UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended September 30, 2001
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from ______________ to _____________
Commission file number 0-13972
------------------------------------------------
PENN TREATY AMERICAN CORPORATION
3440 Lehigh Street, Allentown, PA 18103
(610) 965-2222
Incorporated in Pennsylvania I.R.S. Employer ID No.
023-1664166
-------------------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
The number of shares outstanding of the Registrant's common stock, par value
$.10 per share, as of November 6, 2001 was 19,367,737.
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Penn Treaty American Corporation is one of the leading providers of long-term
nursing home and home health care insurance. Our Unaudited Consolidated Balance
Sheets, Statements of Operations and Comprehensive Income and Statements of Cash
Flows and Notes thereto required under this item are contained on pages 3
through 10 of this report, respectively. Our financial statements represent the
consolidation of our operations and those of our subsidiaries: Penn Treaty
Network America Insurance Company ("PTNA"), American Network Insurance Company
("American Network"), American Independent Network Insurance Company of New York
("American Independent") and Penn Treaty (Bermuda) Ltd. ("Penn Treaty
(Bermuda)") (collectively, the "Insurers") and United Insurance Group Agency,
Inc. ("UIG"), Network Insurance Senior Health Division ("NISHD") and Senior
Financial Consultants (collectively, the "Agencies"), which are underwriters and
marketers of long-term care insurance, disability and other senior-market
products. PTNA is also an underwriter of life insurance products.
2
PENN TREATY AMERICAN CORPORATION
AND SUBSIDIARIES
Consolidated Balance Sheets
(amounts in thousands)
September 30, December 31,
2001 2000
---- ----
(unaudited)
ASSETS
Investments:
Bonds, available for sale at market (cost of $484,902 and $349,877, respectively) $ 505,475 $ 349,488
Bonds, classified as trading 15,872 --
Equity securities at market value (cost of $18,837 and $17,112, respectively) 16,776 16,496
Policy loans 188 142
--------- ---------
Total investments 538,311 366,126
Cash and cash equivalents 65,648 116,596
Property and equipment, at cost, less accumulated depreciation of
$6,327 and $5,162, respectively 12,881 12,467
Unamortized deferred policy acquisition costs 248,103 251,711
Receivables from agents, less allowance for
uncollectable amounts of $199 and $199, respectively 2,177 3,333
Accrued investment income 7,559 6,214
Federal income tax recoverable 2,092 3,671
Cost in excess of fair value of net assets acquired, less
accumulated amortization of $3,960 and $3,314, respectively 26,095 27,064
Present value of future profits acquired 2,075 2,352
Receivable from reinsurers 12,193 16,131
Other assets 51,340 50,466
--------- ---------
Total assets $ 968,474 $ 856,131
========= =========
LIABILITIES
Policy reserves:
Accident and health $ 365,225 $ 348,344
Life 13,083 13,065
Policy and contract claims 203,372 164,565
Accounts payable and other liabilities 24,037 14,706
Long-term debt 79,210 81,968
Deferred income taxes 52,837 45,421
--------- ---------
Total liabilities 737,764 668,069
--------- ---------
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding -- --
Common stock, par value $.10; 40,000 shares authorized, 19,749 and 8,202 shares issued 1,975 820
Additional paid-in capital 78,514 53,879
Accumulated other comprehensive income (loss) 12,028 (662)
Retained earnings 144,898 140,730
--------- ---------
237,415 194,767
Less 915 and 915, respectively, common shares held in treasury, at cost (6,705) (6,705)
--------- ---------
230,710 188,062
--------- ---------
Total liabilities and shareholders' equity $ 968,474 $ 856,131
========= =========
See accompanying notes to consolidated financial statements
3
PENN TREATY AMERICAN CORPORATION
AND SUBSIDIARIES
Consolidated Statements of Operations and Comprehensive Income
(unaudited)
(amounts in thousands, except per share data)
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2001 2000 2001 2000
---- ---- ---- ----
Revenue:
Premiums $ 80,588 $ 91,963 $ 266,646 $ 264,826
Net investment income 8,571 6,874 22,481 19,671
Net realized capital (losses) gains (314) 503 (1,168) 1,244
Trading account (loss) income (1,506) -- (2,830) --
Other income 2,548 2,383 7,313 6,743
--------- --------- --------- ---------
89,887 101,723 292,442 292,484
Benefits and expenses:
Benefits to policyholders 47,220 61,120 179,592 180,519
Commissions 16,920 25,716 62,744 77,088
Net policy acquisition costs amortized (deferred) 7,255 (9,111) 3,608 (32,091)
General and administrative expense 11,079 12,951 36,670 36,285
Reserve for claim litigation -- (500) (250) 1,000
Interest expense 1,238 1,281 3,760 3,843
--------- --------- --------- ---------
83,712 91,457 286,124 266,644
--------- --------- --------- ---------
Income before federal income taxes 6,175 10,266 6,318 25,840
Provision for federal income tax 2,100 3,490 2,148 8,786
--------- --------- --------- ---------
Net income 4,075 6,776 4,170 17,054
--------- --------- --------- ---------
Other comprehensive income:
Unrealized holding gain arising during period 14,341 5,197 15,519 2,022
Income tax expense from unrealized holdings (5,019) (1,767) (5,432) (687)
Reclassification adjustment for realized loss (gain) 1,820 (503) 3,998 (1,244)
Income (tax) benefit from reclassification adjustment (637) 171 (1,400) 423
--------- --------- --------- ---------
Comprehensive income $ 14,580 $ 9,874 $ 16,855 $ 17,568
========= ========= ========= =========
Basic earnings per share $ 0.22 $ 0.93 $ 0.33 $ 2.34
Diluted earnings per share $ 0.22 $ 0.76 $ 0.33 $ 1.96
Weighted average number of shares outstanding 18,836 7,277 12,703 7,277
Weighted average number of shares outstanding (diluted) 18,836 9,982 12,826 9,970
See accompanying notes to consolidated financial statements.
4
PENN TREATY AMERICAN CORPORATION
AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Nine Months Ended September 30,
(unaudited)
(amounts in thousands)
2001 2000
---- ----
Net cash flow from operating activities:
Net income $ 4,170 $ 17,054
Adjustments to reconcile net income to cash
provided by operations:
Amortization of intangible assets 1,516 1,552
Policy acquisition costs, net 3,608 (32,091)
Deferred income taxes 583 515
Depreciation expense 1,165 818
Net realized capital losses (gains) 1,168 (1,244)
Trading account loss 2,830 --
Net proceeds from purchases and sales of trading account (1,172) --
Increase (decrease) due to change in:
Receivables from agents 1,156 (70)
Receivable from reinsurers 3,938 (8)
Policy and contract claims 38,807 19,136
Policy reserves 16,899 67,620
Accounts payable and other liabilities 9,331 (456)
Federal income taxes recoverable 1,579 1,616
Federal income taxes payable -- 2,044
Accrued investment income (1,345) (1,030)
Other, net (1,077) (3,105)
--------- ---------
Cash provided by operations 83,156 72,351
Cash flow used in investing activities:
Net cash purchase of subsidiary -- (6,000)
Proceeds from sales of bonds 70,780 97,406
Proceeds from sales of equity securities 8,395 24,341
Maturities of investments 12,402 10,282
Purchase of bonds (234,412) (156,693)
Purchase of equity securities (12,670) (22,867)
Acquisition of property and equipment (1,579) (2,404)
--------- ---------
Cash used in investing (157,084) (55,935)
Cash flow provided by (used in) financing activities:
Proceeds from exercise of stock options 12 7
Net proceeds from rights offering 25,726 --
Repayments of long-term debt (2,758) (874)
--------- ---------
Cash provided by (used in) financing 22,980 (867)
--------- ---------
(Decrease) increase in cash and cash equivalents (50,948) 15,549
Cash balances:
Beginning of period 116,596 17,347
--------- ---------
End of period $ 65,648 $ 32,896
========= =========
See accompanying notes to consolidated financial statements.
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2001
(unaudited)
(amounts in thousands, except per share data)
The Consolidated Financial Statements should be read in conjunction with these
notes and with the Notes to Consolidated Financial Statements included in the
Annual Report on Form 10-K for the year ended December 31, 2000 of Penn Treaty
American Corporation (the "Company").
In the opinion of management, the summarized financial information reflects all
adjustments (consisting only of normal recurring adjustments) that are necessary
for a fair presentation of the financial position and results of operations,
comprehensive income and cash flows for the interim periods. Certain prior
period amounts have been reclassified to conform to current period presentation.
1. Recent Developments:
In the Company's Annual Report on Form 10-K for the year ended December
31, 2000, it reported that its Report of Independent Accountants contained a
going concern qualification. The going concern qualification addressed the
parent company's liquidity and the statutory capital and surplus position of
PTNA.
On April 27, 2001, the Company distributed rights to its shareholders
and holders of its 6.25% convertible subordinated notes due 2003 ("Rights
Offering") for the purpose of raising new equity capital. Pursuant to the Rights
Offering, holders of the Company's common stock and holders of its convertible
subordinated notes received rights to purchase approximately 11,550 newly issued
shares of common stock at a set price of $2.40 per share. The rights offering
was completed on May 25, 2001 and generated net proceeds of $25,726 in
additional equity capital. The Company contributed $18,000 of the net proceeds
to the statutory capital of its subsidiaries, PTNA and American Network.
At December 31, 2000, PTNA's statutory surplus had decreased such that
it was at the Regulatory Action Level established by the Pennsylvania Insurance
Department (the "Department"), below which a company must prepare and submit to
the Department a Corrective Action Plan that details the insurer's plan to raise
additional statutory capital over the next four years. As a result, PTNA is
required to prepare and submit a Corrective Action Plan (the "Plan") to the
Department for approval.
PTNA has prepared, with the assistance of its consulting actuaries, a
Plan that includes new business generation and additional capital generation
from the sale of assets and reinsurance. As part of the Plan, the Department has
requested PTNA to adopt more conservative claims assumptions in the
establishment of its statutory reserves, as indicated in the preliminary
findings of the Department's most recent financial examination. While PTNA
believes that it may not be required by the Pennsylvania Insurance Act to adopt
these claims assumptions, it agrees that more conservative assumptions for the
computation of statutory reserves are appropriate given recent Company and
industry developments in types of care, policy persistency and claims duration.
However, the Department has rejected PTNA's assertion that premium rate
increases should also be considered in the reestablishment of statutory reserves
where modified assumptions are incorporated.
6
PTNA has incorporated the more conservative assumptions for all new
policies written after June 30, 2001 and proposes to include the impact of these
assumptions for existing business in its calculation of reserves progressively
over a three-year period. PTNA's statutory reserves, as reported for the period
ended September 30, 2001, have been recorded in accordance with the proposed
Plan. Although PTNA began operating under the Plan during the third quarter of
2001, the Department has not yet approved the Plan or PTNA's current reserving
methodology. If the Plan is not approved, PTNA's statutory financial position
could be significantly adversely affected.
Effective September 11, 2001, the Company determined to discontinue the
sale nationally of all new long-term care insurance policies until the Plan was
completed and approved by the Department. This decision resulted from the
Company's concern about further depletion of statutory surplus from new sales
prior to the completion and approval of the Plan and from increasing concern
regarding the status of the Plan expressed by many states in which the Company
is licensed to conduct business.
On August 13, 2001, the Company announced that it had signed a letter
of intent with an unaffiliated insurer for the reinsurance of its disability
product line. Subsequent to September 30, 2001, the Company completed the
reinsurance agreement, effective September 1, 2001, for approximately $5,000.
The statutory surplus of both American Network and PTNA was increased from the
ceding allowanceof the reinsurance agreement. The ceding allowance of
approximately $5,000 has been deferred, and will be amortized over the remaining
life of the reinsured policies.
On August 13, 2001, the Company announced that it had signed a letter
of intent with an unaffiliated insurer for the sale of American Independent and
Penn Treaty (Bermuda). The sale remains subject to the negotiation and execution
of definitive purchase agreements and regulatory approval.
2. Deferred Policy Acquisition Costs and Policy Reserves:
During the second quarter 2001, the Company, with the assistance of its
new consulting actuary, completed an analysis to determine if existing policy
reserves and policy and contract claim reserves, together with the present value
of future gross premiums, would be sufficient to (1) cover the present value of
future benefits to be paid to policyholders and settlement and maintenance costs
and (2) recover unamortized deferred policy acquisition costs. The Company
determined that it would require premium rate increases on a majority of its
existing products in order to fully recover its present deferred policy
acquisition cost asset from future profits.
As a result of this analysis, the Company recorded a loss of
approximately $300 through a net change in the policy reserves and unamortized
deferred policy acquisition costs. Future changes in policy reserves and
unamortized deferred policy acquisition costs will be based on these revised
assumptions. In determining the impairment, the Company evaluated future claims
expectations, premium rates and required rate increases, persistency and expense
projections.
3. Contingencies:
The Company received notice on April 17, 2001 that it and certain of
its key executive officers had been named as defendants in class action lawsuits
filed in the United States District Court for the Eastern District of
Pennsylvania as a result of the Company's recent stock performance. The
complaints in each case allege that the Company and its executives made
misleading statements about the Company's statutory surplus, statutory reserves
and financial health. The Company cannot predict the outcome of these class
action lawsuits; however, it contends that the lawsuits are baseless and
completely without merit, and intends to defend itself vigorously.
7
4. Codification:
In 1998, the National Association of Insurance Commissioners ("NAIC")
adopted the Codification of Statutory Accounting Principles guidance, which
replaces the current Accounting Practices and Procedures manual as the NAIC's
primary guidance on statutory accounting as of January 1, 2001. The Codification
provides guidance in some areas where statutory accounting has been silent and
changes current statutory accounting in other areas.
The Pennsylvania Insurance Department and the New York Insurance
Department, with certain revisions, have adopted the Codification guidance,
effective January 1, 2001. The Company has adopted the Codification guidance,
including certain limitations on the recognition of goodwill and EDP equipment
and other than temporary declines in investments, which reduced the statutory
surplus of the Company's insurance subsidiaries at January 1, 2001 by
approximately $3,050.
5. Investments:
Management has categorized the majority of its investment securities as
available for sale since they may be sold in response to changes in interest
rates, prepayments and similar factors. Investments in this category are
reported at their current market value with net unrealized gains and losses, net
of the applicable deferred income tax effect, being added to or deducted from
the Company's total shareholders' equity on the balance sheet. As of September
30, 2001, shareholders' equity was increased by $12,028 due to unrealized gains
of $18,512 in the investment portfolio. As of December 31, 2000, shareholders'
equity was decreased by $662 due to unrealized losses of $1,005 in the
investment portfolio.
The amortized cost and estimated market value of the Company's
available for sale investment portfolio as of September 30, 2001 and December
31, 2000 are as follows:
September 30, 2001 December 31, 2000
------------------ -----------------
Amortized Estimated Amortized Estimated
Cost Market Value Cost Market Value
---- ------------ ---- ------------
U.S. Treasury securities
and obligations of U.S
Government authorities
and agencies $ 182,652 $ 194,699 $ 120,691 $ 125,981
Obligations of states and
political sub-divisions 572 626 572 600
Mortgage backed securities 38,973 40,245 26,529 26,720
Debt securities issued by
foreign governments 14,298 14,727 15,817 15,549
Corporate securities 248,407 255,178 186,268 180,638
Equities 18,837 16,776 17,112 16,496
--------- --------- --------- ---------
Total Investments $ 503,739 $ 522,251 $ 366,989 $ 365,984
========= ========= ========= =========
Net unrealized gain (loss) 18,512 (1,005)
--------- ---------
$ 522,251 $ 365,984
========= =========
8
Effective January 1, 2001, in accordance with Statement of Financial
Accounting Standard No. 133 "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS No. 133"), the Company transferred its convertible bond
portfolio, which contained embedded derivatives, from the available for sale
category of investments to the trading category. Realized gains and losses and
changes in unrealized gains and losses for the trading portfolio are recorded in
current operations. The unrealized loss at the time of the transfer was $1,064.
During the nine month period ended September 30, 2001, the Company
recognized impairment losses of $1,657 on equity securities, which it deemed to
be other than temporary.
6. New Accounting Principles:
Effective January 1, 2001, the Company adopted SFAS No. 133, as amended
by SFAS No. 137, "Deferral of the Effective Date of FAS 133," which establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
"derivatives") and for hedging activities. SFAS No. 133 requires an entity to
recognize all derivatives as either assets or liabilities in the statement of
financial position and measure those instruments at fair value.
In accordance with SFAS No. 133, the Company transferred its
convertible bond portfolio from the available for sale category to the trading
category.
The Company is party to an interest rate swap agreement, which converts
its mortgage loan from a variable rate to a fixed rate instrument. The Company
determined that the swap qualifies as a cash-flow hedge. The notional amount of
the swap is approximately $1,500. The effects have been determined to be
immaterial to the financial statements.
The Company's involvement with derivative instruments and transactions
is primarily to mitigate its own risk and is not considered speculative in
nature.
In June 2001, the Financial Accounting Standards Board ("FASB") issued
two Statements of Financial Accounting Standards ("SFAS"). SFAS No. 141
"Business Combinations" requires usage of the purchase method for all business
combinations initiated after June 30, 2001, and prohibits the usage of the
pooling of interests method of accounting for business combinations. The
provisions of SFAS No. 141 relating to the application of the purchase method
are generally effective for business combinations completed after July 1, 2001.
Such provisions include guidance on the identification of the acquiring entity,
the recognition of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition provisions
of SFAS No. 141 require an analysis of goodwill, acquired in purchase business
combinations prior to July 1, 2001, to identify and reclassify separately
identifiable intangible assets currently recorded as goodwill.
SFAS No. 142 primarily addresses the accounting for goodwill and
intangible assets subsequent to their acquisition. The Company will adopt SFAS
No. 142 on January 1, 2002 and will cease amortizing goodwill at that time. All
goodwill recognized in the Company's consolidated balance sheet at January 1,
2002 should be assigned to one or more reporting units. Goodwill in each
reporting unit should be tested for impairment by June 30, 2002. An impairment
loss recognized as a result of a transitional impairment test of goodwill should
be reported as the cumulative effect of a change in accounting principle.
9
Although the Company believes there are separately identifiable
intangible assets currently included in the total cost in excess of fair value
of net assets acquired on the consolidated balance sheet, it has not yet
evaluated the impact of SFAS No. 141 and SFAS No. 142 on its financial condition
or results of operations.
7. Reconciliation of Earnings Per Share:
A reconciliation of the numerator and denominator of the basic earnings
per share computation to the numerator and denominator of the diluted earnings
per share computation follows. Basic earnings per share excludes dilution and is
computed by dividing income available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share reflect the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
Anti-dilutive effects are not included.
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2001 2000 2001 2000
---- ---- ---- ----
Net income $ 4,075 $ 6,776 $ 4,170 $17,054
Weighted average common shares outstanding 18,836 7,277 12,703 7,277
Basic earnings per share $ 0.22 $ 0.93 $ 0.33 $ 2.34
======= ======= ======= =======
Net income $ 4,075 $ 6,776 $ 4,170 $17,054
Adjustments net of tax:
Interest expense on convertible debt -- 771 -- 2,313
Amortization of debt offering costs -- 60 -- 180
------- ------- ------- -------
Diluted net income $ 4,075 $ 7,607 $ 4,170 $19,547
======= ======= ======= =======
Weighted average common shares outstanding 18,836 7,277 12,703 7,277
Common stock equivalents due to dilutive
effect of stock options -- 77 123 65
Shares converted from convertible debt -- 2,628 -- 2,628
------- ------- ------- -------
Total outstanding shares for diluted earnings
per share computation 18,836 9,982 12,826 9,970
Diluted earnings per share $ 0.22 $ 0.76 $ 0.33 $ 1.96
======= ======= ======= =======
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Overview
As a result of our insurance subsidiary surplus needs and parent
company liquidity requirements, the Report of Independent Accountants for our
fiscal 2000 financial statements contained a going concern qualification. See "-
Liquidity and Capital Resources."
Our principal products are individual, defined benefit accident and
health insurance policies that consist of nursing home care, home health care,
Medicare supplement and long-term disability insurance. We experienced
significant reductions in new premium sales due to the cessation of new business
generation in all states and as a result of market concerns regarding our
insurance subsidiaries' statutory surplus. Under our proposed Corrective Action
Plan, currently being formulated with the Pennsylvania Insurance Department and
our consulting actuaries, we intend to limit new business growth to levels that
will allow us to maintain sufficient statutory surplus. Our underwriting
practices rely upon the base of experience that we have developed in over 29
years of providing nursing home care insurance, as well as upon available
industry and actuarial information. As the home health care market has
developed, we have encouraged our customers to purchase both nursing home and
home health care coverage, thus providing our insureds with enhanced protection
and broadening our policy base.
Our insurance subsidiaries are subject to the insurance laws and
regulations of the states in which they are licensed to write insurance. These
laws and regulations govern matters such as payment of dividends, settlement of
claims and loss ratios. State regulatory authorities must approve premiums
charged for insurance products. In addition, our insurance subsidiaries are
required to establish and maintain reserves with respect to reported and
incurred but not reported losses, as well as estimated future benefits payable
under our insurance policies. These reserves must, at a minimum, comply with
mandated standards. For a description of current regulatory matters affecting
our insurance subsidiaries, see "- Liquidity and Capital Resources - Subsidiary
Operations."
Our results of operations are affected significantly by the following
other factors:
Level of required reserves for policies in-force. The amount of
reserves relating to reported and unreported claims incurred is determined by
periodically evaluating historical claims experience and statistical information
with respect to the probable number and nature of such claims. Claim reserves
reflect actual experience through the most recent time period. We compare actual
experience with estimates and adjust our reserves on the basis of such
comparisons. Revisions to reserves are reflected in our current results of
operations through benefits to policyholders' expense.
We also maintain reserves for policies that are not currently in claim
based upon actuarial expectations that a policy may go on claim in the future.
These reserves are calculated based on factors that include estimates for
mortality, morbidity, interest rates and persistency. Factor components
generally include assumptions that are consistent with both our experience and
industry practices.
Policy premium levels. We attempt to set premium levels to maximize
profitability. Premium levels on new products, as well as rate increases on
existing products, are subject to government review and regulation.
11
Deferred policy acquisition costs. In connection with the sale of our
insurance policies, we defer and amortize a portion of the policy acquisition
costs over the related premium paying periods of the life of the policy. These
costs include all expenses that are directly related to, and vary with, the
acquisition of the policy, including commissions, underwriting and other policy
issue expenses. The amortization of deferred policy acquisition costs ("DAC") is
determined using the same projected actuarial assumptions used in computing
policy reserves. DAC can be affected by unanticipated terminations of policies
because, upon such terminations, we are required to expense fully the DAC
associated with the terminated policies.
With the assistance of our new consulting actuary, we reviewed the
appropriateness and recoverability of our DAC asset. We determined that we
require premium rate increases on a majority of our existing products in order
to fully recover our present DAC from future profits. In the event that premium
rate increases cannot be obtained as needed, our DAC would be impaired and we
would incur an expense in the amount of the impairment. See "- Net Policy
Acquisition Costs Deferred."
The number of years a policy has been in effect. Claims costs tend to
be higher on policies that have been in-force for a longer period of time. As
the policy ages, it is more likely that the insured will need services covered
by the policy. However, the longer the policy is in effect, the more premium we
receive.
Investment income. Our investment portfolio consists primarily of
investment grade fixed income securities. Income generated from this portfolio
is largely dependent upon prevailing levels of interest rates. Due to the
duration of our investments (approximately 5.0 years), investment interest
income does not immediately reflect changes in market interest rates. However,
we are susceptible to changes in market rates when cash flows from maturing
investments are reinvested at prevailing market rates. As of September 30, 2001,
3.2% of our invested assets were committed to common stocks and small
capitalization preferred stocks.
Lapsation and persistency. Factors that affect our results of
operations include lapsation and persistency, both of which relate to the
renewal of insurance policies. Lapsation is the termination of a policy by
non-renewal. Lapsation is automatic if and when premiums become more than 31
days overdue although, in some cases, a lapsed policy may be reinstated within
six months. Persistency represents the percentage of premiums renewed, which we
calculate by dividing the total annual premiums at the end of each year (less
first year premiums for that year) by the total annual premiums in-force for the
prior year. For purposes of this calculation, a decrease in total annual
premiums in-force at the end of any year would be the result of non-renewal of
policies, including policies that have terminated by reason of death, lapsed due
to nonpayment of premiums and/or been converted to other policies we offered.
First year premiums are premiums covering the first twelve months a policy is
in-force. Renewal premiums are premiums covering all subsequent periods.
Policies renew or lapse for a variety of reasons, both internal and
external. We believe that our efforts to address policyholder concerns or
questions help to ensure policy renewals. We also believe that we enjoy a
favorable reputation among policyholders for providing desirable policy benefits
and efficient claims processing. We work closely with our licensed agents, who
play an integral role in policy conservation and policyholder communication.
12
External factors also contribute to policy renewal or lapsation.
Economic cycles can influence a policyholder's ability to continue the payment
of insurance premiums when due. We believe that tax relief for certain long-term
care insurance premiums and other governmental initiatives, which have raised
public awareness of the escalating costs of long-term care, increase new sales
and renewal payments. The ratings assigned to our insurance subsidiaries by
independent rating agencies also influence consumer decisions.
Lapsation and persistency can both positively and adversely impact
future earnings. Reduced lapses and higher persistency generally result in
higher renewal premiums and lower amortization of deferred acquisition costs,
but may lead to increased claims in future periods. Higher lapsation can result
in reduced premium collection and a greater percentage of higher-risk
policyholders, but requires us to fully expense deferred acquisition costs
relating to lapsed policies in the period in which policies lapse.
Results of Operations
Three Months Ended September 30, 2001 and 2000
(amounts in thousands, except per share data)
Premiums. Total premium revenue earned in the three month period ended September
30, 2001 (the "2001 quarter"), including long-term care, disability, life and
Medicare supplement, decreased 12.4% to $80,588, compared to $91,963 in the same
period in 2000 (the "2000 quarter"). Total premium in the 2001 quarter was
reduced by $10,009 as a result of the accounting for the reinsurance of our
disability product line and the concurrent transferal of associated reserves.
Total first year premium earned in the 2001 quarter decreased 73.9% to
$7,118, compared to $27,240 in the 2000 quarter. First year long-term care
premiums earned in the 2001 quarter decreased 75.0% to $6,629, compared to
$26,464 in the 2000 quarter. We experienced significant reductions in new
premium sales due to the cessation of new business generation in all states and
as a result of market concerns regarding our insurance subsidiaries' statutory
surplus. Under our proposed Corrective Action Plan (the "Plan"), currently being
formulated with the Pennsylvania Insurance Department (the "Department") and our
consulting actuaries, we intend to limit new business growth to levels that will
allow us to maintain sufficient statutory surplus. See "-- Liquidity and Capital
Resources."
Effective September 11, 2001, we determined to discontinue the sale
nationally of all new long-term care insurance policies until the Plan was
completed and approved by the Department. This decision resulted from our
concern about further depletion of statutory surplus from new sales prior to the
completion and approval of the Plan and from increasing concern with respect to
the status of the Plan expressed by many states in which the Company is licensed
to conduct business.
Total renewal premiums earned in the 2001 quarter increased 29.0% to
$83,479, compared to $64,723 in the 2000 quarter. Renewal long-term care
premiums earned in the 2001 quarter increased 33.2% to $80,215, compared to
$60,220 in the 2000 quarter. This increase reflects renewals of a larger base of
in-force policies. We may experience reduced renewal premiums in the future if
policies lapse. Current declines in first year premiums, as discussed above,
will negatively impact future renewal premium growth.
Net Investment Income. Net investment income earned for the 2001
quarter increased 24.7% to $8,571, from $6,874 for the 2000 quarter. Management
attributes this growth to more invested assets as a result of higher established
reserves and from the investment of funds raised under our rights offering. See
"-- Liquidity and Capital Resources." Our average yield on invested assets at
cost, including cash and cash equivalents, was 6.1% in the 2001 and 2000
quarters.
13
Net Realized Capital Gains and Trading Account Activity. During the 2001
quarter, we recognized capital losses of $314, compared to capital gains of $503
in the 2000 quarter. The results in both periods were recorded as a result of
our normal investment management operations and from the impairment of $772 on
equity securities losses, which we deemed to be other than temporary.
We classify our convertible bond portfolio as trading account
investments. Changes in trading account investment market values are recorded in
our statement of operations during the period in which the change occurs, rather
than as an unrealized gain or loss recorded directly through equity. As a
result, we have recorded a trading account loss in the 2001 quarter of $1,506,
which reflects the unrealized and realized loss of our convertible portfolio
that arose during the quarter.
Other Income. We recorded $2,548 in other income during the 2001 quarter, up
from $2,383 in the 2000 quarter. The increase is attributable to an increase in
commissions earned by United Insurance Group on sales of insurance products
underwritten by unaffiliated insurers and to income generated from our ownership
of corporate owned life insurance policies.
Benefits to Policyholders. Total benefits to policyholders in the 2001 quarter
decreased 22.7% to $47,220, compared to $61,120 in the 2000 quarter. Our loss
ratio, or policyholder benefits to premiums, was 58.6% in the 2001 quarter,
compared to 66.5% in the 2000 quarter. Excluding the accounting impact of our
disability reinsurance agreement, our loss ratio in the 2001 quarter was 63.2%.
Our newly reported claims declined significantly during the 2001 quarter, which
served to reduce our loss ratio.
Claims experience can differ from our expectations due to numerous
factors, including mortality rates, duration of care and type of care utilized.
When we experience deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During the 2001
quarter, we filed and sought premium rate increases on the majority of our
policy forms. These rate increases were sought as a result of higher claims
expectations and policyholder persistency than existed at the time of the
original form filings. The assumptions used in requesting and supporting the
premium rate increase filings are consistent with those incorporated in our
newest policy form offerings. We have been generally successful in the past in
obtaining state insurance department approvals for increases. If we are
unsuccessful in obtaining rate increases when deemed necessary, or if we do not
pursue rate increases when actual claims experience exceeds our expectations, we
would suffer a financial loss.
Commissions. Commissions to agents decreased 34.2% to $16,920 in the 2001
quarter, compared to $25,716 in the 2000 quarter.
First year commissions on accident and health business in the 2001
quarter decreased 72.4% to $4,968, compared to $18,009 in the 2000 quarter, due
to the decrease in first year accident and health premiums. The ratio of first
year accident and health commissions to first year accident and health premiums
was 71.2% in the 2001 quarter and 66.3% in the 2000 quarter. We believe that the
increase in the first year commission ratio is primarily attributable to the
sale of policies to younger individuals. We generally pay a higher first year
commission percentage on sales to younger policyholders due to the expectation
that premiums will be collected over a longer period of time.
14
Renewal commissions on accident and health business in the 2001 quarter
increased 32.1% to $12,476, compared to $9,444 in the 2000 quarter, due to the
increase in renewal premiums discussed above. The ratio of renewal accident and
health commissions to renewal accident and health premiums was 15.2% in the 2001
quarter and 15.3% in the 2000 quarter.
During the 2001 quarter, we reduced commission expense by netting $892
from override commissions affiliated insurers paid to our agency subsidiaries.
During the 2000 quarter, we reduced commissions by $1,052.
Net Policy Acquisition Costs Amortized (Deferred). The net deferred policy
acquisition costs in the 2001 quarter decreased to a net charge of $7,255,
compared to a net credit of $9,111 in the 2000 quarter.
Deferred costs are typically all costs that are directly related to,
and vary with, the acquisition of new premiums. These costs include the variable
portion of commissions, which are defined as the first year commission rate less
ultimate renewal commission rates, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based upon actuarial assumptions, including persistency of
policies in-force. In the event a policy lapses prematurely due to death or
termination of coverage, the remaining unamortized portion of the deferred
amount is immediately recognized as expense in the current period.
The amortization of deferred costs is generally offset largely by the
deferral of costs associated with new premium generation. Lower new premium
sales during the 2001 quarter produced significantly less expense deferral to
offset amortized costs.
General and Administrative Expenses. General and administrative expenses in the
2001 quarter decreased 14.5% to $11,079, compared to $12,951 in the 2000
quarter. The 2001 and 2000 quarters include $1,625 and $1,963, respectively of
general and administrative expenses related to United Insurance Group expense.
Excluding the associated premium accounting for the reinsurance of our
disability line, the ratio of total general and administrative expenses to
premium revenues was 12.2% in the 2001 quarter, compared to 14.1% in the 2000
quarter.
Expenses have declined as a result of reduced new premium sales;
however, expenses increased during the 2001 quarter as a result of supplemental
accounting fees, actuarial fees, legal fees and amortization and depreciation
expenses. We believe that if we remain unable to write new business in states
where we have ceased new production we will need to decrease production
expenses.
Provision for Federal Income Taxes. Our provision for federal income taxes for
the 2001 quarter declined 39.8% to $2,100, compared to $3,490 for the 2000
quarter. The effective tax rate of 34.0% in the 2001 and 2000 quarters is below
the normal federal corporate rate as a result of credits from our investments in
tax-exempt bonds and corporate owned life insurance, and from dividends we
receive that are partially exempt from taxation and are partially offset by
non-deductible goodwill amortization and other non-deductible expenses.
Comprehensive Income. During the 2001 quarter, our investment portfolio
generated pre-tax unrealized gains of $14,341, compared to 2000 quarter
unrealized gains of $5,197. After accounting for deferred taxes from these
gains, shareholders' equity increased by $14,580 from comprehensive income
during the 2001 quarter, compared to comprehensive income of $9,874 in the 2000
quarter.
15
Nine Months Ended September 30, 2001 and 2000 (amounts in thousands, except per
share data)
Premiums. Total premium revenue earned in the nine month period ended September
30, 2001 (the "2001 period"), including long-term care, disability, life and
Medicare supplement, increased 0.7% to $266,646, compared to $264,826 in the
same period in 2000 (the "2000 period"). Total premium in the 2001 period was
reduced by $10,009 as a result of the accounting for the reinsurance of our
disability product line and the concurrent transferal of associated reserves.
Total first year premiums earned in the 2001 period decreased 48.6% to
$39,934, compared to $77,687 in the 2000 period. First year long-term care
premiums earned in the 2001 period decreased 49.8% to $38,153, compared to
$75,959 in the 2000 period. We experienced significant reductions in new premium
sales due to the cessation of new business generation in all states during the
third quarter and as a result of the market's concerns regarding our insurance
subsidiaries' statutory surplus. Under our proposed Plan, we intend to limit
future new business growth to levels that will allow us to maintain sufficient
statutory surplus. See "-- Liquidity and Capital Resources."
The Company previously believed that the Plan would be completed on or
before September 1, 2001. Effective September 11, 2001, the Company determined
to discontinue the sale nationally of all new long-term care insurance policies
until the Plan was completed and approved by the Department. This decision
resulted from the Company's concern about further depletion of statutory surplus
from new sales prior to the completion and approval of the Plan and from
increasing concern regarding the status of the Plan expressed by many states in
which the Company is licensed to conduct business.
Total renewal premiums earned in the 2001 period increased 26.5% to
$236,721, compared to $187,139 in the 2000 period. Renewal long-term care
premiums earned in the 2001 period increased 28.0% to $225,715, compared to
$176,319 in the 2000 period. This increase reflects renewals of a larger base of
in-force policies, as well as a continued increase in policyholder persistency.
Net Investment Income. Net investment income earned for the 2001 period
increased 14.3% to $22,481, from $19,671 for the 2000 period. Management
attributes this growth to more invested assets as a result of higher established
reserves and from the investment of additional funds generated from our rights
offering. Our average yield on invested assets at cost, including cash and cash
equivalents, was 5.6% in the 2001 period, compared to 6.1% in the 2000 period.
The average yield is lower due to reduced market rates for reinvesting of
maturing investments and due to higher cash balances held during the 2001
period.
Net Realized Capital Gains and Trading Account Activity. During the 2001 period,
we recognized capital losses of $1,168, compared to capital gains of $1,244 in
the 2000 period. The results in both periods were recorded as a result of our
normal investment management operations and from the impairment of $1,657 on
equity securities losses, which we deemed to be other than temporary.
16
We classify our convertible bond portfolio as trading account
investments. Changes in trading account investment market values are recorded in
our statement of operations during the period in which the change occurs, rather
than as an unrealized gain or loss recorded directly through equity. Therefore,
we recorded a trading account loss in the 2001 period of $2,830, which reflects
the unrealized and realized loss of our convertible portfolio that arose during
the period.
Other Income. We recorded $7,313 in other income during the 2001 period, up from
$6,743 in the 2000 period. The increase is attributable to an increase of
commissions earned by United Insurance Group on sales of insurance products
underwritten by unaffiliated insurers and to income generated from corporate
owned life insurance policies.
Benefits to Policyholders. Total benefits to policyholders in the 2001 period
decreased 0.5% to $179,592, compared to $180,519 in the 2000 period. Our loss
ratio, or policyholder benefits to premiums, was 67.4% in the 2001 period,
compared to 68.2% in the 2000 period. Excluding the accounting impact of our
disability reinsurance agreement, our loss ratio in the 2001 period was 68.5%
Management has seen an increase during the 2001 period in claim
duration, for which it has established higher reserves. We have increased our
reserves approximately $2,500 during the 2001 period through the increase of our
loss adjustment expense reserve, which is established for the funding of
administrative costs associated with the payment of current claims.
Claims experience can differ from our expectations due to numerous
factors, including mortality rates, duration of care and type of care utilized.
When we experience deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During the 2001
period, we filed and sought premium rate increases on the majority of our policy
forms. These rate increases were sought as a result of higher claims
expectations and policyholder persistency than existed at the time of the
original form filings. The assumptions used in requesting and supporting the
premium rate increase filings are consistent with those incorporated in our
newest policy form offerings. We have been generally successful in the past in
obtaining state insurance department approvals for increases. If we are
unsuccessful in obtaining rate increases when deemed necessary, or if we do not
pursue rate increases when actual claims experience exceeds our expectations, we
would suffer a financial loss.
During the 2001 period, with the assistance of our new consulting
actuary, we completed an analysis to determine if existing policy reserves and
policy and contract claim reserves, together with the present value of future
gross premiums, would be sufficient to (1) cover the present value of future
benefits to be paid to policyholders and settlement and maintenance costs and
(2) recover unamortized deferred policy acquisition costs. We determined that we
would require premium rate increases on certain of our existing products in
order to fully recover our present deferred acquisition cost asset from future
profits. As a result of this analysis, we recorded a loss of approximately $300
through a net change in the policy reserves and unamortized deferred policy
acquisition costs. Future changes in policy reserves and unamortized deferred
policy acquisition costs will be based on these revised assumptions in future
periods. In determining the impairment, we evaluated future claims expectations,
premium rates and our ability to obtain future rate increases, persistency and
expense projections.
Commissions. Commissions to agents decreased 18.6% to $62,744 in the 2001
period, compared to $77,088 in the 2000 period.
17
First year commissions on accident and health business in the 2001
period decreased 47.3% to $26,528, compared to $50,382 in the 2000 period, due
to the decrease in first year accident and health premiums. The mix of
policyholder issue ages for new business affects the percentage of commissions
paid for new business due to our age-scaled commission rates. Generally, sales
to younger policyholders receive a higher commission percentage. The ratio of
first year accident and health commissions to first year accident and health
premiums was 67.5% in the 2001 period and 65.5% in the 2000 period.
Renewal commissions on accident and health business in the 2001 period
increased 33.6% to $37,744, compared to $28,261 in the 2000 period, consistent
with the increase in renewal premiums discussed above. The ratio of renewal
accident and health commissions to renewal accident and health premiums was
16.4% in the 2001 period and 15.7% in the 2000 period.
During the 2001 period, we reduced commission expense by netting $2,973
from override commissions that affiliated insurers paid to our subsidiary
agencies. During the 2000 period, we similarly reduced commissions by $3,652.
Net Policy Acquisition Costs Amortized (Deferred). The net deferred policy
acquisition costs in the 2001 period decreased 88.8% to a net amortized expense
of $3,608, compared to net deferrals of $32,091 in the 2000 period.
Deferred costs are typically all costs that are directly related to,
and vary with, the acquisition of policies. These costs include the variable
portion of commissions, which are defined as the first year commission rate less
ultimate renewal commission rates, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based upon actuarial assumptions, including persistency of
policies in-force. In the event a policy lapses prematurely due to death or
termination of coverage, the remaining unamortized portion of the deferred
amount is immediately recognized as expense in the current period.
The amortization of deferred costs is generally offset largely by the
deferral of costs associated with new premiums generation. Lower new premium
sales during the 2001 period produced significantly less expense deferral to
offset amortized costs.
As a result of our recent actuarial analysis, we recorded a loss of
approximately $300 through a net change in the policy reserves and unamortized
deferred policy acquisition costs. Future changes in policy reserves and
unamortized deferred policy acquisition costs will be based on these revised
assumptions in future periods. In determining the impairment, we evaluated
future claims expectations, premium rates and required rate increases,
persistency and expense projections.
We estimate that current policy reserves and our DAC asset were reduced
by offsetting amounts of approximately $7,500 during the 2001 period due to this
analysis.
General and Administrative Expenses. General and administrative expenses in the
2001 period increased 1.1% to $36,670, compared to $36,285 in the 2000 period.
The 2001 and 2000 periods include $4,995 and $6,219, respectively of general and
administrative expenses related to United Insurance Group expense. The ratio of
total general and administrative expenses to premium revenues was 13.3% in the
2001 period, compared to 13.7% in the 2000 period.
18
General and administrative expenses also increased during the 2001
period as a result of supplemental accounting and actuarial fees, legal fees and
depreciation expenses. We believe that if we remain unable to write new business
in states where we have ceased new production, we will need to decrease
production expenses further.
Reserve for Claim Litigation. In the second quarter 2000, a jury awarded
compensatory damages of $24 and punitive damages of $2,000 in favor of the
plaintiff in a disputed claim case against one of our subsidiaries, for which we
had maintained a $1,000 reserve. During the second quarter 2001, we agreed to
settle the claim for $750, and reversed the reserve balance.
Provision for Federal Income Taxes. Our provision for federal income taxes for
the 2001 period decreased 75.6% to $2,148, compared to $8,786 for the 2000
period. The effective tax rate of 34.0% in the 2001 and 2000 periods is below
the normal federal corporate rate as a result of credits from the small life
insurance company deduction, as well as our investments in tax-exempt bonds,
corporate owned life insurance, and from dividends received that are partially
exempt from taxation. These credits are partially offset by non-deductible
goodwill amortization.
Comprehensive Income. During the 2001 period, our investment portfolio generated
pre-tax, unrealized gains of $15,519, compared to the 2000 period of $2,022.
After accounting for deferred taxes from these gains, shareholders' equity
increased by $16,855 from comprehensive income during the 2001 period, compared
to comprehensive income of $17,568 in the 2000 period.
Liquidity and Capital Resources
In our Annual Report on Form 10-K for the year ended December 31, 2000,
we reported that we had received a going concern qualification from our
independent accountants. The going concern qualification addressed parent
liquidity and the statutory capital and surplus position of our primary
insurance subsidiary.
Our consolidated liquidity requirements have historically been created
and met from the operations of our insurance subsidiaries. Our primary sources
of cash are premiums, investment income and maturities of investments. We have
obtained, and may continue to obtain, cash through public offerings of our
common stock, capital markets activities or debt instruments. The primary uses
of cash are policy acquisition costs (principally commissions), payments to
policyholders, investment purchases and general and administrative expenses.
In the 2001 period, our cash flows were attributable to cash provided
by operations, cash used in investing and cash provided by financing. Our cash
decreased $50,948 in the 2001 period primarily due to the purchase of $247,082
in bonds and equity securities. Cash was provided primarily from the maturity
and sale of $91,577 in bonds and equity securities and our rights offering,
which generated net proceeds of $25,726 during the 2001 period. These sources of
funds were supplemented by $83,156 from operations. The major provider of cash
from operations was premium revenue used to fund reserve additions of $55,706.
Our cash increased $15,549 in the 2000 period primarily due to $132,029
provided from the sale and maturity of bonds and equity securities and $72,351
provided from operations. The major provider of cash from operations was premium
revenue used to fund reserve increases of $86,756. The major use of cash was
$179,560 used for the purchase of bonds and equity securities. We also used
$6,000 for the purchase of Network Insurance Senior Health Division, an
insurance agency.
19
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets. At September 30, 2001, the market value of our bond portfolio
represented 104.2% of our cost, with a current unrealized gain of $20,573. Our
equity portfolio market value was below cost by $2,061 at September 30, 2001.
Our market value of our bond portfolio was below our cost by $389 and our equity
portfolio was below cost by $616 at December 31, 2000.
As of September 30, 2001, shareholders' equity was increased by
$12,028 due to unrealized gains of $18,512 in the investment portfolio. As of
December 31, 2000, shareholders' equity was decreased by $662 due to unrealized
losses of $1,005 in the investment portfolio.
Subsidiary Operations
At December 31, 2000, our primary insurance subsidiary's statutory
surplus was $14,969 and had decreased so that, for regulatory purposes, it was
at the Regulatory Action Level, below which a company must file a Corrective
Action Plan that details the insurer's plan to raise additional statutory
capital over the next four years. As a result, our subsidiary is required to
submit a Corrective Action Plan (the "Plan") to the Pennsylvania Insurance
Department (the "Department") for approval. Individual states in which our
insurance subsidiaries are licensed to conduct business may also suspend our
certificates of authority if they believe that our subsidiary's capital and
surplus levels are deficient.
Our largest insurance subsidiary has prepared, with the assistance of
its consulting actuaries, a Plan that includes new business generation and
additional capital generation from the sale of assets and reinsurance. As part
of the Plan, the Department has requested our subsidiary to adopt more
conservative claims assumptions in the establishment of its statutory reserves,
as indicated in the preliminary findings of the Department's most recent
financial examination. While our subsidiary believes that it may not be required
by the Pennsylvania Insurance Act to adopt these claims assumptions, it agrees
that more conservative assumptions for the computation of statutory reserves are
appropriate given recent Company and industry developments in types of care,
policy persistency and claims duration. However, the Department has rejected our
subsidiary's assertion that premium rate increases should also be considered in
the reestablishment of statutory reserves where modified assumptions are
incorporated.
Our subsidiary has incorporated these assumptions for all new policies
written after June 30, 2001 and proposes to include the impact of these
assumptions for existing business in its calculation of reserves progressively
over a three-year period. Our subsidiary's statutory reserves, as reported for
the period ended September 30, 2001, reflect its proposal under the Plan.
Although our subsidiary began operating under the Plan during the third quarter
of 2001, the Department has not yet approved the Plan or our subsidiary's
current reserving methodology. If the Plan is not adopted, our subsidiary's
statutory financial position could be significantly adversely affected.
In addition, we have projected our statutory capital and surplus, on a
quarterly basis, beyond the required Plan period. Our projections include
existing and new business in order to allow us to assess our statutory capital
strength at varying levels of new business growth. We intend to utilize these
projections to control future growth within allowable statutory constraints and
to monitor our need for additional statutory capital as appropriate.
20
We previously believed that the Plan would be completed on or before
September 1, 2001. Effective September 11, 2001, we determined to discontinue
the sale nationally of all new long-term care insurance policies until the Plan
reached completion and approval by the Department. This decision resulted from
our concern about further depletion of statutory surplus from new sales prior to
the completion and approval of the Plan and from increasing concern regarding
the status of the Plan expressed by many states in which we are licensed to
conduct business. We believe that our ability to commence the sale of new
long-term care insurance policies in many states is dependent upon the
completion and approval of the Plan.
During the 2001 quarter, we filed and sought premium rate increases on
the majority of our policy forms. These rate increases were sought as a result
of higher claims expectations and policyholder persistency than existed at the
time of the original form filings. The assumptions used in requesting and
supporting the premium rate increase filings are consistent with those
incorporated in our newest policy form offerings.
At September 30, 2001, our primary subsidiary's total adjusted capital
had increased to $21,491. However, the Department has not yet approved the
reserving methodology incorporated in our September 30, 2001 statutory filings.
We believe that if we experience further decline in our statutory surplus beyond
our projections, or if the Department does not accept our reserving methodology
and proposed Plan, the Department would require further corrective action. This
corrective action could include, but may not be limited to, the continued
cessation of new business generation or placing the subsidiary under
Departmental supervision or into involuntary receivership, which could result in
the liquidation of all subsidiary assets. In this event, our shareholders would
likely receive little if any value from the sale or liquidation of this
subsidiary.
As part of the Plan, the Department has requested that we seek its
approval prior to taking certain actions. These include payment of dividends,
transactions with affiliates, new investments, incurral of debt, pledging of
assets and new reinsurance agreements. The Department is also requiring monthly
reports related to our financial condition.
On March 31, 2001, we contributed the common stock ownership of one of
our insurance subsidiaries to our largest insurance subsidiary as a capital
infusion. This resulted in an increase of statutory surplus for that insurer of
$4,875.
On May 28, 2001, we contributed $18,000 from the net proceeds of our
rights offering (see "- Parent Company Operations") to the statutory capital and
surplus of our largest insurance subsidiary. It subsequently contributed $4,000
to its subsidiary, another affiliated insurance subsidiary of the Company.
Our subsidiaries' debt currently consists primarily of a mortgage note
in the amount of approximately $1,500 that was issued by a former subsidiary and
assumed by another subsidiary when that subsidiary was sold. The mortgage note
is currently amortized over 15 years, and has a balloon payment due on the
remaining outstanding balance in December 2003. Although the note carries a
variable interest rate, we have entered into an amortizing swap agreement with
the same bank with a nominal amount equal to the outstanding debt, which has the
effect of converting the note to a fixed rate of interest of 6.85%.
21
Parent Company Operations
Our parent company is a non-insurer that directly or indirectly
controls 100% of the voting stock of our insurance company subsidiaries. If we
are unable to meet our financial obligations, become insolvent or discontinue
operations, the financial condition and results of operations of our insurance
company subsidiaries could be materially affected.
Parent company debt currently consists of $74,750 of 6.25% convertible
subordinated notes due 2003, as well as an installment note in the amount of
$2,858 issued in connection with the purchase of United Insurance Group. The
convertible subordinated notes, issued in November 1996, are convertible into
common stock at $28.44 per share until maturity in November 2003. The
convertible subordinated notes carry a fixed interest coupon of 6.25%, payable
semi-annually. At maturity, to the extent that the convertible subordinated
notes have not been converted into common stock, we will have to repay their
entire principal amount in cash. We expect that we will need to refinance the
convertible subordinated notes upon their maturity in 2003, unless they are
converted into common stock.
On January 1, 1999, we purchased all of the common stock of United
Insurance Group, a Michigan based consortium of long-term care insurance
agencies, for $18,192. As part of the purchase, we issued a note payable for
$8,078, which was in the form of a three-year zero-coupon installment note. The
installment note, after discounting for imputed interest, was recorded as a note
payable of $7,167, and had an outstanding balance of $2,858 at September 30,
2001. The remainder of the purchase was for cash.
At June 30, 2000, we had a $3,000 line of credit from a bank, which was
unused. The bank did not renew the line of credit at December 31, 2000.
Cash flow needs of the parent company primarily include principal and
interest payments on outstanding debt and limited operating expenses. The
funding is primarily derived from the operating cash flow of our agency
operations, tax sharing arrangements with our subsidiaries and dividends, if
allowed under insurance department regulations, from the insurance subsidiaries.
However, as noted above, the dividend capabilities of the insurance subsidiaries
are limited.
On April 27, 2001, we distributed rights to our shareholders and
holders of our 6.25% convertible subordinated notes due 2003 for the purpose of
raising new equity capital. Pursuant to the rights offering, holders of our
common stock and holders of our convertible subordinated notes received rights
to purchase approximately 11,550 newly issued shares of common stock at a set
price of $2.40 per share. The rights offering was completed on May 25, 2001 and
generated net proceeds of $25,726 in additional equity capital. We contributed
$18,000 of the net proceeds to the statutory capital of our largest insurance
subsidiary. The remaining proceeds are sufficient to meet our parent liquidity
requirements through December 31, 2001.
On August 13, 2001, we announced that we had signed a letter of intent
for the sale of American Independent and Penn Treaty (Bermuda) for approximately
$11,000. Under the proposed agreement with respect to our subsidiaries, we would
continue to provide fee-based administrative support for all existing and new
long-term care insurance policies. The sales remain subject to negotiation and
execution of definitive purchase agreements and regulatory approval. We
anticipate that we will use the proceeds of the proposed sale to bolster our
subsidiary statutory surplus and for additional parent company liquidity.
22
Subsequent to September 30, 2001, we announced that we had completed
the reinsurance of our disability product line, effective September 1, 2001, for
approximately $5,000. The statutory surplus of our insurance subsidiaries was
increased from the ceding allowance of the sale. The ceding allowance of
approximately $5,000 has been deferred, and will be amortized over remaining
life of the reinsured policies.
We believe that our parent company and subsidiaries will have ongoing
capital and liquidity needs that extend beyond our current cash availability and
liquid resources. Therefore, we are continuing to assess all financial
alternatives, including, but not limited to, venture capital, partnerships,
acquisitions and reinsurance transactions. There are no assurances that we will
be successful.
New Accounting Principles
Effective January 1, 2001, we adopted SFAS No. 133, as amended by SFAS
No. 137, "Deferral of the Effective Date of FAS 133," which establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
"derivatives") and for hedging activities. SFAS No. 133 requires an entity to
recognize all derivatives as either assets or liabilities in the statement of
financial position and measure those instruments at fair value.
In accordance with SFAS No. 133, we transferred our convertible bond
portfolio from the available for sale category to the trading category. The
unrealized loss at the time of the transfer was $1,064, which has been included
in current operations.
We are party to an interest rate swap agreement, which serves to
convert our mortgage loan from a variable rate to a fixed rate instrument. We
have determined that the swap qualifies as a cash-flow hedge. The notional
amount of the swap is approximately $1,500. The effects have been determined to
be immaterial to the financial statements.
Our involvement with derivative instruments and transactions is
primarily to offer protection to others or to mitigate our own risk and is not
considered speculative in nature.
In June 2001, the Financial Accounting Standards Board ("FASB") issued
two Statements of Financial Accounting Standards ("SFAS"). SFAS No. 141,
"Business Combinations," requires usage of the purchase method for all business
combinations initiated after June 30, 2001, and prohibits the usage of the
pooling of interests method of accounting for business combinations. Such
provisions include guidance on the identification of the acquiring entity, the
recognition of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition provisions
of SFAS No. 141 require an analysis of goodwill acquired in business
combinations prior to July 1, 2001 to identify and reclassify separately
identifiable intangible assets currently recorded as goodwill.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily
addresses the accounting for goodwill and intangible assets subsequent to their
acquisition. We will adopt SFAS No. 142 on January 1, 2002 and will cease
amortizing goodwill at that time. All goodwill recognized in our consolidated
balance sheet at January 1, 2002 should be assigned to one or more reporting
units. Goodwill in each reporting unit should be tested for impairment by June
30, 2002. An impairment loss recognized as a result of a transitional impairment
test of goodwill should be reported as the cumulative effect of a change in
accounting principle.
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Although we believe there are separately identifiable intangible assets
currently included in the total cost in excess of fair value of net assets
acquired on the consolidated balance sheet, we have not yet evaluated the impact
of SFAS No. 141 and SFAS No. 142 on our financial condition or results of
operations.
Forward Looking Statements
Certain statements we make in this filing may be considered
forward-looking within the meaning of the Private Securities Litigation Reform
Act of 1995. Although we believe that our expectations are based upon reasonable
assumptions within the bounds of our knowledge of our business and operations,
there can be no assurance that actual results of operations will not differ
materially from our expectations. Factors that could cause actual results to
differ from expectations include, among others, whether our Corrective Action
Plan will be considered and approved by the Pennsylvania Insurance Department as
well as other insurance regulators, the timing of such approval, actions which
could be taken by state regulators including rehabilitation, the adverse
financial impact of suspending new business sales, our ability to raise adequate
capital to meet the requirements of current business, anticipated growth,
liquidity needs and our debt obligations, the possible sale of certain product
lines and our New York subsidiary, the ability to write business, the adequacy
of loss reserves and the recoverability of our deferred acquisition cost asset,
our ability to qualify new insurance products for sale in certain states, our
ability to resume generating new business in states in which we have ceased new
sales, our ability to succeed in obtaining necessary rate increases, our ability
to comply with government regulations and the requirements that may be imposed
by state regulators as a result of our surplus levels, the ability of senior
citizens to purchase our products in light of the increasing costs of health
care, the modality of premium revenue, our ability to defend against adverse
litigation and our ability to maintain and expand our network of productive
independent agents, especially in light of the cessation of new business. For
additional information, please refer to our Annual Report on Form 10-K and other
documents filed with the Securities and Exchange Commission.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets.
A significant portion of our assets and liabilities are financial
instruments, which are subject to the market risk of potential losses from
adverse changes in market rates and prices. Our primary market risk exposures
relate to interest rate risk on fixed rate domestic medium-term instruments and,
to a lesser extent, domestic short-term and long-term instruments. We have
established strategies, asset quality standards, asset allocations and other
relevant criteria for our portfolio to manage our exposure to market risk.
We currently have an interest rate swap on our mortgage with the same
bank, which is used as a hedge to convert the mortgage to a fixed interest rate.
We believe that since the notional amount of the swap is amortized at the same
rate as the underlying mortgage, and that both financial instruments are with
the same bank, no credit or financial risk is carried with the swap.
Our financial instruments are held for purposes other than trading,
except for our convertible bond portfolio. Our portfolio does not contain any
significant concentrations in single issuers (other than U.S. treasury and
agency obligations), industry segments or geographic regions.
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We urge caution in evaluating overall market risk from the information
below. Actual results could differ materially because the information was
developed using estimates and assumptions as described below, and because
insurance liabilities and reinsurance receivables are excluded in the
hypothetical effects (insurance liabilities represent 78.8% of total liabilities
and reinsurance receivables on unpaid losses represent 1.3% of total assets).
Long-term debt, although not carried at fair value, is included in the
hypothetical effect calculation.
The hypothetical effects of changes in market rates or prices on the
fair values of financial instruments as of September 30, 2001, excluding
insurance liabilities and reinsurance receivables on unpaid losses because such
insurance related assets and liabilities are not carried at fair value, would
have been as follows:
If interest rates had increased by 100 basis points, there would have
been an approximate $19,219,000 decrease in the net fair value of our investment
portfolio less our long-term debt and the related swap agreement. The change in
fair values was determined by estimating the present value of future cash flows
using models that measure the change in net present values arising from selected
hypothetical changes in market interest rate. A 200 basis point increase in
market rates at September 30, 2001 would have resulted in an approximate
$36,942,000 decrease in the net fair value. If interest rates had decreased by
100 and 200 basis points, there would have been an approximate $20,867,000 and
$43,554,000 net increase, respectively, in the net fair value of our total
investments and debt.
We hold certain mortgage and asset backed securities as part of our
investment portfolio. The fair value of these instruments may react in a convex
or non-linear fashion when subjected to interest rate increases or decreases.
The anticipated cash flows of these instruments may differ from expectations in
changing interest rate environments, resulting in duration drift or a varying
nature of predicted time-weighted present values of cash flows. The result of
unpredicted cash flows from these investments could cause the above hypothetical
estimates to change. However, we believe that the minimal amount we have
invested in these instruments and their broadly defined payment parameters
sufficiently outweigh the cost of computer models necessary to accurately
predict their possible impact to our investment income from the hypothetical
effects of changes in market rates or prices on the fair values of financial
instruments as of September 30, 2001.
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PART II OTHER INFORMATION
Item 1. Legal Proceedings
Our subsidiaries are parties to various lawsuits generally arising in
the normal course of their business.
On April 17, 2001, we received notice that the company and certain of
our key executive officers were named in class action lawsuits filed in United
States District Court for the Eastern District of Pennsylvania as a result of
our recent stock performance. The complaints in each case allege that the
company and its executives made misleading statements about the company's
statutory surplus, statutory reserves and financial health. We contend that the
lawsuits are baseless and completely without merit, and intend to defend
ourselves vigorously.
Item 2. Changes in Securities
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
We filed no exhibits or reports on Form 8-K during the quarter ended
September 30, 2001.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant had duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PENN TREATY AMERICAN CORPORATION
--------------------------------
Registrant
Date: November 14, 2001 /s/ Irving Levit
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Irving Levit
Chairman of the Board, President and
Chief Executive Officer
Date: November 14, 2001 /s/ Cameron B. Waite
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Cameron B. Waite
Chief Financial Officer