---- (Unaudited) (Unaudited) CASH FLOW OPERATING ACTIVITIES: Net (loss) income $ (8,451) $ 7,039 $ 3,604 $ 13,760 $10,543 Adjustments to reconcile net (loss) income to net cash used in operating activities: Equity in undistributed earnings of subsidiaries 7,239 (9,701) (7,141) (17,309) (14,062) Extraordinary gain (1,007) (170) (73) (3) Depreciation and amortization 524 520 721 883 464 Change in assets and liabilities: Net payable to parent and subsidiaries (1,187) 69 (2,370) 1,126 53 Other assets 134 311 338 (466) 2,040 Accounts payable and accrued expenses 1,231 (428) (7) 374 (2,113) Interest payable (988) (961) (18) (78) 3 ---------- --------- --- ---------- ----------- Net cash used in operating activities (2,505) (3,151) (5,043) (1,783) (3,075) --------- -------- --------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures 77 2 (553) 210 Proceeds from sales/maturities of available-for-sale -------- --------- --------- -- investments 2,698 ------ ------- -------- --------- --------- Net cash provided by (used in) investing activities 77 2 (553) 2,908 ---------- ------------- - --------- CASH FLOW FROM FINANCING ACTIVITIES: Repurchase of convertible subordinated debentures (2,432) (55) (583) (3,143) (27) Capital contribution 3,665 Dividend to Sierra (2,637) Dividend from subsidiaries 6,800 3,000 6,000 Stock option activity _______ 418 1,737 ------ ------ ---------- --------- Net cash provided by financing activities 1,731 2,945 5,417 940 1,710 ---------- ---------- ----- ---------- ---------- NET CHANGE IN CASH AND CASH EQUIVALENTS (774) (129) 376 (1,396) 1,543 ---------- ---------- --- ------- --------- CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 857 481 481 1,877 334 ---------- ---------- --- -------- ---------- CASH AND CASH EQUIVALENTS AT END OF $ = PERIOD $ 83 $ 352 857 $ 481 $1,877 ========== =========== === ========= ======
No person has been authorized to give any information or to make any representations other than those contained in the exchange offer and, if given or made, such information or representations must not be relied upon as having been authorized. This statement and any related documents do not constitute an offer to buy or the solicitation of an offer to sell debentures or common stock in any circumstances in which such offer or solicitation is unlawful. In those jurisdictions where the securities, blue sky or other laws require the offer to be made by a licensed broker or dealer, the offer shall be deemed to be made on behalf of CII Financial by the dealer manager or one or more registered brokers or dealers licensed under the laws of such jurisdiction. In order to tender, a holder must send or deliver a properly completed and signed Letter of Transmittal, certificates for old junior subordinated debentures and any other required documents to the Exchange Agent at its address set forth below or tender pursuant to DTC's Automated Tender Offer Program. The Exchange Agent for the Exchange Offer is: WELLS FARGO CORPORATE TRUST By Registered & Certified Mail: WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations MAC N9303-121 PO Box 1517 Minneapolis, MN 55480 By Regular Mail or Overnight Courier: WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations MAC N9303-121 Sixth & Marquette Avenue Minneapolis, MN 55479 In Person by Hand Only: WELLS FARGO BANK MINNESOTA, N.A. 12th Floor - Northstar East Building Corporate Trust Services 608 Second Avenue South Minneapolis, MN 55479 By Facsimile (for Eligible Institutions only): (612) 667-4927 For Information or Confirmation by Telephone: (800) 344-5128 Any questions or requests for assistance or for additional copies of this Prospectus, the Letter of Transmittal or related documents may be directed to the Information Agent at its telephone number set forth below. A holder may also contact the Dealer Manager at its telephone number set forth below or such holder's broker, dealer, commercial bank, trust company or other nominee for assistance concerning the Exchange Offer. The Information Agent for the Exchange Offer is: D.F. King & Co., Inc. 77 Water Street New York, New York 10005 Bankers and Brokers Call Collect: (212) 269-5550 All Others Call Toll-Free: (800) 735-3591 The exclusive Dealer Manager for the Exchange Offer is: Banc of America Securities LLC 100 North Tryon Street, 7th Floor Charlotte, North Carolina 28255 Attention: High Yield Special Products (704) 388-4813 (Collect) (888) 292-0070 (Toll Free) II-6 II-1 PART II INFORMATION NOT REQUIRED IN PROSPECTUS Item 20. Indemnification of Directors and Officers. Section 317 of the California Corporations Code authorizes a corporation to indemnify any director or officer who was or is a party or is threatened to be made a party to any proceeding (other than an action by or in the right of the corporation to obtain a judgment in its favor) because the person is or was a director or officer of the corporation, against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in connection with the proceeding. This indemnification is allowed only if the person acted in good faith and in a manner the person reasonably believed to be in the best interests of the corporation. In the case of a criminal proceeding, the person must have had no reasonable cause to believe his or her conduct was unlawful. A corporation may advance expenses incurred in defending any proceeding prior to the final disposition of the proceeding if the corporation receives an undertaking by or on behalf of the director or officer to repay that amount if it is ultimately determined that the person is not entitled to be indemnified. A corporation may also indemnify a director or officer against expenses actually and reasonably incurred by that person in connection with the defense or settlement of the action by or in the right of the corporation to obtain a judgment in its favor. This indemnification is allowed only if the person acted in good faith and in a manner the person believed to be in the best interests of the corporation and its shareholders. The decision of whether indemnification will be provided in a particular case will be made by (i) a majority vote of a quorum consisting of directors who are not parties to the proceeding, (ii) if a quorum is not obtainable, by independent legal counsel in a written opinion, (iii) approval of a majority of the shareholders, excluding the shares of the person to be indemnified; or (iv) the court in which the proceeding is or was pending. Indemnification is not allowed if it would be inconsistent with (i) a resolution of the shareholders, (ii) the company's articles of incorporation or by-laws, (iii) an agreement in effect at the time of the cause of action, or (iv) any condition expressly imposed by a court in approving a settlement. In addition, a California corporation may obtain and maintain insurance on behalf of any director or officer of the corporation for any liability asserted against him or her, whether or not the corporation has the power to indemnify him or her against liability under the California Corporations Code. Article 7 of CII Financial, Inc.'s (the "Company") by-laws provide for the indemnification under certain conditions of directors, officers, employees any agents acting in their official capacities. The Company has not entered into separate indemnification agreements with any of its officers or directors. The Company has purchased directors' and officers' liability insurance insuring the Company's officers and directors against certain liabilities and expenses incurred by such persons in such capacities. Item 21. Exhibits and Financial Statement Schedules. (a) Exhibits Exhibit Number Description 1 --Form of Dealer Management Agreement* 3.1 --Articles of Incorporation of the Company* 3.2 --Bylaws of the Company* 4.1 --Form of Indenture, of old junior subordinated debentures due 2001 from the Company to Manufacturers Hanover Trust Company as Trustee dated September 15, 1991, incorporated by reference to Exhibit 4.2 of Post-Effective Amendment No. 1 on Form S-3 to Registration Statement on Form S-4 dated October 6, 1995 (Reg. No. 33-60591) 4.2 --First Supplemental Indenture between the Company, Sierra Health Services, Inc. ("Sierra") and Chemical Bank as Trustee, dated as of October 31, 1995, to Indenture dated September 15, 1991, incorporated by reference to Exhibit 4.3 of Post-Effective Amendment No. 2 on Form S-3 to Registration Statement on Form S-4 dated October 31, 1995 (Reg. No. 33-60591) 4.3 --Form of Indenture, of 9% senior subordinated debentures due September 15, 2006 from the Company to Wells Fargo Bank Minnesota, N.A., as Trustee* 4.4 --Specimen 9% senior subordinated debenture due September 15, 2006 of the Company* 5.1 --Opinion of Morgan, Lewis & Bockius LLP as to the legality of the 9% senior subordinated debentures due September 15, 2006 of the Company being registered* 10.1 --Administrative Services agreement between Health Plan of Nevada, Inc. and Sierra dated December 1, 1987, incorporated by reference to Exhibit 10.17 to Sierra's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 10.2 --Administrative Services agreement between Sierra Health and Life Insurance Company, Inc. and Sierra dated April 1, 1989, incorporated by reference to Exhibit 10.18 to Sierra's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 10.3 --Agreement between Health Plan of Nevada, Inc. and the United States Health Care Financing Administration dated July 24, 1992, incorporated by reference to Exhibit 10.18 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1992 10.4 --Credit Agreement dated as of October 30, 1998, among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank, First Union National Bank as Syndication Agent, and the other financial institutions party thereto, dated as of October 30, 1998, incorporated by reference to Exhibit 10.4 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.5 --First Amendment to Credit Agreement among Sierra, as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank and the other financial institutions party thereto, dated as of November 23, 1998, incorporated by reference to Exhibit 10.5 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.6 --Second Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of January 15, 1999, incorporated by reference to Exhibit 10.6 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.7 --Third Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of September 30, 1999, incorporated by reference to Exhibit 10.7 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1999 10.8 --Amended and Restated Credit Agreement among Sierra as borrower, Bank of America, N.A. as Administrative Agent and Issuing Bank, First Union National Bank, as Syndication Agent and the other financial institutions party thereto, dated as of December 15, 2000 incorporated by reference to Sierra's Report on Form 8-K dated December 22, 2000. 10.9 --Agreement and Plan of Merger dated as of June 12, 1995 among Sierra, Health Acquisition Corp., and the Company, incorporated by reference to the Report on Form 8-K dated June 13, 1995, as amended 10.10 --Guaranty, dated as of August 23, 2000, among the Company, among others, as guarantors, in favor of Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto* 10.11 --First Amendment to Guaranty among the Company, among others, as guarantors, in favor of Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto* 10.12 --First and Second Underlying Excess Loss Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.13 --Casualty Quota Share Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.14 --Statutory Workers' Compensation Excess of Loss Reinsurance Agreement dated January 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.15 --Summary of Workers' Compensation Excess of Loss Reinsurance Agreement dated July 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.16 --Limited Partnership Agreement of the 2716 N. Tenaya Way Limited Partnership dated December 3, 1998, among California Indemnity Insurance Company, Commercial Casualty Insurance Company and Sierra * 10.17 --Lease of 2716 North Tenaya Way, Las Vegas, Nevada, dated December 28, 1998, among 2716 N. Tenaya Way Limited Partnership, California Indemnity Insurance Company and Commercial Casualty Insurance Company* 10.18 --Lease of 5627 Gibraltar Drive, Pleasanton, California, dated April 20, 1992, among the Company and Hacienda Venture* 10.19 --First Amendment dated August 22, 1994, to the Lease of 5627 Gibraltar Drive, Pleasanton, California, among the Company and Hacienda Venture* 10.20 --Second Amendment dated August 19, 1999, to the Lease of 5627 Gibraltar Drive, Pleasanton, California, among the Company and Property LS OB One, successor in interest to Hacienda Venture* 10.21 --Intercompany Pooling Agreement dated January 1, 1999, among California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas * 10.22 --Investment Services Agreement dated January 1, 1999, among Sierra, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas * 10.23 --Tax Allocation Agreement dated May 30, 1997, among Sierra, Health Plan of Nevada, the Company, Sierra Health and Life Insurance Company, California Indemnity Insurance Company, Commercial Casualty Insurance Company and CII Insurance Company * 10.24 --Intercompany Services Agreement dated January 1, 1999, by and between Sierra and California Indemnity Insurance Company * 12 --Ratio of Earnings to Fixed Charges of the Company 21 --Subsidiaries of the Company* 23.1 --Consent of Deloitte & Touche LLP 23.2 --Consent of Morgan, Lewis & Bockius LLP (included in the opinion filed as Exhibit 5.1)* 24 --Powers of Attorney for the Company (included on signature page hereof) 25 --Statement of Eligibility of Trustee on Form T-1* 27 --Financial Data Schedule 99.1 --Form of Letter of Transmittal 99.2 --Form of Notice of Guaranteed Delivery 99.3 --Form of Notice of Brokers, Dealers, Commercial Banks, Trust Companies and other Nominees 99.4 --Form of Notice to Clients 99.5 --Form of Company Letter to Debenture holders 99.6 --Form of Exchange Agent Agreement * - ------------------- * To be filed by amendment Item 22. Undertakings. The undersigned registrant hereby undertakes: (1) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) To include any prospectus required by Section 10(a)(3) of the Securities Act of 1933; (ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than 20 percent change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement. (iii) To include any material with respect to the plan of distribution and not previously disclosed in the registration statement or any material change to such information in the registration statement; (2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (3) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. (4) Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of the Securities Act, the Registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Las Vegas, State of Nevada, on the 26th day of December 2000. CII FINANCIAL, INC. By / s / Kathleen M. Marlon Kathleen M. Marlon President, Chief Executive Officer and Chairman Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated. Each person whose signature to this Registration Statement appears below hereby appoints Kathleen M. Marlon, as his/her attorney-in-fact, to sign on his/her behalf individually and in the capacity stated below and to file all supplements, amendments and post-effective amendments to this Registration Statement and any and all instruments or documents filed as a part of or in connection with this Registration Statement or any amendment or supplement thereto, and any such attorney-in-fact may make such changes and additions to this Registration Statement as such attorney-in-fact may deemed necessary or appropriate. Signature Title Date President, Chief Executive / s / Kathleen M. Marlon Officer, Chairman and December 26, 2000 Kathleen M. Marlon Director (Principal Executive Officer) / s / John F. Okita Chief Financial Officer December 26, 2000 John F. Okita (Principal Financial and Accounting Officer) / s / Paul H. Palmer Director December 26, 2000 Paul H. Palmer / s / Frank E. Collins Director December 26, 2000 Frank E. Collins Exhibit Index Exhibit Number Description 1 --Form of Dealer Management Agreement* 3.1 --Articles of Incorporation of CII Financial, Inc. (the "Company")* 3.2 --Bylaws of the Company* 4.1 --Form of Indenture, of old junior subordinated debentures due 2001 from the Company to Manufacturers Hanover Trust Company as Trustee dated September 15, 1991, incorporated by reference to Exhibit 4.2 of Post-Effective Amendment No. 1 on Form S-3 to Registration Statement on Form S-4 dated October 6, 1995 (Reg. No. 33-60591) 4.2 --First Supplemental Indenture between the Company, Sierra Health Services, Inc. ("Sierra") and Chemical Bank as Trustee, dated as of October 31, 1995, to Indenture dated September 15, 1991, incorporated by reference to Exhibit 4.3 of Post-Effective Amendment No. 2 on Form S-3 to Registration Statement on Form S-4 dated October 31, 1995 (Reg. No. 33-60591) 4.3 --Form of Indenture, of 9% senior subordinated debentures due September 15, 2006 from the Company to Wells Fargo Bank Minnesota, N.A., as Trustee* 4.4 --Specimen 9% senior subordinated debenture due September 15, 2006 of the Company* 5.1 --Opinion of Morgan, Lewis & Bockius LLP as to the legality of the 9% senior subordinated debentures due September 15, 2006 of the Company being registered* 10.1 --Administrative Services agreement between Health Plan of Nevada, Inc. and Sierra dated December 1, 1987, incorporated by reference to Exhibit 10.17 to Sierra's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 10.2 --Administrative Services agreement between Sierra Health and Life Insurance Company, Inc. and Sierra dated April 1, 1989, incorporated by reference to Exhibit 10.18 to Sierra's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 10.3 --Agreement between Health Plan of Nevada, Inc. and the United States Health Care Financing Administration dated July 24, 1992, incorporated by reference to Exhibit 10.18 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1992 10.4 --Credit Agreement dated as of October 30, 1998, among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank, First Union National Bank as Syndication Agent, and the other financial institutions party thereto, dated as of October 30, 1998, incorporated by reference to Exhibit 10.4 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.5 --First Amendment to Credit Agreement among Sierra, as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank and the other financial institutions party thereto, dated as of November 23, 1998, incorporated by reference to Exhibit 10.5 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.6 --Second Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of January 15, 1999, incorporated by reference to Exhibit 10.6 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1998 10.7 --Third Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of September 30, 1999, incorporated by reference to Exhibit 10.7 to Sierra's Annual Report on Form 10-K filed for the fiscal year ended December 31, 1999 10.8 --Amended and Restated Credit Agreement among Sierra as borrower, Bank of America, N.A. as Administrative Agent and Issuing Bank, First Union National Bank, as Syndication Agent and the other financial institutions party thereto, dated as of December 15, 2000* 10.9 --Agreement and Plan of Merger dated as of June 12, 1995 among Sierra, Health Acquisition Corp., and the Company, incorporated by reference to the Report on Form 8-K dated June 13, 1995, as amended 10.10 --Guaranty, dated as of August 23, 2000, among the Company, among others, as guarantors, in favor of Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto* 10.11 --First Amendment to Guaranty among the Company, among others, as guarantors, in favor of Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto* 10.12 --First and Second Underlying Excess Loss Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.13 --Casualty Quota Share Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.14 --Statutory Workers' Compensation Excess of Loss Reinsurance Agreement dated January 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.15 --Summary of Workers' Compensation Excess of Loss Reinsurance Agreement dated July 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas* 10.16 --Limited Partnership Agreement of the 2716 N. Tenaya Way Limited Partnership dated December 3, 1998, among California Indemnity Insurance Company, Commercial Casualty Insurance Company and Sierra* 10.17 --Lease of 2716 North Tenaya Way, Las Vegas, Nevada, dated December 28,1998, among 2716 N. Tenaya Way Limited Partnership, California Indemnity Insurance Company and Commercial Casualty Insurance Company * 10.18 --Lease of 5627 Gilbraltar Drive, Pleasanton, California, dated April 20, 1992, among the Company and Hacienda Venture* 10.19 --First Amendment dated August 22, 1994, to the Lease of 5627 Gilbraltar Drive, Pleasanton, California, among the Company and Hacienda Venture* 10.20 --Second Amendment dated August 19, 1999, to the Lease of 5627 Gilbraltar Drive, Pleasanton, California, among the Company and Property LS OB One, successor in interest to Hacienda Venture* 10.21 --Intercompany Pooling Agreement dated January 1, 1999, among California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas * 10.22 --Investment Services Agreement dated January 1, 1999, among Sierra, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas * 10.23 --Tax Allocation Agreement dated May 30, 1997, among Sierra, Health Plan of Nevada, the Company, Sierra Health and Life Insurance Company, California Indemnity Insurance Company, Commercial Casualty Insurance Company and CII Insurance Company * 10.24 --Intercompany Services Agreement dated January 1, 1999, by and between Sierra and California Indemnity Insurance Company * 12 --Ratio of Earnings to Fixed Charges of the Company * 21 --Subsidiaries of the Company * 23.1 --Consent of Deloitte & Touche LLP 23.2 --Consent of Morgan, Lewis & Bockius LLP (included in the opinion filed as Exhibit 5.1)* 24 --Powers of Attorney for the Company (included on signature page hereof) 25 --Statement of Eligibility of Trustee on Form T-1 27 --Financial Data Schedule 99.1 --Form of Letter of Transmittal 99.2 --Form of Notice of Guaranteed Delivery. 99.3 --Form of Notice of Brokers, Dealers, Commercial Banks, Trust Companies and Other Nominees 99.4 --Form of Notice to Clients 99.5 --Form of Company Letter to Debenture holders 99.6 --Form of Exchange Agent Agreement * - ------------------- * To be filed by amendment EX-12 2 0002.txt Exhibit 12 RATIO OF EARNINGS TO FIXED CHARGES
Nine Months Ended September 30, For the year Ended December 31, 2000 1999 1999 1998 1997 1996 1995 (dollars in thousands) (dollars in thousands) Pre-tax (loss) income before discontinued operations and extraordinary gains $(14,007) $11,854 $7,095 $17,878 $10,813 $10,630 $9,083 Fixed Charges: Interest expense 2,717 2,751 3,706 4,301 4,091 4,123 4,868 Capitalized interest 0 130 130 0 0 0 0 Interest relating to rental expense (1) 704 632 867 438 433 542 491 ------ ------ ------ ------ ------ ------ ------ Total fixed charges 3,421 3,513 4,703 4,739 4,524 4,665 5,359 Earnings available for fixed charges $(10,586) $15,367 $11,798 $22,617 $15,337 $15,295 $14,442 Ratio of earnings to fixed charges (3.09x) 4.37x 2.51x 4.77x 3.39x 3.28x 2.69x
- ------------------------------------------------------------------------------ (1) The representative interest portion of rental expense was deemed to be one-third of all rental expense. Earnings were not sufficient to cover fixed charges during the first nine months of 2000 by $14,007,000; all other periods had sufficient income to cover charges. EX-23 3 0003.txt Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT To the Board of Directors and Stockholder of CII Financial, Inc. Las Vegas, Nevada We consent to the use in this Registration Statement of CII Financial, Inc. (the "Company") on Form S-4 of our report dated December 21, 2000, appearing in the Prospectus, which is a part of this Registration Statement, and to the references to us under the headings "Summary Historical Financial and Other Data of CII Financial", "Selected Financial and Other Data" and "Experts" in such Prospectus. /s/DELOITTE & TOUCHE LLP Las Vegas, Nevada December 21, 2000 EX-27 4 0004.txt
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEC FORM S-4 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 9-MOS DEC-31-2000 JAN-01-2000 SEP-30-2000 164,660 22,154 0 1,732 16,541 7,108 231,604 19,408 211,594 2,732 492,852 341,902 16,206 0 0 76,230 0 0 3,604 54,910 492,852 90,951 11,217 (460) 0 84,020 8,606 0 (14,007) (4,902) (9,105) 0 654 0 (8,451) 0 0 134,305 63,843 20,177 15,763 49,893 152,669 20,177
EX-27 5 0005.txt
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEC FORM S-4 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 58,254 12,075 (174) 0 34,813 5,737 0 11,854 4,815 7,039 0 0 0 7,039 0 0 174,467 36,061 (1,248) 12,836 64,668 131,776 (1,248)
EX-27 6 0006.txt
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEC FORM S-4 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1999 JAN-01-1999 DEC-31-1999 165,296 25,023 0 3,486 9,375 6,559 226,572 16,833 131,862 2,378 404,338 244,394 13,300 0 0 80,591 0 0 3,604 62,449 404,338 82,955 19,776 (381) 0 61,461 6,339 0 7,095 3,602 3,493 0 111 0 3,604 0 0 174,469 51,541 9,920 21,207 80,416 134,305 9,920
EX-27 7 0007.txt
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEC FORM S-4 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 185,644 53,967 0 882 14,717 6,185 283,509 22,114 58,424 1,804 379,880 212,264 11,158 0 0 82,511 0 0 3,604 70,343 379,880 134,274 18,241 1,988 0 94,347 19,216 0 17,878 4,166 13,712 0 48 0 13,760 0 0 181,643 103,990 (9,643) 29,591 71,932 174,462 (9,643)
EX-27 8 0008.txt
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEC FORM S-4 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 129,197 16,781 580 0 93,332 19,860 0 10,813 272 10,541 0 2 0 10,543 0 0 172,100 102,302 (8,970) 26,812 56,977 181,643 (8,970)
EX-99 9 0009.txt A registration statement has been filed with the Securities and Exchange Commission in connection with the Exchange Offer. The completion of the Exchange Offer is dependent upon the Registration Statement becoming effective. CII Financial, Inc. LETTER OF TRANSMITTAL To Exchange the outstanding 7 1/2% Convertible Subordinated Debentures due September 15, 2001 of CII Financial, Inc. THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M. , NEW YORK CITY TIME, ON JANUARY 25, 2001 UNLESS THE EXCHANGE OFFER IS EXTENDED (THE "EXPIRATION DATE"). TENDERS MAY BE WITHDRAWN PRIOR TO 5:00 P.M., NEW YORK CITY TIME, ON THE EXPIRATION DATE. The Exchange Agent for the Exchange Offer is: Wells Fargo Corporate Trust By Registered & Certified Mail: By Regular Mail or Overnight Courier: WELLS FARGO BANK MINNESOTA, N.A. WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations Corporate Trust Operations MAC N9303-121 MAC N9303-121 PO Box 1517 Sixth & Marquette Avenue Minneapolis, MN 55480 Minneapolis, MN 55479 In Person by Hand Only: By Facsimile (for Eligible Institutions Only): (612) 667-4927 WELLS FARGO BANK MINNESOTA, N.A. 12th Floor - Northstar East Building For Information or Confirmation by Corporate Trust Services Telephone:(800)344-5128 608 Second Avenue South Minneapolis, MN Delivery of this Letter of Transmittal to an address other than as set forth above, or transmission of instructions via a fax number other than as set forth above, will not constitute a valid delivery. The instructions contained herein and in the preliminary prospectus (the "Preliminary Prospectus") should be read carefully before this Letter of Transmittal is completed. The exchange offer (the "Exchange Offer") is conditioned on the satisfaction of certain conditions, more fully described in the Preliminary Prospectus under the caption "The Exchange Offer--Conditions to, and Amendment of the Exchange Offer," including the valid tender of more than 90% of the outstanding 7 1/2% convertible subordinated debentures due September 15, 2001 (the "old junior subordinated debentures"). The Preliminary Prospectus contains a more complete description of the Exchange Offer and the conditions thereof. Use this Letter of Transmittal only to tender old junior subordinated debentures pursuant to the Exchange Offer. This Letter of Transmittal and the instructions hereto is to be used by the holders of old junior subordinated debentures. This Letter of Transmittal is to be used by such holders of old junior subordinated debentures if (1) old junior subordinated debentures are to be physically delivered to the Exchange Agent herewith by such holders, or (2) tender of old junior subordinated debentures is to be made by book-entry transfer to the Exchange Agent's account at DTC pursuant to the procedures set forth under the caption "The Exchange Offer--Procedures for Exchanging Debentures" in the Preliminary Prospectus; and, in each case, instructions are not being transmitted through the DTC Automated Tender Offer Program ("ATOP"). Holders of old junior subordinated debentures who are tendering by book-entry transfer to the Exchange Agent's account at DTC can execute the tender through ATOP. DTC participants that are accepting the Exchange Offer must transmit their acceptance to DTC, which will verify the acceptance and execute a book-entry delivery to the Exchange Agent's account at DTC. DTC will send an agent's message (the "Agent's Message") to the Exchange Agent for its acceptance. Delivery of the Agent's Message by DTC will satisfy the terms of the Exchange Offer as to the tender of old junior subordinated debentures. DTC participants may also accept the Exchange offer by completing and delivering a Notice of Guaranteed Delivery to the Exchange Agent at its address set forth on the front cover of this Letter of Transmittal and subsequently delivering old junior subordinated debentures and the Agent's Message through ATOP. See Instruction 2. The Exchange Offer is not being made to (nor will tenders of old junior subordinated debentures be accepted from or on behalf of) holders in any jurisdiction in which the making or acceptance of the exchange offer would not be in compliance with the laws of such jurisdiction. Delivery of instructions or documents to DTC does not constitute delivery to the Exchange Agent. Only holders of old junior subordinated debentures may validly tender old junior subordinated debentures. The undersigned should complete, execute and deliver this Letter of Transmittal to indicate the action the undersigned desires to take with respect to the Exchange Offer. The instructions included with this Letter of Transmittal must be followed. Questions and requests for assistance or for additional copies of the Preliminary Prospectus, this Letter of Transmittal and the Notice of Guaranteed Delivery may be directed to Wells Fargo Corporate Trust in its capacity as Exchange Agent. See Instruction 9 below. If holders desire to tender their old junior subordinated debentures pursuant to the Exchange Offer and (i) such old junior subordinated debentures are not lost, but are not immediately available, (ii) time will not permit this Letter of Transmittal and such old junior subordinated debentures or other required documents to reach the Exchange Agent prior to 5:00 p.m. (New York City time) on the Expiration Date or (iii) the procedures for book-entry transfer (including delivery of an Agent's Message) cannot be completed prior to 5:00 p.m. (New York City time) on the Expiration Date, such holders may effect a tender of such old junior subordinated debentures in accordance with the guaranteed delivery procedures set forth in the Preliminary Prospectus under the caption, "The Exchange Offer--Procedures for Exchanging Debentures--Guaranteed Delivery." See Instruction 2 below. 2 TENDER OF OLD JUNIOR SUBORDINATED DEBENTURES /__/ CHECK HERE IF CERTIFICATES REPRESENTING TENDERED OLD JUNIOR SUBORDINATED DEBENTURES ARE ENCLOSED HEREWITH /__/ CHECK HERE IF TENDERED OLD JUNIOR SUBORDINATED DEBENTURES ARE BEING DELIVERED BY BOOK-ENTRY TRANSFER MADE TO THE ACCOUNT MAINTAINED BY THE EXCHANGE AGENT WITH DTC AND COMPLETE THE FOLLOWING: Name of Tendering Institution: ----------------------------------------------- Account Number: -------------------------------------------------------------- Transaction Code Number: ------------------------------------------------------ /__/ CHECK HERE IF TENDERED OLD JUNIOR SUBORDINATED DEBENTURES ARE BEING DELIVERED PURSUANT TO A NOTICE OF GUARANTEED DELIVERY PREVIOUSLY DELIVERED TO THE EXCHANGE AGENT AND COMPLETE THE FOLLOWING: Name of Registered Holder(s): ------------------------------------------------- Window Ticket No. (if any): --------------------------------------------------- Date of Execution of Notice of Guaranteed Delivery: --------------------------- Name of Eligible Institution that Guaranteed Delivery: ------------------------ Upon the terms and subject to the conditions of the exchange offer set forth in this Letter of Transmittal and the accompanying Preliminary Prospectus, you can choose to exchange your old junior subordinated debentures under either of the following options: o $1,000 in principal amount of new 9% senior subordinated debentures due September 15, 2006 (the "new senior subordinated debentures") of CII Financial, Inc. ("CII Financial") for each $1,000 in principal amount of old junior subordinated debentures that you tender; or o $525 in cash for each $1,000 in principal amount of the old junior subordinated debentures that you tender, up to a maximum of $19.5 million in aggregate principal amount of old junior subordinated debentures as described below. We are only offering to purchase a maximum of $19.5 million aggregate principal amount of old junior subordinated debentures for cash. If holders of more than $19.5 million aggregate principal amount of all junior subordinated debentures elect the cash option, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19.5 million principal amount of old junior subordinated debentures for cash and we will exchange the balance of the old junior subordinated debentures we receive for new senior subordinated debentures. All holders who elect the cash option will be permitted to sell the same fraction of their old junior subordinated debentures for cash. This fraction will equal $19.5 million, divided by the aggregate principal amount of all debentures tendered for cash by all holders. List below the old junior subordinated debentures to which this Letter of Transmittal relates. If the space provided is inadequate, list the certificate numbers and principal amounts on a separately executed schedule and affix the schedule to this Letter of Transmittal. Tenders of old junior subordinated debentures will be accepted only in principal amounts of $1,000 or integral multiples thereof. 3 DESCRIPTION OF OLD JUNIOR SUBORDINATED DEBENTURES Item 1. Name(s) and address(es) of registered holder(s) of old junior subordinated debentures or name of DTC participant and DTC participant's DTC account number in which old junior subordinated debentures are held. (Please fill in blank) Certificate Principal Amount Number(s)1 Tendered (2) $ Total Principal Amount of old junior subordinated $ debentures tendered (1) Need not be completed by holders of old junior subordinated debentures tendering by book-entry transfer. (2) A tendering holder of old junior subordinated debentures may tender all or some of the old junior subordinated debentures held by such holder. 5 ELECTION AS TO FORM OF EXCHANGE OFFER CONSIDERATION Item 2. Special Issuance/Special Delivery Instructions. If you are accepting the Exchange Offer, you may elect to receive either $525 in cash or a new $1,000 principal amount of 9% senior subordinated debentures due September 15, 2006 (the "new senior subordinated debentures") of CII Financial, for each $1,000 in aggregate principal amount of old junior subordinated debentures held by you (provided we are only offering to purchase a maximum of $19.5 million aggregate principal amount of old junior subordinated debentures). If you hold more than $1,000 in aggregate principal amount of old junior subordinated debentures, you need not make the same election for each $1,000 principal amount of debentures. For example, if you hold $100,000 aggregate principal amount of old junior subordinated debentures and you choose to tender in the exchange offer you may elect to receive cash for $65,000 of your old junior subordinated debentures and 9% debentures for the remaining $35,000 of your old junior subordinated debentures. /__/ Mark this box if you want your new senior subordinated debentures to be issued in another name. (Complete the "Special Issuance Instructions" below.) /__/ Mark this box if you want to provide special mailing instructions for the statements, new senior subordinated debentures or cash to which you may be entitled. (Complete the "Special Delivery Instructions" below.) Item 3. Election as to Form of Consideration. A. /__/ Check this box if you want to tender all of your old junior subordinated debentures in exchange for $525 in cash for each $1,000 principal amount of old junior subordinated debentures tendered by you. B. /__/ Check this box if you want to tender all of your old junior subordinated debentures in exchange for $1,000 principal amount of new senior subordinated debentures for each $1,000 principal amount of old junior subordinated debentures tendered by you. C. /__/ Check this box, and complete the remainder of this Item, if you hold more than $1,000 in aggregate principal amount of old junior subordinated debentures and you wish to make a mixed election as to form of consideration. (1) __________ Indicate the principal amount of your old junior subordinated debentures being tendered for which you elect to receive cash. (2)___________ Indicate the principal amount of your old junior subordinated debentures for which you elect to receive only new senior subordinated debentures. (3) Total principal amount for which you are making this mixed election. (This amount is the total of Items 3C(1) and 3C(2)above and must be equal to the total principal of the Registered Holder's old junior subordinated debentures being tendered as indicated in Item 1 above.) The names and addresses of the holders of old junior subordinated debentures should be printed, if not already printed above, exactly as they appear on the certificates representing old junior subordinated debentures tendered hereby. The old junior subordinated debentures and the principal amount of old junior subordinated debentures that the undersigned wishes to tender should be indicated in the appropriate boxes. 6 NOTE: SIGNATURES MUST BE PROVIDED BELOW. PLEASE READ THE ACCOMPANYING INSTRUCTIONS CAREFULLY. Ladies and Gentlemen: Upon the terms and subject to the conditions of the Exchange Offer, the undersigned hereby tenders to CII Financial the aggregate principal amount of the old junior subordinated debentures indicated above. Subject to, and effective upon, the acceptance for exchange of the principal amount of the old junior subordinated debentures tendered hereby, the undersigned hereby assigns and transfers to, or upon the order of, CII Financial all right, title and interest in and to such old junior subordinated debentures as are being tendered hereby. The undersigned hereby irrevocably constitutes and appoints the Exchange Agent the true and lawful agent and attorney-in-fact of the undersigned with respect to such tendered old junior subordinated debentures, with full powers of substitution, among other things, to cause the old junior subordinated debentures being tendered to be assigned, transferred and exchanged. The undersigned hereby represents and warrants that the undersigned has full power and authority to tender, sell, assign and transfer the old junior subordinated debentures being tendered, and to acquire the cash and new senior subordinated debentures of CII Financial, as the case may be, issuable upon the exchange of such tendered old junior subordinated debentures, and that, when the same are accepted for exchange, CII Financial will acquire good and unencumbered title thereto, free and clear of all liens, restrictions, charges and encumbrances and not subject to any adverse claim when the same are accepted by CII Financial. The undersigned will, upon request, execute and deliver any additional documents deemed by CII Financial to be necessary or desirable to complete the sale, assignment and transfer of the old junior subordinated debentures tendered hereby. All authority conferred or agreed to be conferred in this Letter of Transmittal and every obligation of the undersigned hereunder shall be binding upon the successors, assigns, heirs, executors, administrators, trustees in bankruptcy and legal representatives of the undersigned and shall not be affected by, and shall survive the death or incapacity of the undersigned. You may withdraw tenders of debentures at any time prior to the expiration of the Exchange Offer, but the exchange consideration shall not be payable in respect of old junior subordinated debentures so withdrawn. Any permitted withdrawal of old junior subordinated debentures may not be rescinded, and any old junior subordinated debentures properly withdrawn will thereafter be deemed not validly tendered for purposes of the Exchange Offer. Withdrawn old junior subordinated debentures may, however, be re-tendered by again following one of the appropriate procedures described in the Preliminary Prospectus at any time prior to the expiration of the Exchange Offer. The undersigned understands that tenders of old junior subordinated debentures pursuant to any of the procedures described in the Preliminary Prospectus and in the instructions hereto and acceptance of such old junior subordinated debentures by CII Financial will constitute a binding agreement between the undersigned and CII Financial upon the terms and subject to the conditions of the Exchange Offer. For purposes of the Exchange Offer, the undersigned understands that validly tendered old junior subordinated debentures (or defectively tendered old junior subordinated debentures with respect to which CII Financial has, or has caused to be, waived such defect) will be deemed to have been accepted by CII Financial if, as and when CII Financial gives oral or written notice thereof to the Exchange Agent. The undersigned hereby represents and warrants that the undersigned is relying on the information contained in the accompanying Preliminary Prospectus in making its investment decision with respect to the Exchange Offer. The undersigned further acknowledges that neither CII Financial nor any person representing CII Financial has made any representation to it with respect to CII Financial, the Exchange Offer or the issuance of the exchange considerations, other than the information contained in the accompanying Preliminary Prospectus. The undersigned understands that the delivery and surrender of any old junior subordinated debentures are not effective, and the risk of loss of the old junior subordinated debentures does not pass to the Exchange Agent, until receipt by the Exchange Agent of this Letter of Transmittal (or a copy thereof), properly completed and duly executed, together with all accompanying evidences of authority and any other required documents in form satisfactory to CII Financial. All questions as to the form of all documents and the validity (including time of receipt) and acceptance of tenders of old junior subordinated debentures will be determined by CII Financial, which determination shall be final and binding. Unless otherwise indicated herein under "A. Special Issuance/Delivery Instructions," the undersigned hereby 7 request(s) that any old junior subordinated debentures representing principal amounts not accepted for exchange be issued in the name(s) of, and delivered to, the undersigned (and in the case of old junior subordinated debentures tendered by book-entry transfer, by credit to the account of DTC). Unless otherwise indicated herein under "B. Special Issuance/ Delivery Instructions," the undersigned hereby request(s) that the exchange consideration issued in exchange for tendered old junior subordinated debentures be issued in the name(s) of, and delivered to, the undersigned (and in the case of old junior subordinated debentures tendered by book-entry transfer, by credit to the account of DTC). In the event that the "A. Special Issuance/Delivery Instructions" box is completed, the undersigned hereby request(s) that any old junior subordinated debentures representing principal amounts not accepted for exchange be issued in the name(s) of, and be delivered to, the person(s) at the address(es) therein indicated. The undersigned recognizes that CII Financial has no obligation pursuant to the "A. Special Issuance/Delivery Instructions" box to transfer any old junior subordinated debentures from the names of the registered holder(s) of old junior subordinated debentures thereof if CII Financial does not accept for exchange any of the principal amount of such old junior subordinated debentures so tendered. In the event that the "B. Special Issuance/Delivery Instructions" box is completed, the undersigned hereby request(s) that the exchange consideration issued in exchange for tendered old junior subordinated debentures be issued in the name(s) of, and be delivered to, the person(s) at the address(es) therein indicated. 8 A. SPECIAL ISSUANCE DELIVERY INSTRUCTIONS (See Instructions) To be completed ONLY if old junior subordinated debentures in a principal amount not accepted for exchange are to be issued in the name of someone other than the person(s) whose signature(s) appear(s) with this Letter of Transmittal or sent to an address different from that shown in the box entitled "Description of Old Junior Subordinated Debentures" within this Letter of Transmittal. Name --------------------------------------------------- (Please Print) Address ------------------------------------------------ (Zip Code) --------------------------------------------------- --------------------------------------------------- (Tax Identification or Social Security Number) (See Substitute Form W-9 herein) B. SPECIAL ISSUANCE DELIVERY INSTRUCTIONS (See Instructions) To be completed ONLY if the new senior subordinated debentures exchanged for old junior subordinated debentures are to be issued in the name of someone other than the person(s) whose signature(s) appear(s) with this Letter of Transmittal or sent to an address different from that shown in the box entitled "Description of Old Junior Subordinated Debentures" within this Letter of Transmittal. Name --------------------------------------------------- (Please Print) Address ------------------------------------------------ (Zip Code) --------------------------------------------------- --------------------------------------------------- (Tax Identification or Social Security Number) (See Substitute Form W-9 herein) 9 PLEASE SIGN HERE (To be completed by all tendering and consenting holders of old junior subordinated debentures regardless of whether old junior subordinated debentures are being physically delivered herewith) By completing, executing and delivering this Letter of Transmittal, the undersigned hereby tenders, the principal amount of the old junior subordinated debentures listed in the box above labeled "Description of Old Junior Subordinated Debentures" under the column heading "Principal Amount Tendered." This Letter of Transmittal must be signed by the holder(s) of old junior subordinated debentures exactly as such name(s) appear(s) on certificate(s) representing old junior subordinated debentures, or if tendered by a participant in DTC, exactly as such participant's name appears on a security position listing as the owner of old junior subordinated debentures. If signature is by trustees, executors, administrators, guardians, attorneys-in-fact, officers of corporations or others acting in a fiduciary or representative capacity, please set forth full title and see Instruction 4. --------------------------------------------------- --------------------------------------------------- Signature(s) of Registered Holder(s) of old junior subordinated Debentures or Authorized Signatory (See guarantee requirement below) Dated ----------------------------------------------------------------------- Name(s) ----------------------------------------------------------------------- Firm ----------------------------------------------------------------------- (Please Print) Capacity ---------------------------------------------------------------------- Address(es) ------------------------------------------------------------------- (Including Zip Code) Area Code and Telephone Number ------------------------------------------------ Area Code and Fax Number ------------------------------------------------------ Tax Identification or Social Security No. ------------------------------------- (COMPLETE ACCOMPANYING SUBSTITUTE FORM W-9 Medallion Signature Guarantee (If Required--See Instructions 1 and 4) Authorized Signature ---------------------------------------------------------- Name of Firm ------------------------------------------------------------------ 10 INSTRUCTIONS Forming Part of the Terms and Conditions of the Exchange Offer 1. Signature Guarantees. Signatures on this Letter of Transmittal must be guaranteed by a Medallion Signature Guarantor, unless the old junior subordinated debentures are tendered hereby by a registered holder of old junior subordinated debentures (or by a participant in DTC whose name appears on a Securities position listing as the owner of such old junior subordinated debentures) that has not completed any of the boxes entitled "Special Issuance/Delivery Instructions" on this Letter of Transmittal. If the old junior subordinated debentures are registered in the name of a person other than the signer of this Letter of Transmittal or if old junior subordinated debentures not accepted for exchange are to be returned to a person other than the registered holder of such old junior subordinated debentures, then the signatures on this Letter of Transmittal accompanying the tendered old junior subordinated debentures must be guaranteed by a Medallion Signature Guarantor as described above. See Instruction 4. 2. Delivery of Letter of Transmittal and old junior subordinated Debentures; Guaranteed Delivery Procedures. This Letter of Transmittal is to be completed by holders of old junior subordinated debentures if (1) certificates representing old junior subordinated debentures are to be physically delivered to the Exchange Agent herewith by such holders, or (2) tender of old junior subordinated debentures is to be made by book-entry transfer to the Exchange Agent's account at DTC pursuant to the procedures set forth under the caption "The Exchange Offer--Procedures for Exchanging Debentures" in the Preliminary Prospectus; and, in each case, instructions are not being transmitted through ATOP. Holders of old junior subordinated debentures must deliver all physically delivered old junior subordinated debentures, or a confirmation of a book-entry transfer into the Exchange Agent's account at DTC of all old junior subordinated debentures delivered electronically, as well as a properly completed and duly executed Letter of Transmittal (or a copy thereof) and any other documents required by this Letter of Transmittal, must be received by the Exchange Agent at its address set forth herein on or prior to the Expiration Date. Delivery of documents to DTC does not constitute delivery to the Exchange Agent. The method of delivery of this Letter of Transmittal, the old junior subordinated debentures and all other required documents, including delivery through DTC and any acceptance of Agent's Message delivered through ATOP, is at the option and risk of the tendering holder of old junior subordinated debentures. If delivery is by mail, registered mail with return receipt requested, properly insured, is recommended. In all cases, sufficient time should be allowed for such documents to reach the Exchange Agent. Except as otherwise provided in this Instruction 2, delivery will be deemed made only when actually received by the Exchange Agent. If a holder of old junior subordinated debentures desires to tender old junior subordinated debentures pursuant to the Exchange Offer and time will not permit this Letter of Transmittal, certificates representing such old junior subordinated debentures and all other required documents to reach the Exchange Agent, or the procedures for book-entry transfer cannot be completed, on or prior to the Expiration Date, such holder of old junior subordinated debentures must tender such old junior subordinated debentures pursuant to the guaranteed delivery procedures set forth under the caption "The Exchange Offer--Procedures for Exchanging Debentures--Guaranteed Delivery" in the Preliminary Prospectus. Pursuant to such procedures, (1) such tender must be made by or through an "eligible institution," as the term is used in the Preliminary Prospectus), (2) a properly completed and duly executed Notice of Guaranteed Delivery, substantially in the form provided herewith, or an Agent's Message with respect to guaranteed delivery that is accepted by CII Financial, must be received by the Exchange Agent, either by hand delivery, mail, telegram, or facsimile transmission, on or prior to the Expiration Date; and (3) the certificates representing all tendered old junior subordinated debentures, in proper form for transfer (or confirmation of a book-entry transfer of all old junior subordinated debentures delivered electronically into the Exchange Agent's account at DTC pursuant to the procedures for such transfer set forth in the Preliminary Prospectus), together with a properly completed and duly executed Letter of Transmittal (or manually signed facsimile thereof) and any other documents required by this Letter of Transmittal, or in the case of a book-entry transfer, a properly transmitted Agent's Message, must be received by the Exchange Agent within three New York Stock Exchange trading days after the date of execution of the Notice of Guaranteed Delivery. No alternative, conditional or contingent tenders will be accepted. All tendering holders of old junior subordinated debentures, by execution of this Letter of Transmittal (or a copy thereof), waive any right to receive any notice of the acceptance of their old junior subordinated debentures for payment. 11 3. Inadequate Space. If the space provided herein is inadequate, the certificate numbers and/or the principal amount represented by old junior subordinated debentures should be listed on a separate signed schedule attached hereto. 4. Signature on Letter of Transmittal, Instruments of Transfer and Endorsements. If this Letter of Transmittal is signed by the registered holder of the old junior subordinated debentures tendered hereby, the signature(s) must correspond with the name(s) as written on the face of the certificate(s) without alteration, enlargement or any change whatsoever. If this Letter of Transmittal is signed by a participant in DTC whose name is shown as the owner of the old junior subordinated debentures tendered hereby, the signature must correspond with the name shown on the security position listing as the owner of the old junior subordinated debentures. If any of the old junior subordinated debentures tendered hereby are registered in the name of two or more holders, all such holders of old junior subordinated debentures must sign this Letter of Transmittal. If any of the old junior subordinated debentures tendered hereby are registered in different names on several certificates, it will be necessary to complete, sign and submit as many Letters of Transmittal as there are different registrations of certificates. If this Letter of Transmittal or any old junior subordinated debentures or instrument of transfer is signed by a trustee, executor, administrator, guardian, attorney-in-fact, agent, officer of a corporation or other person acting in a fiduciary or representative capacity, such person should so indicate when signing, and proper evidence satisfactory to CII Financial, of such person's authority to so act must be submitted. When this Letter of Transmittal is signed by the registered holders of the old junior subordinated debentures listed and transmitted hereby, no endorsements of the old junior subordinated debentures or separate instruments of transfer are required unless the old junior subordinated debentures tendered and not accepted for exchange are to be issued to a person other than the registered holder of the old junior subordinated debentures, in which case signatures on such old junior subordinated debentures or instruments of transfer must be guaranteed by a Medallion Signature Guarantor. If this Letter of Transmittal is signed other than by the registered holder of the old junior subordinated debentures listed, the old junior subordinated debentures must be endorsed or accompanied by appropriate instruments of transfer signed exactly as the name or names of the registered holder(s) appear on the old junior subordinated debentures, and signatures on such old junior subordinated debentures or instruments of transfer must be guaranteed by a Medallion Signature Guarantor, unless the signature is that of an "eligible institution." 5. Special Issuance and Delivery Instructions. If certificates for unexchanged old junior subordinated debentures are to be issued in the name of a person other than the signer of this Letter of Transmittal and/or such old junior subordinated debentures are to be returned to someone other than the signer of this Letter of Transmittal or to an address other than that shown above, the appropriate "A. Special Issuance/Delivery Instructions" box on this Letter of Transmittal should be completed. Furthermore, if the exchange consideration exchanged for old junior subordinated debentures are to be issued in the name of a person other than the signer of this Letter of Transmittal and/or are to be sent to someone other than the signer of this Letter of Transmittal or to an address other than that shown above, the appropriate "B. Special Issuance/Delivery Instructions" boxes on this Letter of Transmittal should be completed. All old junior subordinated debentures tendered by book-entry transfer and not accepted for exchange will be returned by crediting the account at DTC designated above as the account for which such old junior subordinated debentures were delivered. 6. Transfer Taxes. Except as set forth in this Instruction 6, owners who tender their old junior subordinated debentures for exchange will not be obligated to pay any transfer taxes. If, however, new senior subordinated debentures are to be delivered to, or issued in the name of, any person other than the registered owner of the old junior subordinated debentures; or old junior subordinated debentures are registered in the name of any person other than the person signing the letter of transmittal; or a transfer tax is imposed for any reason other than the exchange of new senior subordinated debentures or old junior subordinated debentures in connection with the exchange offer; then the amount of any transfer taxes, whether imposed on the registered owner or any other persons, will be payable by the tendering holder. If satisfactory evidence of payment of such taxes or exemption from them is not submitted with the letter of transmittal, the amount of such transfer taxes will be billed directly to the tendering holder. 7. Waiver of Conditions. The conditions of the Exchange Offer may be amended or waived by CII Financial,in whole or in part, at any time and from time to time, in the case of any old junior subordinated debentures tendered. 12 8. Substitute Form W-9. Unless an exemption from backup withholding tax and information reporting requirements is otherwise established with the Exchange Agent, each tendering holder of old junior subordinated debentures (or other payee) must provide the Exchange Agent with a correct United States taxpayer identification number ("TIN"), generally the holder's United States Social Security or federal employer identification number, and with other information on Substitute Form W-9, which is provided under "Important Tax Information" below, that the holder (or other payee) is not subject to backup withholding tax. Failure to provide the information on the Substitute Form W-9 may subject the tendering holder (or other payee) to a $50 penalty imposed by the United States Internal Revenue Service and 31% backup withholding tax. The box in Part 3 of the Substitute Form W-9 may be checked if the tendering holder (or other payee) has not been issued a TIN and has applied for a TIN or intends to apply for a TIN in the near future. If the box in Part 3 is checked and the Exchange Agent is not provided with a TIN, the Exchange Agent will withhold any amounts required to be withheld. See the enclosed "Guidelines for Certification of Taxpayer Identification Number on Substitute Form W-9" for additional instructions. 9. Requests for Assistance or Additional Copies. Any questions or requests for assistance or additional copies of the Preliminary Prospectus or this Letter of Transmittal may be directed to the Exchange Agent at its telephone number and location listed below. A holder of old junior subordinated debentures may also contact Banc of America Securities LLC, at its telephone number and location listed below, or such holder's broker, dealer, commercial bank or trust company or nominee for assistance concerning the Exchange Offer. 13 IMPORTANT TAX INFORMATION Under United States federal income tax law, a holder of old junior subordinated debentures whose tendered old junior subordinated debentures are accepted for exchange generally is required to provide the Exchange Agent with such holder's current TIN on Substitute Form W-9 below. If such holder of old junior subordinated debentures is an individual, the TIN is his or her Social Security number. If the Exchange Agent is not provided with the correct TIN, the holder of old junior subordinated debentures or other payee may be subject to a $50 penalty imposed by the United States Internal Revenue Service. In addition, such holder of old junior subordinated debentures or other payee with respect to old junior subordinated debentures exchanged pursuant to the Exchange Offer may be subject to 31% backup withholding tax. Backup withholding tax is not an additional tax. Rather, the United States federal income tax liability of persons subject to backup withholding tax will be reduced by the amount of tax withheld. If withholding results in an overpayment of taxes, a refund may be obtained provided that the required information is furnished to the United States Internal Revenue Service. Certain holders of old junior subordinated debentures (including, among others, all corporations and certain foreign individuals) are not subject to these backup withholding tax and reporting requirements. Non-U.S. holders of 7 1/2 debentures must establish their status as exempt recipients, and can do so by submitting to the Exchange Agent a properly completed Substitute Form W-8 (which is provided below), signed under penalties of perjury and attesting to such holder's exempt status. Purpose of Substitute Form W-9 To prevent backup withholding tax, the holder of old junior subordinated debentures is required to notify the Exchange Agent of the holder's current TIN (or the TIN of any other payee) by completing the form below, certifying that the TIN provided on Substitute Form W-9 is correct (or that such holder of Notes is awaiting a TIN), and that (1) the holder of old junior subordinated debentures has not been notified by the United States Internal Revenue Service that the holder of old junior subordinated debentures is subject to backup withholding tax as a result of failure to report all interest or dividends, or (2) the United States Internal Revenue Service has notified the holder of old junior subordinated debentures that the holder of old junior subordinated debentures is no longer subject to backup withholding tax. What Number to Give the Exchange Agent The holder of old junior subordinated debentures is required to give the Exchange Agent the TIN (e.g., Social Security number or employer identification number) of the record owner of the old junior subordinated debentures. If the old junior subordinated debentures are registered in more than one name or are not registered in the name of the actual owner, consult the enclosed "Guidelines for Certification of Taxpayer Identification Number on Substitute Form W-9" for additional guidance on which number to report. 14 PAYER'S NAME: CII Financial, Inc. SUBSTITUTE Form W-9 United States Department of the Treasury Internal Revenue Service Payer's Request for Taxpayer Identification Number ("TIN") Part 1-PLEASE PROVIDE YOUR TIN IN THE BOX AT RIGHT AND CERTIFY BY SIGNING AND DATING BELOW. Social Security Number(s) or ------------------------------------ Employer Identification Number(s) Part 2-Certification-Under Penalties of Perjury, I certify that: (1) The number shown on this form is my correct taxpayer identification number (or I am waiting for a number to be issued to me), and (2) I am not subject to backup withholding because (a) I am exempt from backup withholding, or (b) I have not been notified by the United States Internal Revenue Service ("IRS") that I am subject to backup withholding as a result of a failure to report all interest or dividends, or (c) the IRS has notified me that I am no longer subject to backup withholding. Part 3- Awaiting TIN /__/ Certification Instructions -- You must cross out item (2) above if you have been notified by the IRS that you are currently subject to backup withholding because of underreporting interest or dividends on your tax return. SIGNATURE DATE ----------------------------------------------------------- Note: FAILURE TO COMPLETE AND RETURN THIS FORM MAY RESULT IN A $50 PENALTY IMPOSED BY THE UNITED STATES INTERNAL REVENUE SERVICE AND BACKUP WITHHOLDING. PLEASE REVIEW THE ENCLOSED GUIDELINES FOR CERTIFICATION OF TAXPAYER IDENTIFICATION NUMBER ON SUBSTITUTE FORM W-9 FOR ADDITIONAL DETAILS. Note: YOU MUST COMPLETE THE FOLLOWING CERTIFICATE IF YOU CHECKED THE BOX IN PART 3 OF THE SUBSTITUTE FORM W-9 CERTIFICATE OF AWAITING TAXPAYER IDENTIFICATION NUMBER I certify under penalties of perjury that a taxpayer identification number has not been issued to me, and either (1) I have mailed or delivered an application to receive a taxpayer identification number to the appropriate United States Internal Revenue Service Center or Social Security Administration office, or (2) I intend to mail or deliver an application in the near future. I understand that, if I do not provide a taxpayer identification number, I will be subject to backup withholding tax until I provide a taxpayer identification number. Signature Date ----------------------------------- ------------------------------ 15 The Exchange Agent for the Exchange Offer is: Wells Fargo Corporate Trust By Registered & Certified Mail: By Regular Mail or Overnight Courier: WELLS FARGO BANK MINNESOTA, N.A. WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations Corporate Trust Operations MAC N9303-121 MAC N9303-121 PO Box 1517 Sixth & Marquette Avenue Minneapolis, MN 55480 Minneapolis, MN 55479 In Person by Hand Only: By Facsimile (for Eligible Institutions Only):(612) 667-4927 WELLS FARGO BANK MINNESOTA, N.A. 12th Floor - Northstar East Building For Information or Confirmation by Corporate Trust Services Telephone: (800) 344-5128 608 Second Avenue South Minneapolis, MN Any questions or requests for assistance or for additional copies of the Preliminary Prospectus, the Letter of Transmittal or the Notice of Guaranteed Delivery may be directed to the Exchange Agent. A holder of old junior subordinated indentures may also contact D.F. King & Co., Inc. or Banc of America Securities LLC at their respective telephone numbers set forth below, or such holder's broker, dealer, commercial bank, trust company or other nominee, for assistance concerning the Exchange Offer. The Information Agent for the The Exclusive Dealer Manager for the Exchange Offer is: Exchange Offer is: D.F. King & Co., Inc. Banc of America Securities LLC 77 Water Street 100 North Tryon St., 7th Floor New York, New York 10005 Charlotte, North Carolina 28255 Banks and Brokers, call Attention: High Yield Special Products collect: (212) 269-5500 All Others, Call Toll-Free: (800) 735-3591 (704) 388-4813 (Collect) (888) 292-0070 (Toll Free) 16 EX-99 10 0010.txt - ------------------------------------------------------------------------------- A registration statement has been filed with the Securities and Exchange Commission in connection with the Exchange Offer. The completion of the Exchange Offer is dependent upon the registration statement becoming effective. - ------------------------------------------------------------------------------- CII Financial, Inc. NOTICE OF GUARANTEED DELIVERY To Exchange the outstanding 7 1/2% Convertible Subordinated Debentures due September 15, 2001 of CII Financial, Inc. - ------------------------------------------------------------------------------- THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME, ON JANUARY 25, 2001 UNLESS THE EXCHANGE OFFER IS EXTENDED (THE "EXPIRATION DATE"). TENDERS MAY BE WITHDRAWN PRIOR TO 5:00P.M., NEW YORK CITY TIME, ON THE EXPIRATION DATE. - ------------------------------------------------------------------------------- You must use this form or one substantially equivalent to this form to accept the Exchange Offer of CII Financial, Inc. ("CII Financial") made pursuant to the preliminary Prospectus and Exchange Offer, dated December 26, 2000 (the "Preliminary Prospectus"), if the procedure for book-entry transfer cannot be completed on a timely basis or time will not permit all required documents to reach Wells Fargo Corporate Trust, as exchange agent (the "Exchange Agent") prior to 5:00 p.m., New York City time, on the Expiration Date of the Exchange Offer. Such form may be delivered or transmitted by facsimile transmission, mail or hand delivery to the Exchange Agent as set forth below. In addition, in order to utilize the guaranteed delivery procedure to tender the 7 1/2% convertible subordinated debentures due September 15, 2001 (the "old junior subordinated debentures") pursuant to the Exchange Offer, a Letter of Transmittal (or facsimile thereof) or an electronic confirmation pursuant to the Depository Trust Company's ATOP system, with any required signature guarantees and any other required documents must also be received by the Exchange Agent prior to 5:00 p.m., New York City time, on the Expiration Date. The Exchange Agent for the Exchange Offer is: Wells Fargo Corporate Trust By Registered & Certified Mail: By Regular Mail or Overnight Courier: WELLS FARGO BANK MINNESOTA, N.A. WELLS FARGO BANK MINNESOTA, N.A. Corporate Trust Operations Corporate Trust Operations MAC N9303-121 MAC N9303-121 PO Box 1517 Sixth & Marquette Avenue Minneapolis, MN 55480 Minneapolis, MN 55479 In Person by Hand Only: By Facsimile (for Eligible Institutions Only): (612) 667-4927 WELLS FARGO BANK MINNESOTA, N.A. 12th Floor - Northstar East Building For Information or Confirmation by Corporate Trust Services Telephone:(800) 344-5128 608 Second Avenue South Minneapolis, MN Delivery of this instrument to an address other than as set forth above, or transmission via facsimile to a number other than as set forth above, will not constitute a valid delivery. Ladies and Gentlemen: Upon the terms and conditions set forth in the Prospectus and the accompanying Letter of Transmittal, the undersigned hereby tenders to CII Financial the principal amount of old junior subordinated debentures set forth below pursuant to the guaranteed delivery procedure described in the "The Exchange Offer--Procedures for Exchanging Debentures--Guaranteed Delivery" section of the Prospectus. All authority herein conferred or agreed to be conferred by this Notice of Guaranteed Delivery shall survive the death or incapacity of the undersigned and every obligation of the undersigned, and hereunder shall be binding upon the heirs, personal representatives, executives, administrators, successors, assigns, trustees in bankruptcy and other legal representatives of the undersigned. You may withdraw tenders of debentures at any time prior to the expiration of the Exchange Offer, but the exchange consideration shall not be payable in respect of old junior subordinated debentures so withdrawn. Any permitted withdrawal of old junior subordinated debentures may not be rescinded, and any old junior subordinated debentures properly withdrawn will thereafter be deemed not validly tendered for purposes of the Exchange Offer. Withdrawn old junior subordinated debentures may, however, be re-tendered by again following one of the appropriate procedures described in the Preliminary Prospectus at any time prior to the expiration of the Exchange Offer. 2 PLEASE SIGN AND COMPLETE Signature(s) of holder(s) of Address: old junior subordinated debentures or authorized signatory: ==================================== ====================================== - ------------------------------------ -------------------------------------- Name(s) of holder(s) of Area Code & Telephone No.: old junior subordinated debentures: - ------------------------------------ ------------------------------------- - ------------------------------------ - ------------------------------------ ------------------------------------- Area Code & Fax No.: -------------------------------------- -------------------------------------- Principal amount of old junior If old junior subordinated debentures subordinated debentures: will be delivered by book-entry transfer at The Depository Trust Company, please provide the account ____________________________________ number DTC Account No. _____________________ Certificate No(s). of old junior subordinated debentures - --------------------------------------- Date: ________________________________ This Notice of Guaranteed Delivery must be signed by the holder(s) of the old junior subordinated debentures exactly as their name(s) appear(s) on certificates for old junior subordinated debentures, or on a security position listing, or by persons authorized to become registered holder(s) by endorsements and documents transmitted with this Notice of Guaranteed Delivery, if signature is by a trustee, executor, administrator, guardian, attorney-in-fact, officer or other person acting in a fiduciary or representative capacity, such person must provide the following information: 3 PLEASE PRINT NAME(S) AND ADDRESS(ES) Name(s): - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- Capacity: - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- Address(es): - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- - ------------------- ----------------------------------------------------------- Do not send old junior subordinated debentures with this form. The old junior subordinated debentures should be sent to the Exchange Agent together with a properly completed and duly executed Letter of Transmittal. 4 Guarantee (Not to be used for signature guarantee) The undersigned, a member firm of a registered national securities exchange or of the National Association of Securities Dealers, Inc., or a commercial bank or trust company having an office or a correspondent in the United States, hereby (1) represents that each holder of old junior subordinated debentures on whose behalf this tender is being made "own(s)" the old junior subordinated debentures tendered hereby within the meaning of Rule 14e-4 under the United States Securities Exchange Act of 1934, as amended, (2) represents that such tender of old junior subordinated debentures complies with such Rule 14e-4, and (3) guarantees that, within three New York Stock Exchange trading days from the date of this Notice of Guaranteed Delivery, a properly completed and duly executed Letter of Transmittal (or facsimile thereof), together with certificates representing the old subordinated debentures tendered hereby in proper form for transfer (or confirmation of the book-entry of such old junior subordinated debentures into DTC's account at a Book-Entry Transfer Facility, pursuant to the procedure for book-entry set forth in the Prospectus under the caption "The Exchange Offer--Procedures for Exchanging Debentures," including delivery of an Agent's Message (as defined in the Letter of Transmittal) in connection therewith), and required documents will be deposited by the undersigned with DTC. Name of Firm: ______________________ ----------------------------------- Authorized Signature Address: ___________________________ - ------------------------------------ Area Code & Telephone No.: Name: Title: Date: 5 EX-99 11 0011.txt - --------------------------------------------------------------------------- A registration statement has been filed with the Securities and Exchange Commission in connection with the Exchange Offer. The completion of the Exchange Offer is dependent upon the registration statement becoming effective. - ------------------------------------------------------------------------------- CII Financial, Inc. NOTICE Dated December 26, 2000 To Exchange the outstanding 7 1/2% Convertible Subordinated Debentures due September 15, 2001 of CII Financial, Inc. - ----------------------------------------------------------------------------- THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME, ON JANUARY 25, 2001 UNLESS THE EXCHANGE OFFER IS EXTENDED (THE "EXPIRATION DATE"). TENDERS MAY BE WITHDRAWN PRIOR TO 5:00 P.M., NEW YORK CITY TIME, ON THE EXPIRATION DATE. - ------------------------------------------------------------------------------- To: Brokers, Dealers, Commercial Banks, Trust Companies and other Nominees. Enclosed for your consideration is material relating to the offer by CII Financial, Inc. ("CII Financial") to exchange: o $1,000 in principal amount of new 9% senior subordinated debentures due September 15, 2006 of CII Financial (the "new senior subordinated debentures") for each $1,000 in principal amount of the old junior subordinated debentures that you tender; or o $525 cash for each $1,000 in principal amount of the 7 1/2% convertible subordinated debentures due September 15, 2001 of CII Financial (the "old junior subordinated debentures") that you tender, up to a maximum of $19.5 million in aggregate principal amount of old junior subordinated debentures, as described in the Preliminary Prospectus under the caption "The Exchange Offer--Terms of the Exchange Offer." CII Financial will pay in cash accrued and unpaid interest on all old junior subordinated debentures accepted in the Exchange Offer through, but not including, the date of acceptance. You may withdraw tenders of debentures at any time prior to the expiration of the Exchange Offer, but the exchange consideration shall not be payable in respect of old junior subordinated debentures so withdrawn. Any permitted withdrawal of old junior subordinated debentures may not be rescinded, and any old junior subordinated debentures properly withdrawn will thereafter be deemed not validly tendered for purposes of the Exchange Offer. Withdrawn old junior subordinated debentures may, however, be re-tendered by again following one of the appropriate procedures described in the Preliminary Prospectus at any time prior to the expiration of the Exchange Offer. CII Financial will pay to Soliciting Dealers a solicitation fee of $2.50 per $1,000 of old junior subordinated debentures tendered, accepted for purchase and paid pursuant to the Exchange Offer, provided, that the aggregate solicitation fee paid to any one Soliciting Dealer shall not exceed $15,000. A "Soliciting Dealer" is an entity covered by a Letter of Transmittal which designated its name as having solicited and obtained the tender, and it is (i) any broker or dealer in securities, excluding the Dealer Manager, which is a member of any national securities exchange or of the NASD, (ii) any foreign broker or dealer not eligible for membership in the NASD which agrees to conform to the NASD's Rules of Fair Practice in soliciting tenders outside the United States to the same extent as though it were an NASD member, or (iii) any bank or trust company. No such fee shall be payable to a Soliciting Dealer with respect to the tender of old subordinated junior debentures by a holder unless the Letter of Transmittal accompanying such tender designates such Soliciting Dealer. No such fee shall be payable to a Soliciting Dealer in respect of old junior subordinated debentures registered in the name of such Soliciting Dealer unless such old junior subordinated debentures are held by such Soliciting Dealer as nominee and such old junior subordinated debentures are being tendered for the benefit of one or more beneficial owners identified on the Letter of Transmittal. No such fee shall be payable to a Soliciting Dealer if such Soliciting Dealer is required for any reason to transfer the amount of such fee to a depositing holder (other than itself). No such fee shall be paid to a Soliciting Dealer with respect to old junior subordinated debentures tendered for such Soliciting Dealer's own account. No broker, dealer, bank, trust company or fiduciary shall be deemed to be the agent of CII Financial, the Exchange Agent, the Dealer Manager or the Information Agent for purposes of the Exchange Offer. CII Financial will also, upon request, reimburse Soliciting Dealers for reasonable and customary handling and mailing expenses incurred by them in forwarding materials relating to the Exchange Offer to their customers. IN ORDER FOR A SOLICITING DEALER TO RECEIVE A SOLICITATION FEE, WELLS FARGO CORPORATE TRUST AS EXCHANGE AGENT (THE "EXCHANGE AGENT"), MUST HAVE RECEIVED FROM SUCH SOLICITING DEALER A PROPERLY COMPLETED AND DULY EXECUTED NOTICE OF SOLICITED TENDERS IN THE FORM ATTACHED HERETO (OR FACSIMILE THEREOF) WITHIN THREE BUSINESS DAYS AFTER THE EXPIRATION OF THE OFFER. For your information and for forwarding to your clients for whom you hold the old junior subordinated debentures registered in your name or in the name of your nominee, we are enclosing the following documents: 1. Preliminary Prospectus dated December 26, 2000; 2. The Letter of Transmittal for your use and for the information of your clients, together with Guidelines for Certification of Taxpayer Identification Number on Substitute Form W-9 providing information relating to backup United States federal income tax withholding and a Substitute Form W-8 for non-U.S. holders of old junior subordinated debentures; 3. A printed form of letter, including a Letter of Instructions, which may be sent to your clients for whose account you hold old junior subordinated debentures registered in your name or in the name of your nominee, with space provided for obtaining such clients' instructions with regard to the Exchange Offer; 4. A Notice of Guaranteed Delivery to be used to accept the Exchange Offer if the old junior subordinated debentures and all other required documents cannot be delivered to the Exchange Agent by the Expiration Date. Notwithstanding any other provision hereof, exchange of the cash or new senior subordinated debentures for the old junior subordinated debentures tendered and accepted for exchange pursuant to the Exchange Offer will, in all cases, be made only after receipt by the Exchange Agent of the tendered old junior subordinated debentures (or book entry confirmation of the transfer of such old junior subordinated debentures into the Exchange Agent's account at DTC) and a Letter of Transmittal (of facsimile thereof) with respect to such old junior subordinated debentures properly completed and duly executed, with any required signature guarantees and any other documents requried by the Letter of Transmittal, or a properly transmitted Agent's message; and 5. A return envelope addressed to the Exchange Agent. DTC participants will be able to execute tenders through the DTC Automated Tender Offer Program. WE URGE YOU TO CONTACT YOUR CLIENTS AS PROMPTLY AS POSSIBLE IN ORDER TO OBTAIN THEIR INSTRUCTIONS. Any inquiries you may have with respect to the Exchange Offer should be addressed, or requests for additional copies of the enclosed materials, should be directed Wells Fargo Corporate Trust, the Exchange Agent for the Exchange Offer at its address and telephone number set forth on the front of the Letter of Transmittal. Very truly yours, CII FINANCIAL, INC. NOTHING CONTAINED HEREIN OR IN THE ENCLOSED DOCUMENTS SHALL CONSTITUTE YOU OR ANY PERSON AS AGENT OF CII FINANCIAL OR THE DEALER MANAGER OR THE INFORMATION AGENT OR THE EXCHANGE AGENT, OR AUTHORIZE YOU OR ANY OTHER PERSON TO USE ANY DOCUMENT OR MAKE ANY STATEMENTS ON BEHALF OF ANY OF THEM IN CONNECTION WITH THE EXCHANGE OFFER OTHER THAN THE DOCUMENTS ENCLOSED HEREWITH AND THE STATEMENTS CONTAINED THEREIN. IMPORTANT: The Letter of Transmittal (or a facsimile thereof), together with old junior subordinated debentures and all other required documents must be received by the Exchange Agent on or prior to the Expiration Date in order for holders to receive the exchange consideration. CII Financial, Inc. NOTICE OF SOLICITED TENDERS FOR THE OLD JUNIOR SUBORDINATED DEBENTURES CUSIP NUMBER 12551LAB7 List below the aggregate principal amount of old junior subordinated debentures tendered by each beneficial owner whose tender you have solicited. All old junior subordinated debentures beneficially owned by a beneficial owner, whether in one account or several, and in however many capacities, must be aggregated for purposes of completing the table below. Any questions as to what constitutes beneficial ownership should be directed to the Exchange Agent. If the space below is inadequate, list the old junior subordinated debentures in a separate signed schedule and affix the list to this Notice of Solicited Tenders. ALL NOTICES OF SOLICITED TENDERS SHOULD BE DETACHED BY TEARING ALONG THE PERFORATED EDGE AND RETURNED TO THE EXCHANGE AGENT AT THE ADDRESS SET FORTH ON THE BACK COVER OF THE OFFER TO PURCHASE WITHIN THREE NEW YORK STOCK EXCHANGE TRADING DAYS AFTER THE EXPIRATION OF THE OFFER. NOTICES MAY BE FAXED TO THE EXCHANGE AGENT BY ELIGIBLE INSTITUTIONS AT (612)-667-4927 CONFIRMATION TELEPHONE NUMBER (800) 344-5218 ALL QUESTIONS CONCERNING THE NOTICES OF SOLICITED TENDERS SHOULD BE DIRECTED TO THE INFORMATION AGENT AT THE TELEPHONE NUMBER SET FORTH ON THE BACK COVER OF THE PRELIMINARY PROSPECTUS. ALL SOLICITING DEALERS ARE REQUIRED TO COMPLETE THE FOLLOWING. PLEASE TYPE OR PRINT NEATLY. DTC Participant VOI Ticket Principal Amount of Number of Number Number* Debentures Requested for Beneficial Owner(s) Payment Represented - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------- * Complete if old junior subordinated debentures delivered by book-entry transfer. Please submit a separate VOI ticket for old junior subordinated debentures tendered when the solicitation fee is to be directed to another Soliciting Dealer. DO NOT SEND OLD JUNIOR SUBORDINATED DEBENTURE CERTIFICATES WITH THIS FORM. YOUR OLD JUNIOR SUBORDINATED DEBENTURE CERTIFICATES MUST BE SENT WITH THE LETTER OF TRANSMITTAL. PLEASE COMPLETE THE SIGNATURE FORM ON THE LAST PAGE. SOLICITATION FEE PAYMENT INSTRUCTIONS ISSUE CHECK TO: Firm (Please Print) Attention Address (Include Zip Code) Phone Number Taxpayer Identification or Social Security No. Applicable VOI Number Principal Amount of Debentures IF SOLICITATION FEES ARE PAID TO ANOTHER ELIGIBLE INSTITUTION(S), PLEASE COMPLETE THE FOLLOWING BOXES: ISSUE CHECK TO: Firm (Please Print) Attention Address (Include Zip Code) Phone Number Taxpayer Identification or Social Security No. Applicable VOI Number Principal Amount of Debentures ISSUE CHECK TO: Firm (Please Print) Attention Address (Include Zip Code) Phone Number Taxpayer Identification or Social Security No. Applicable VOI Number Principal Amount of Debentures NOTE: IF ADDITIONAL PAYMENT INSTRUCTIONS, PLEASE COPY AND ATTACH. All questions as to the validity, form and eligibility (including time of receipt) of Notices of Solicited Tenders will be determined by the Exchange Agent, in its sole discretion, which determination will be final and binding. Neither the Exchange Agent nor any other person will be under any duty to give notification of any defects or irregularities in any Notice of Solicited Tenders or incur any liability for failure to give such notification. The undersigned hereby confirms that: (i) it has complied with the applicable requirements of the Securities Exchange Act of 1934, as amended, and the applicable rules and regulations thereunder, in connection with such solicitation; (ii) it is entitled to such compensation for such solicitation under the terms and conditions of the Exchange Offer; (iii) in soliciting tenders of old junior subordinated debentures, it has used no soliciting materials other than those furnished by CII Financial; and (iv) if it is a foreign broker or dealer not eligible for membership in the NASD, it has agreed to conform to the NASD's Rules of Fair Practice in making solicitations. Firm Name: By: Title: Address (Including Zip Code): Area Code and Telephone Number: EX-99 12 0012.txt EXHIBIT 99.4 - ----------------------------------------------------------------------------- A registration statement has been filed with the Securities and Exchange Commission in connection with the Exchange Offer. The completion of the Exchange Offer is dependent upon the registration statement becoming effective. - ------------------------------------------------------------------------------ CII Financial, Inc. NOTICE Dated December 26, 2000 To Exchange the outstanding 7 1/2% Convertible Subordinated Debentures due September 15, 2001 of CII Financial, Inc. - ----------------------------------------------------------------------------- THE EXCHANGE OFFER WILL EXPIRE AT 5:00 P.M., NEW YORK CITY TIME, ON JANUARY 25, 2001 UNLESS THE EXCHANGE OFFER IS EXTENDED (THE "EXPIRATION DATE"). TENDERS MAY BE WITHDRAWN PRIOR TO 5:00 P.M., NEW YORK CITY TIME, ON THE EXPIRATION DATE. - ------------------------------------------------------------------------------ To Our Clients: Enclosed for your consideration is a preliminary Prospectus dated December 26, 2000 (the "Preliminary Prospectus"), and the related Letter of Transmittal (the "Letter of Transmittal"), relating to the offer (the "Exchange Offer") by CII Financial, Inc. ("CII Financial") to exchange: o $1,000 in principal amount of new 9% senior subordinated debentures due September 15, 2006 of CII Financial (the "new senior subordinated debentures") for each $1,000 in principal amount of the old junior subordinated debentures that you tender; or o $525 in cash for each $1,000 in principal amount of 7 1/2% convertible subordinated debentures due September 15, 2001 of CII Financial (the "old junior subordinated debentures") that you tender, up to a maximum of $19.5 million in aggregate principal amount of old junior subordinated debentures, as described in the Preliminary Prospectus under the caption "The Exchange Offer-Terms of the Exchange Offer." CII Financial will pay in cash all accrued and unpaid interest on all old junior subordinated debentures accepted in the Exchange Offer through, but not including, the date of acceptance. This material is being forwarded to you as the beneficial owner of the old junior subordinated debentures held by us for your account but not registered in your name. A tender of such old junior subordinated debentures may only be made by us as the holder of record and pursuant to your instructions. Accordingly, we request instructions as to whether you wish us to tender on your behalf the old junior subordinated debentures held by us for your account, pursuant to the terms and conditions set forth in the enclosed Preliminary Prospectus and Letter of Transmittal. Your instructions should be forwarded to us as promptly as possible in order to permit us to tender the old junior subordinated debentures on your behalf in accordance with the provisions of the Exchange Offer. Any old junior subordinated debentures tendered pursuant to the Exchange Offer may be withdrawn at any time before the Expiration Date. Your attention is directed to the following: 1.The Exchange Offer is for any and all old junior subordinated debentures. 2. The Exchange Offer is subject to certain conditions set forth in the Preliminary Prospectus in the section captioned "The Exchange Offer--Conditions to, and Amendment of, the Exchange Offer." 3. Any transfer taxes incident to the transfer of old subordinated debentures from the holder to CII Financial will be paid by CII Financial, except as otherwise provided in the Instructions in the Letter of Transmittal. 4. The Exchange Offer expires at 5:00 p.m., New York City time, on January 25, 2001 unless extended by CII Financial. If you wish to have us tender some or all of your old junior subordinated debentures, please so instruct us by completing, executing and returning to us the instruction form on the back of this letter. The Letter of Transmittal is furnished to you for information only and may not be used directly by you to tender old junior subordinated debentures. You may withdraw tenders of debentures at any time prior to the expiration of the Exchange Offer, but the exchange consideration shall not be payable in respect of old junior subordinated debentures so withdrawn. Any permitted withdrawal of old junior subordinated debentures may not be rescinded, and any old junior subordinated debentures properly withdrawn will thereafter be deemed not validly tendered for purposes of the Exchange Offer. Withdrawn old junior subordinated debentures may, however, be re-tendered by again following one of the appropriate procedures described in the Preliminary Prospectus at any time prior to the expiration of the Exchange Offer. INSTRUCTIONS WITH RESPECT TO THE EXCHANGE OFFER The undersigned acknowledge(s) receipt of your letter and the enclosed material referred to therein relating to the Exchange Offer made by CII Financial, Inc. with respect to the old junior subordinated debentures. This will instruct you to tender the old subordinated debentures indicated below held by you for the account of the undersigned, upon and subject to the terms and conditions set forth in the Preliminary Prospectus and related Letter of Transmittal. - ------------------------------------------------------------------------------ Old Junior Subordinated Debentures that are to be tendered. - ----------------------------------------------------------------------------- - ------------------------------------------------------------ ---------------- Principal Tendered: Form of Exchange Offer Consideration: - ------------------------------------------------------------ ---------------- - ------------------------------------------------------------ --------------- $ Cash - ------------------------------------------------------------ ----------------- - ------------------------------------------------------------ ----------------- $ New Senior Subordinated Debentures - ------------------------------------------------------------ - ------------------------------------------------------------ ---------------- Total Principal Tendered: $ - ------------------------------------------------------------ ----------------- - ------------------------------------------------------------------------------- PLEASE SIGN HERE - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (Signature) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Name(s) (Please Print) - ----------------------------------------------------------------------------- - ---------------------------------------------------------------------------- Address - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Zip Code - ----------------------------------------------------------------------------- - ---------------------------------------------------------------------------- Area Code and Telephone No. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Area Code and Fax No. - ------------------------------------------------------------------------------ - ----------------------------------------------------------------------------- Tax Identification or Social Security No. - ----------------------------------------------------------------------------- - ------------------------------------------------------------------------------ My Account Number with You - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------ Date - ------------------------------------------------------------------------------ EX-99 13 0013.txt Exhibit 99.5 December 26, 2000 To Holders of CII Financial, Inc. 7-1/2% Convertible Subordinated Debentures Due September 15, 2001 We are offering to acquire all of our outstanding $47,059,000 principal amount of 7-1/2% Convertible Subordinated Debentures Due September 15, 2001, CUSIP No. 12551LAB7. The purpose of this letter is to call your attention to certain important information regarding our offer. The offer expires at 5:00 p.m., New York City time, on January 25, 2001, unless extended. You can choose to sell your old 7-1/2% debentures for either cash or new debentures. o If you choose new debentures, you will receive $1,000 principal amount of our new 9% senior subordinated debentures due 2006 for each $1,000 principal amount of your old 7-1/2% junior subordinated debentures, plus accrued and unpaid interest in cash. o If you choose cash, you will receive $525 in cash for each $1,000 principal amount of your old 7-1/2% junior subordinated debentures, plus accrued and unpaid interest in cash. However, we will purchase no more than $19.5 million total principal amount of old debentures for cash. If holders of more than $19.5 million total principal amount of old 7-1/2% debentures elect to sell their debentures for cash, we will not have enough cash to pay for all the debentures that holders elect to sell. In that case, we will purchase a total of $19.5 million principal amount of debentures for cash and we will exchange the balance of your debentures for new debentures. All holders who elect to receive cash will be treated equally in this process. We are a holding company with no significant operating assets of our own. Our subsidiaries are regulated insurance companies which are restricted from providing us with dividends or other funds. Currently, our subsidiaries are prohibited from paying any dividends to us without prior approval by the California Department of Insurance. We intend to seek approval from the California Department for our subsidiaries to provide a portion of the funds we need to complete this offer. Your old 7-1/2% junior subordinated debentures will mature on September 15, 2001. We are making this offer because, although our insurance subsidiaries are solvent, CII Financial has no available source of cash with which to pay your old 7-1/2% debentures when they mature. As many of you know, the California workers' compensation market, where we conduct more than 77% of our business, has been severely impacted in recent years by intense price competition brought on by changes in applicable insurance regulations. Some of our largest competitors are now facing bankruptcy or receivership and we incurred a net loss of $8.5 million for the nine months ended September 30, 2000. However, we have recently seen improvement in our pricing in California as a number of our competitors have been forced to retrench or exit the market altogether. While there can be no assurance that this trend will continue, we believe we will be in a better position to repay the new 9% senior subordinated debentures when they mature on September 15, 2006 than we are to pay the old 7-1/2% debentures on September 15, 2001. In addition, we have provided a cash option for holders who do not wish to exchange their old debentures for new debentures. - ------------------------------------------------------------------------------- In considering our offer, you should be aware of a number of significant risks that will affect any old debentures that remain outstanding after expiration of our offer. 1) We, and other affiliates, are guarantors of $185 million of loans made under credit facilities of our parent, Sierra Health Services. Our old 7-1/2% debentures rank junior to our guarantee of the credit facilities. In the event of a default in payment on our old debentures, Sierra's senior lenders would have the right to receive payment in full on our guarantee prior to any payment being made on the old debentures. 2) Up to $47 million principal amount of new 9% senior subordinated debentures due 2006 will be issued. Any old 7-1/2% debentures that remain outstanding will rank junior to all of the new 9% senior subordinated debentures. 3) There may be no active trading market for any old 7-1/2% debentures that remain outstanding after completion of the offer. As a result, you may have difficulty selling your old debentures after expiration of the offer. We intend to list the new 9% senior subordinated debentures on the New York Stock Exchange. - ------------------------------------------------------------------------------ If you want to participate in the offer, you must make the necessary arrangements promptly. In particular, if your debentures are held through a broker, dealer, bank, trust company or other nominee, you will need to instruct this firm to tender the debentures on your behalf. Since this procedure may take a considerable amount of time, you should give these instructions as soon as possible. The offer expires at 5:00 p.m., New York City time, on January 25, 2001 unless extended. The terms of the offer are contained in our Preliminary Prospectus and Exchange Offer, which accompanies this letter. The offer is subject to certain conditions, including participation by holders of at least 90% of the outstanding debentures, receipt of sufficient financing, receipt of necessary approvals from our regulators and receipt of necessary consents from bank lenders. If you need assistance making arrangements to tender your securities, please call the Information Agent for the offer, D.F. King & Co., at (800) 735-3591. If you have any questions about the offer, please call the Dealer Manager for the offer, Banc of America Securities, at (888) 292-0070. We appreciate your consideration of our offer. Sincerely, Kathleen M. Marlon Chairman, President, and Chief Executive Officer A registration statement relating to the new debentures has been filed with the Securities and Exchange commission but has not yet become effective. The new debentures may not be sold nor may tenders be accepted prior to the time the registration statement becomes effective. This shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of the new debentures in any State in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such State. -----END PRIVACY-ENHANCED MESSAGE-----