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 June 30, 2002
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 August 12, 2002 was 19,907,737.
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 12 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)
June 30, December 31,
2002 2001
---- ----
(unaudited)
ASSETS
Investments:
Bonds, available for sale at market (cost of $24,511 and $463,618, respectively) $ 25,437 $ 478,608
Equity securities at market value (cost of $0 and $8,760, respectively) - 9,802
Policy loans 209 181
---------- ----------
Total investments 25,646 488,591
Cash and cash equivalents 24,750 114,600
Property and equipment, at cost, less accumulated depreciation of
$7,444 and $6,594, respectively 12,483 12,783
Unamortized deferred policy acquisition costs 175,601 180,052
Receivables from agents, less allowance for
uncollectable amounts of $199 1,328 2,190
Accrued investment income 377 7,907
Federal income tax recoverable 3,706 4,406
Goodwill 20,620 25,771
Present value of future profits acquired 1,729 1,937
Receivable from reinsurers 22,017 25,594
Corporate owned life insurance 56,221 54,478
Experience account due from reinsurer 594,449 -
Other assets 21,533 22,058
---------- ----------
Total assets $ 960,460 $ 940,367
========== ==========
LIABILITIES
Policy reserves:
Accident and health $ 416,936 $ 382,660
Life 13,142 13,386
Policy and contract claims 232,459 214,466
Accounts payable and other liabilities 11,561 19,422
Long-term debt 76,288 79,190
Deferred income taxes 32,137 38,447
---------- ----------
Total liabilities 782,523 747,571
---------- ----------
Commitments and contingencies - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding - -
Common stock, par value $.10; 40,000 shares authorized,
20,261 and 19,749 shares issued 2,026 1,975
Additional paid-in capital 96,739 94,802
Accumulated other comprehensive income 596 10,583
Retained earnings 85,281 92,141
---------- ----------
184,642 199,501
Less 915 common shares held in treasury, at cost (6,705) (6,705)
---------- ----------
177,937 192,796
---------- ----------
Total liabilities and shareholders' equity $ 960,460 $ 940,367
========== ==========
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 June 30, Six Months Ended June 30,
--------------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
Revenues:
Premium revenue $ 83,906 $ 90,039 $168,142 $186,058
Net investment income 10,172 7,185 19,707 13,910
Net realized capital gains (losses) 41 712 14,564 (854)
Trading account gain (loss) - 399 - (1,324)
Market gain (loss) on experience account 17,299 - (8,654) -
Other income 5,044 2,365 7,814 4,765
-------- -------- -------- --------
116,462 100,700 201,573 202,555
-------- -------- -------- --------
Benefits and expenses:
Benefits to policyholders 62,515 60,235 142,702 132,372
Commissions 11,677 20,836 24,507 45,824
Net policy acquisition costs amortized (deferred) 7,777 1,750 4,451 (3,647)
General and administrative expense 10,873 12,957 21,585 25,591
Expense and risk charges on reinsurance 3,577 - 7,154 -
Claim litigation costs - - - (250)
Excise tax expense 792 - 1,373 -
Interest expense 1,194 1,240 2,390 2,522
-------- -------- -------- --------
98,405 97,018 204,162 202,412
-------- -------- -------- --------
Gain (loss) before federal income taxes and cumulative
effect of accounting change 18,057 3,682 (2,589) 143
Federal income tax provision (benefit) 6,139 1,252 (880) 49
-------- -------- -------- --------
Net income (loss) before cumulative effect of
accounting change 11,918 2,430 (1,709) 94
Cumulative effect of change in accounting principle - - (5,151) -
-------- -------- -------- --------
Net income (loss) 11,918 2,430 (6,860) 94
-------- -------- -------- --------
Other comprehensive income:
Unrealized holding gain (loss) arising during period 92 (3,961) (542) 1,180
Income tax (provision) benefit from unrealized holdings (31) 1,386 184 (412)
Reclassification of (gain) loss included in net loss (41) (1,111) (14,564) 2,178
Income tax benefit (provision) from reclassification adjustment 14 378 4,952 (760)
-------- -------- -------- --------
Comprehensive income (loss) $ 11,952 $ (878) $(16,830) $ 2,280
======== ========= ========= =========
Basic earnings per share from net income (loss) before
cumulative effect of accounting change $ 0.62 $ 0.20 $ (0.09) $ 0.01
Basic earnings per share from net income (loss) $ 0.62 $ 0.20 $ (0.36) $ 0.01
Diluted earnings per share from net income (loss) before
cumulative effect of accounting change $ 0.57 $ 0.20 $ (0.09) $ 0.01
Diluted earnings per share from net income (loss) $ 0.57 $ 0.20 $ (0.36) $ 0.01
Weighted average number of shares outstanding 19,349 11,857 19,102 9,585
Weighted average number of shares outstanding (diluted) 22,372 11,857 19,102 9,594
See accompanying notes to consolidated financial statements.
4
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Six Months Ended June 30,
(unaudited)
(amounts in thousands)
2002 2001
---- ----
Cash flow from operating activities:
Net (loss) income $ (6,860) $ 94
Adjustments to reconcile net (loss) income to cash
provided by operations:
Amortization of intangible assets 388 945
Cumulative effect of accounting change 5,151 -
Amortization of deferred reinsurance premium 1,320 -
Policy acquisition costs, net 4,451 (3,647)
Deferred income taxes (1,165) 25
Depreciation expense 850 632
Net realized capital (gains) losses (14,564) 854
Trading account loss - 1,324
Net proceeds from purchase and sales of trading securities - (707)
Increase (decrease) due to change in:
Receivables from agents 862 756
Receivable from reinsurers 3,577 (959)
Experience account due from reinsurer (30,920) -
Policy and contract claims 17,993 37,178
Policy reserves 34,032 15,415
Accounts payable and other liabilities (7,861) 197
Federal income taxes recoverable 700 36
Accrued investment income 7,530 (1,735)
Other, net (1,370) 1,292
-------- -------
Cash provided by operations 14,114 51,701
Cash flow from investing activities:
Proceeds from sales of bonds 469,473 34,358
Proceeds from sales of equity securities 9,547 4,728
Proceeds from maturities of bonds 3,572 8,408
Purchase of bonds (20,164) (175,104)
Purchase of equity securities (20) (8,151)
Increase in corporate owned life insurance (1,743) -
Initial premium for experience account (563,529) -
Acquisition of property and equipment (550) (1,128)
-------- -------
Cash used in investing (103,414) (136,889)
Cash flow from financing activities:
Proceeds from exercise of stock options - 12
Proceeds from stock offering 2,352 25,726
Repayments of long-term debt (2,902) (2,737)
-------- -------
Cash (used in) provided by financing (550) 23,001
-------- -------
Decrease in cash and cash equivalents (89,850) (62,187)
Cash balances:
Beginning of period 114,600 116,596
-------- --------
End of period $ 24,750 $ 54,409
======== ========
See accompanying notes to consolidated financial statements.
5
PENN TREATY AMERICAN CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002
(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, 2001 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 the current period
presentation.
1. Regulatory Developments:
The Company's subsidiaries are required to hold statutory surplus that is,
at a minimum, above a calculated authorized control level at which the
Pennsylvania Insurance Department (the "Department") may place its subsidiary
under regulatory control, leading to rehabilitation or liquidation. Insurers are
obligated to hold additional statutory surplus above the authorized control
level. At December 31, 2000, the Company's primary insurance subsidiary,
representing 94% of our direct premium, had Total Adjusted Capital at the
Regulatory Action level. As a result, it was required to file a Corrective
Action Plan (the "Plan") with the insurance commissioner.
On February 12, 2002, the Department approved the Plan. It requires the
Company's Pennsylvania insurance subsidiaries to comply with certain agreements
at the direction of the Department, including, but not limited to:
o The entrance into the reinsurance agreement for substantially all of its
existing business at December 31, 2001. (See Note 2)
o New investments are limited to those rated by the National Association of
Insurance Commissioners ("NAIC") as 1 or 2.
o Affiliated transactions are limited and require Department approval.
o An agreement to increase statutory reserves; the reinsurance agreement has
provided the capacity to accommodate this increase and will provide an
additional $65,000 throughout 2002-2004, such that the Insurers' policy
reserves will be based on new, current claims assumptions and will not
include any rate increases. These claim assumptions are applied to all
policies, regardless of issue year and are assumed to have been present
since the policy was first issued.
As a result of their statutory capital positions and pending the
formulation and approval of the Plan, the Company's Pennsylvania insurance
subsidiaries ceased new sales during 2001. Upon the approval by the Department
of the Plan, the Company recommenced new sales in 23 states. The Company has
since recommenced sales in four additional states, including its announced
addition of Florida in July 2002, which has historically represented
approximately 25% of the Company's new business sales.
6
2. Reinsurance Agreements:
As a primary component of the Plan, effective December 31, 2001, the
Company entered a reinsurance transaction to reinsure, on a quota share basis,
substantially all of its respective long-term care insurance policies then
in-force. The agreement was entered with Centre Solutions (Bermuda) Limited. The
agreement is subject to certain coverage limitations, including an aggregate
limit of liability that is a function of certain factors and that may be reduced
in the event that rate increases are not obtained. The agreement meets the
requirements to qualify as reinsurance for statutory accounting, but not for
generally accepted accounting principles.
The initial premium of the reinsurance treaty resulted in the transfer of
approximately $563,000 in cash and marketable securities during February 2002,
and $56,000 as funds held due to the reinsurer. The initial premium and future
cash flows of the reinsured policies, less claims payments, ceding commissions
and risk charges, is credited to a notional experience account, which is held
for the Company's benefit in the event of commutation and recapture following
December 31, 2007. The reinsurer provides the Company with an experience account
investment credit equal to the total return of a series of benchmark indices and
hedges, which are designed to closely match the duration of the Company's claims
liabilities. The Company is accounting for the experience account investment
credit in accordance with FASB No. 133 and has determined to bi-furcate the
total return into two components:
1. the investment income component, or an embedded derivative debt host
with a yield that is represented by the current yield to maturity of
the underlying benchmark indices, and
2. a change in market value component, which reflects the effect of a
change in current interest rates, as determined by the current market
value of the underlying indices. As a result, the Company's future
financial statements are subject to significant volatility.
During the period ending June 30, 2002, the Company recorded $9,750 in net
investment income from the debt host and a market loss of $8,654.
The reinsurance agreement contains commutation provisions and allows the
Company to recapture the reserve liabilities and the current experience account
balance as of December 31, 2007, or on December 31 of any year thereafter. The
Company intends to commute the agreement on December 31, 2007; therefore, it is
accounting for the reinsurance agreement in anticipation of this commutation. In
the event the Company does not commute the agreement on December 31, 2007, it
will be subject to escalating expenses. Additionally, the reinsurance provisions
contain covenants and conditions that, if breached, may result in the immediate
commutation of the agreement and the payment of $2,500 per quarter from the
period of the breach through December 31, 2007. These covenants include, but are
not limited to, covenants relating to material breaches and insolvency.
As part of the agreement, the reinsurer was granted four tranches of
warrants to purchase shares of non-voting convertible preferred stock. The first
three tranches of warrants to purchase are exercisable through December 31, 2007
at common stock equivalent prices ranging from $4.00 to $12.00 per share, if
converted. The reinsurer, at its sole discretion, may execute a cash exercise or
a cashless exercise. If exercised for cash, at the reinsurer's option, the
warrants could yield additional capital and liquidity of approximately $20,000
and, if converted, would represent ownership of approximately 15% of the
outstanding shares of our common stock. If the agreement is not commuted
following December 31, 2007, the reinsurer may exercise the fourth tranche of
convertible preferred stock purchase warrants at a common stock equivalent price
of $2.00 per share. If converted, the convertible preferred stock potentially
generates additional capital of $12,000 and would represent an additional 20% of
the then outstanding common stock. The reinsurer is under no obligation to
exercise any of the warrants.
7
The warrants are part of the consideration for the reinsurance contract and
are recognized as premium expense over the anticipated life of the contract. The
warrants were valued at the issuance date using a Black-Scholes model with the
following assumptions: 6.0 years expected life, volatility of 70.9% and a risk
free rate of 4.74%. The $15,855 value of the warrants was recorded as a deferred
premium as of December 31, 2001. $1,320 of the deferred premium was amortized to
expense during the six months ended June 30, 2002.
The agreement also granted the reinsurer an option to participate in
reinsuring new business sales up to 50% on a quota share basis. In August 2002,
the Company announced that the reinsurer had exercised its option to reinsure a
portion of future sales. Final terms are still pending.
3. Contingencies:
The Company and certain of its key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by shareholders of the
Company, on their own behalf and on behalf of a putative class of similarly
situated shareholders who purchased shares of the Company's common stock from
July 23, 2000 through and including March 29, 2001. The consolidated amended
class action complaint seeks damages in an unspecified amount for losses
allegedly incurred as a result of misstatements and omissions allegedly
contained in the Company's periodic reports filed with the SEC, certain press
releases issued by the Company, and in other statements made by its officials.
The alleged misstatements and omissions relate, among other matters, to the
statutory capital and surplus position of the Company's largest subsidiary,
PTNA. On December 7, 2001, the defendants filed a motion to dismiss the
complaint, which has been denied. The Company believes that the complaint is
without merit, and it and its executives will continue to vigorously defend the
matter.
8
4. Investments:
Management has categorized all of its investment securities as available
for sale because 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 June 30, 2002,
shareholders' equity was increased by $611 due to unrealized gains of $926 in
the investment portfolio. As of December 31, 2001, shareholders' equity was
increased by $10,581 due to unrealized gains of $16,032 in the investment
portfolio. The amortized cost and estimated market value of the Company's
available for sale investment portfolio as of June 30, 2002 and December 31,
2001 are as follows:
June 30, 2002 December 31, 2001
------------- -----------------
Amortized Estimated Amortized Estimated
Cost Market Value Cost Market Value
---- ------------ ---- ------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 13,451 $ 14,513 $164,712 $172,063
Obligations of states and
political sub-divisions -- -- 572 612
Mortgage backed securities 1,924 1,970 42,587 43,331
Debt securities issued by
foreign governments 206 212 11,954 12,089
Corporate securities 8,930 8,742 243,793 250,513
Equities -- -- 8,760 9,802
Policy Loans 209 209 181 181
-------- -------- -------- --------
Total Investments $ 24,720 $ 25,646 $472,559 $488,591
======== ======== ======== ========
Net unrealized gain 926 16,032
-------- --------
$ 25,646 $488,591
======== ========
The majority of the Company's investment portfolio was transferred to the
reinsurer as part of the initial premium paid for the Company's December 31,
2001 reinsurance transaction. The reinsurer maintains a notional experience
account for the Company's benefit in the event of future commutation of the
reinsurance agreement. The Company receives an investment credit equal to the
total return of a series of benchmark indices and hedges. The experience account
balance at June 30, 2002 was $594,449.
Pursuant to certain statutory licensing requirements, as of June 30, 2002,
the Company had on deposit bonds aggregating $8,637 in Insurance Department
special deposit accounts. The Company is not permitted to remove the bonds from
these accounts without approval of the regulatory authority.
9
5. 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 shareholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share reflects 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 June 30, Six Months Ended June 30,
--------------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
Net income (loss) before cumulative effect of
accounting change $ 11,918 $ 2,430 $ (1,709) $ 94
Weighted average common shares outstanding 19,349 11,857 19,102 9,585
-------- -------- -------- --------
Basic earnings per share from net income (loss) before
cumulative effect of accounting change $ 0.62 $ 0.20 $ (0.09) $ 0.01
======== ======== ======== ========
Net income (loss) before cumulative effect of
accounting change $ 11,918 $ 2,430 $ (1,709) $ 94
Cumulative effect of accounting change -- -- (5,151) --
-------- -------- -------- --------
Net income (loss) $ 11,918 $ 2,430 $ (6,860) $ 94
======== ======== ======== ========
Basic earnings per share from net income (loss) $ 0.62 $ 0.20 $ (0.36) $ 0.01
======== ======== ======== ========
Adjustments net of tax:
Interest expense on convertible debt $ 771 $ -- $ -- $ --
Amortization of debt offering costs 60 -- -- --
-------- -------- -------- --------
Diluted net income (loss) before cumulative effect of
accounting change $ 12,748 $ 2,430 $ (1,709) $ 94
======== ======== ======== ========
Diluted net income (loss) $ 12,748 $ 2,430 $ (6,860) $ 94
======== ======== ======== ========
Weighted average common shares outstanding 19,349 11,857 19,102 9,585
Common stock equivalents due to dilutive
effect of stock options/warrants 395 -- -- 9
Shares converted from convertible debt 2,628 -- -- --
-------- -------- -------- --------
Total outstanding shares for diluted earnings
per share computation 22,372 11,857 19,102 9,594
-------- -------- -------- --------
Diluted earnings per share from net income (loss) before
cumulative effect of accounting change $ 0.57 $ 0.20 $ (0.09) $ 0.01
======== ======== ======== ========
Diluted earnings per share $ 0.57 $ 0.20 $ (0.36) $ 0.01
======== ======== ======== ========
10
6. New Accounting Principles:
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 June 30, 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, "Goodwill and Other Intangible Assets," primarily addresses
the accounting for goodwill and intangible assets subsequent to their
acquisition. The Company adopted SFAS No. 142 on January 1, 2002 and ceased
amortizing goodwill at that time. During the second quarter 2002, the Company
completed an impairment analysis of goodwill, in accordance with FASB No. 142.
The Company's goodwill was recorded as a result of the purchase of its agencies
and its insurance subsidiaries. As part of its evaluation, the Company completed
numerous steps in determining the revocerability of its goodwill. The first
required step was the measurement of total enterprise fair value versus book
value. Because the Company's fair market value, as measured by its stock price,
was below book value at January 1, 2002, goodwill was next evaluated at a
reporting unit level, which comprised its insurance agencies and insurance
subsidiaries.
Upon completion of its evaluation, the Company determined that the goodwill
associated with the agency purchases was fully recoverable. The deficiency of
current market value to book value was assigned to the insurance subsidiary
values. As a result, the Company determined that the goodwill associated with
its insurance subsidiaries was impaired and recognized an impairment loss of
$5,151 from its transitional impairment test of goodwill, which it recorded as a
cumulative effect of change in accounting principle. The impairment has been
recorded effective January 1, 2002. Management has completed an assessment of
other intangible assets and has determined to continue to amortize these assets
so as to closely match the future profit emergence from these assets.
No goodwill was amortized for the six months ended June 30, 2002. For the
six months ended June 30, 2001, the Company amortized $646 of goodwill. For
comparative purposes, the following table adjusts net income and basic and
diluted earnings per share for the second quarter and six months ended June 30,
2001, as if goodwill amortization had ceased at the beginning of 2001.
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- ----------------------------
2002 2001 2002 2001
---- ---- ---- ----
Reported net income (loss) $ 11,918 $ 2,430 $ (1,709) $ 94
Adjustment for goodwill amortization, net of tax -- 213 -- 427
---------- --------- --------- ---------
Adjusted net income (loss) $ 11,918 $ 2,643 $ (1,709) $ 521
========== ========= ========= =========
Reported basic earnings per share $ 0.62 $ 0.20 $ (0.09) $ 0.01
Adjustment for goodwill amortization, net of tax -- 0.02 -- 0.04
---------- --------- --------- ---------
Adjusted basic earnings per share $ 0.62 $ 0.22 $ (0.09) $ 0.05
========== ========= ========= =========
Reported diluted earnings per share $ 0.57 $ 0.20 $ (0.09) $ 0.01
Adjustment for goodwill amortization, net of tax -- 0.02 -- 0.04
---------- --------- --------- ---------
Adjusted diluted earnings per share $ 0.57 $ 0.22 $ (0.09) $ 0.05
========== ========= ========= =========
11
7. Equity Placement:
In March 2002, the Company completed a private placement of 510 shares of
common stock for net proceeds of approximately $2,352. The common stock was sold
to several current and new institutional investors, at $4.65 per share. The
offering price was a 10 percent discount to the 30-day average price of our
common stock prior to the issuance of the new shares. The Company's common stock
is listed on the New York Stock Exchange. Pursuant to registration rights
granted in the private placement, the Company filed a registration statement
registering for resale the shares granted in the private placement. The
Securities and Exchange Commission declared the registration statement effective
on June 20, 2002. The proceeds of the private placement provided additional
liquidity to the parent company to meet its current year debt service
obligations. The proceeds, together with currently available cash sources, are
not sufficient to meet the December 2003 final interest requirement of the debt
or to retire the debt upon maturity.
In June 2002, the Company completed a private placement of 30 shares of
common stock as compensation to its financial advisor in conjunction with the
private placement of 510 shares and in consideration of future services. The
Company filed the registration statement and it was declared effective by the
Securities and Exchange Commission on June 20, 2002.
8. Subsequent Event:
On August 7, 2002, the Company announced that its board of directors had
authorized an offer of up to $74,750 in aggregate principal amount of 6-1/4%
Convertible Subordinated Notes due 2008 in exchange for up to all of its
outstanding 6-1/4% Convertible Subordinated Notes due 2003. Under the proposed
terms of the exchange, the new notes would have terms similar to the current
notes but would mature in October 2008 and would be convertible into shares of
the Company's common stock at a conversion price of $5.31. The current notes
mature in December 2003 and are convertible into shares of the Company's common
stock at a conversion price of $28.44. In addition, beginning in October 2004,
the new notes would be mandatorily convertible if, at any time, the 15-day
average closing price of the Company's common stock exceeds 110% of the
conversion price. The Company expects to make all necessary filings with the
Securities and Exchange Commission by August 31, 2002 and to commence the
exchange offer as soon as practicable thereafter.
12
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Overview
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 during 2001 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 Corrective Action Plan (the
"Plan"), which was approved by the Pennsylvania Insurance Department (the
"Department") in February 2002, we recommenced sales in certain states, but
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 30 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
policyholders 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" and
"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. Reserves are released to income if
and when policies lapse.
We also maintain reserves for policies that are not currently on 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, premium rate increases and persistency.
Factor components generally include assumptions that are consistent with both
our experience and industry practices. Reserves are released to income if, and
when, policies lapse.
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.
13
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.
The number of years a policy has been in-force. Claims costs tend to be
higher on policies that have been in-force for a longer period of time. As the
insured 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 and experience account. Our investment portfolio,
excluding our experience account, 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 income does not immediately reflect
changes in market interest rates.
In February 2002, in connection with our December 31, 2001 reinsurance
agreement, we transferred substantially all of our investment portfolio to our
reinsurer. The reinsurer will maintain a notional experience account for our
benefit that includes the initial premium paid, all future cash flows from the
reinsured business and accumulated investment earnings. The reinsurer provides
the Company with an experience account investment credit equal to the total
return of a series of benchmark indices and hedges, which are designed to
closely match the duration of the Company is claims liabilities. The Company's
accounting for the experience account investment credit in accordance with FAS
No. 133 and has determined to bi-furcate the total return into two components:
1. the investment income component, or an embedded derivative debt host
with a yield that is represented by the current yield to maturity of
the underlying benchmark indices, in effect providing the Company with
investment earnings equal to current market rates, and
2. a change in market value component, which reflects the effect of a
change in current interest rates, as determined by the current market
value of the underlying indices. As a result, the Company's future
financial statements are subject to significant volatility. Recorded
market value gains or losses, although recognized in current earnings,
are expected to be offset in future periods as a result of our receipt
of the most recent market rates, and, therefore, have no anticipated
long-term impact on shareholder value.
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 conversion 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.
14
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.
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, a greater percentage of higher-risk policyholders,
and accelerated expensing of deferred acquisition costs. However, higher
lapsation may lead to decreased claims in future periods.
Results of Operations
Three Months Ended June 30, 2002 and 2001
(amounts in thousands, except per share data)
Premiums. Total premium revenue earned in the three month period ended June 30,
2002 (the "2002 quarter"), including long-term care, disability, life and
Medicare supplement, decreased 6.8% to $83,906, compared to $90,039 in the same
period in 2001 (the "2001 quarter").
Total first year premiums earned in the 2002 quarter decreased 90.1% to
$1,276, compared to $12,906 in the 2001 quarter. First year long-term care
premiums earned in the 2002 quarter decreased 91.5% to $1,040, compared to
$12,299 in the 2001 quarter. We experienced significant reductions in new
premium sales due to the cessation of new business generation in all states and
due to continued market concerns regarding our insurance subsidiaries' statutory
surplus. As a result, we expect to experience similar declines in future
quarters compared to comparable prior periods. Under our Corrective Action Plan
(the "Plan"), which was approved by the Pennsylvania Insurance Department (the
"Department") in the first quarter of 2002, we recommenced sales in certain
states, but intend to limit new business growth to levels that will allow us to
maintain sufficient statutory surplus. See "Liquidity and Capital Resources."
Effective September 10, 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. Upon the approval by the Department of the Plan in February
2002, we recommenced new sales in 23 states. We have since recommenced sales in
four additional states, including Florida, which has historically represented
approximately 25% of our new business production. We are actively working with
the remaining states in order to recommence sales in all jurisdictions.
15
Total renewal premiums earned in the 2002 quarter increased 7.1% to
$82,630, compared to $77,133 in the 2001 quarter. Renewal long-term care
premiums earned in the 2002 quarter increased 9.1% to $79,974, compared to
$73,325 in the 2001 quarter. This increase reflects renewals of a larger base of
in-force policies as well as the impact of premium rate increases, the
implementation that began in the 2002 quarter. We may experience reduced renewal
premiums in the future if policies lapse, especially given our recent premium
rate increases that are anticipated to cause additional policy lapses. 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 2002 quarter
increased 41.6% to $10,172, from $7,185 for the 2001 quarter.
As a result of our new reinsurance agreement, substantially all of our
investable assets from business written prior to December 31, 2001, were
transferred to the reinsurer. The reinsurer maintains a notional experience
account on our behalf in the event that the reinsurance agreement is later
commuted. As discussed above in "Overview," the notional account is credited
with an investment credit equal to the most recent yield to maturity on a series
of benchmark indices and hedges, which are designed to closely match the
duration of our liabilities. See "Liquidity and Capital Resources."
Our average yield on invested assets at cost, including cash and cash
equivalents, was 6.55% and 5.43%, respectively, in the 2002 and 2001 quarters.
The higher yield in the 2002 quarter resulted from having investments only in
higher yielding bonds (including the makeup of the underlying experience account
indices, which have a duration of approximately 11 years), rather than in common
stocks, in which we had investments in the 2001 quarter. The investment income
component of our experience account investment credit generated $9,750 in the
2002 quarter.
Net Realized Capital Gains and Trading Account Activity. During the 2002
quarter, we recognized capital gains of $41, compared to capital gains of $712
in the 2001 quarter. The results in the 2002 and 2001 quarters were recorded as
a result of our normal investment management operations.
During 2001, we classified our convertible bond portfolio as trading
account investments. Changes in trading account investment market values were
recorded in our statement of operations during the period in which the change
occurred, rather than as an unrealized gain or loss recorded directly through
equity. As a result, we recorded a trading account gain in the 2001 quarter of
$399, which reflected the unrealized and realized loss of our convertible
portfolio that arose during that quarter. No investments were classified as
trading during the 2002 quarter.
Market gain (loss) on experience account. We recorded a market gain on our
experience account balance of $17,299 in the 2002 quarter.
As discussed in "Overview" and "Net Investment Income" above, the reinsurer
of our new reinsurance agreement maintains a notional experience account for our
benefit in the event of future recapture. The notional experience account will
receive an investment credit based upon the total return of a series of
benchmark indices and derivative hedges, which are designed to closely match the
duration of our reserve liabilities. Periodic changes in the market values of
the benchmark indices and derivative hedges are recorded in our financial
statements as a realized gain or loss in the period in which they occur. As a
result, our future financial statements are subject to significant volatility.
16
Other Income. We recorded $5,044 in other income during the 2002 quarter, up
from $2,365 in the 2001 quarter. The increase is attributable primarily 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 2002 quarter
increased 3.8% to $62,515, compared to $60,235 in the 2001 quarter. Our loss
ratio, or policyholder benefits to premiums, was 74.3% in the 2002 quarter,
compared to 66.9% in the 2001 quarter.
As a result of our analysis and process refinement for claims duration and
incurred but are not yet reported ("IBNR"), we increased our claim reserves in
the 2002 quarter by approximately $9,000.
As discussed in "Overview" above, we establish reserves for current claims
based upon current and historical experience of our policyholder benefits,
including an expectation of claims incidence and duration, as well as the
establishment of a reserve for claims that have been IBNR. We continuously
monitor our experience to determine the best estimate of reserves to be held for
future payments of these claims. As a result, we periodically refine our process
to incorporate the most recent known information in establishing these reserves.
We are currently completing a continuance study of our historical claims
duration. We expect to use this study in the future refinement of our claim
reserve determination. Prior to the completion of this study, we have
established our reserves for current claims based upon our best estimate of
future claims development after evaluating historical claims patterns. We
believe that the completion of our continuance study will enable us to further
refine our process for establishing individual claim reserves and that we will
no longer use a lag study methodology.
Also, amounts are established for IBNR based upon our best estimates and
are generally calculated as a percentage of other known pending claim reserves.
Our most recent analysis suggested that this percentage historically varies in
different quarters as a result of seasonal incidence of claims and the delay in
reporting these claims to the Company. Our analysis also included a review of
the seasonality of our claims incidence over the past several years. This
analysis indicated that the incidence of claims varies throughout the year, as
does the delay in the reporting of the claims by the policyholders. We have
reflected the impact of the seasonality in our reserving estimates, which served
to partially offset the increase in reserves indicated by the lag study
discussed above. We have included, and will continue to include, this
expectation in the establishment of IBNR in the 2002 quarter and in subsequent
quarters.
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 third
quarter 2001, we filed for 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 currently received approval for
more than 90% of the rate increases requested. We have been generally
successful in the past in obtaining state insurance department approvals for
increases. If we are unsuccessful in obtaining future 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.
17
Our benefit reserves, which are held for policyholders not currently on
claim, are highly dependent upon policyholder persistency. As a result of our
recently implemented premium rate increases, our persistency declined to
approximately 85% in the 2002 quarter compared to 89% during the first quarter
of 2002. This decline, or "shock lapse," was within the bounds of our
expectations and served to reduce benefit reserves by approximately $5,000
during the 2002 quarter. Management believes that shock lapses are generally not
preferable to policy persistence in that the lapsing policyholders are assumed
to be healthier and lower risks. Also, while recognizing a current period income
benefit from the release of reserves, future period revenues are reduced as a
result of lapsation.
Commissions. Commissions to agents decreased 44.0% to $11,677 in the 2002
quarter, compared to $20,836 in the 2001 quarter.
First year commissions on accident and health business in the 2002 quarter
decreased 91.7% to $719, compared to $8,671 in the 2001 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
56.3% in the 2002 quarter and 68.4% in the 2001 quarter. We believe that the
decrease in the first year commission ratio is primarily attributable to the
increased sale of our Secured Risk policy, which pays a lower, limited
commission. Our Secured Risk policy provides limited benefits to higher risk
policyholders at a substantially increased premium rate. We believe that we are
likely to experience an increase in the sale of these policies when we reenter
sales in many states as a result of our lower financial ratings.
Renewal commissions on accident and health business in the 2002 quarter
decreased 8.0% to $11,734, compared to $12,754 in the 2001 quarter, due to the
decrease in renewal premiums discussed above. The ratio of renewal accident and
health commissions to renewal accident and health premiums was 14.3% in the 2002
quarter and 17.0% in the 2001 quarter. This ratio reflects the sale of more
Secured Risk and Medicare Supplement policies in the 2001 quarter, which pay no
or reduced renewal commissions. Also, we do not pay commissions on premium
revenue that results from rate increases. As a result of premium rate increases
for which implementation began in the 2002 quarter, commission ratios are
reduced.
During the 2002 quarter, we reduced commission expense by netting $646 from
override commissions affiliated insurers paid to our agency subsidiaries. During
the 2001 quarter, we reduced commissions by $1,089.
Net policy acquisition costs amortized (deferred). The net deferred policy
acquisition costs in the 2002 quarter decreased to a net amortization of costs
of $7,777, compared to $1,750 in the 2001 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.
18
The net amortization of deferred policy acquisition costs is effected by
new business generation, imputed interest on prior reserves and policy
persistency. During the 2002 quarter, higher policyholder lapses (as noted under
"Premiums"), resulted in increased amortization of deferred policy acquisition
costs.
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 2002 and 2001 quarters produced significantly less expense
deferral to offset amortized costs.
General and administrative expenses. General and administrative expenses in the
2002 quarter decreased 16.1% to $10,873, compared to $12,957 in the 2001
quarter. The 2002 and 2001 quarters include $1,574 and $1,713, respectively of
general and administrative expenses related to United Insurance Group expense.
The ratio of total general and administrative expenses to premium revenues,
excluding United Insurance Group, was 11.1% in the 2002 quarter, compared to
12.5% in the 2001 quarter.
Expenses have declined as a result of reduced new premium sales, related
underwriting and policy issuance expenses and management initiatives to reduce
operating expenses. However, we believe that if we remain unable to write new
business in certain states where we have ceased new production, or if we are
unable to utilize our existing staff and infrastructure capacity to generate
additional premiums, we will need to decrease production expenses further.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance
agreement provides the reinsurer with annual expense and risk charges, which are
charged against our experience account in the event of future commutation of the
agreement. The annual charge consists of a fixed cost and a variable component
based upon reserve and capital levels needed to support the reinsured business.
In the 2002 quarter, we accrued $3,577 for this charge. In addition, we are
subject to an excise tax for premium payments made to a foreign reinsurer. We
recorded $792 for excise tax expenses in the 2002 quarter as a result.
Provision for federal income taxes. As a result of increased taxable income our
provision for federal income taxes for the 2002 quarter increased 390.4% to
$6,139, compared to an income tax provision of $1,252 for the 2001 quarter. The
effective tax rate of 34% in the 2002 and 2001 quarters is below the normal
federal corporate rate as a result of anticipated credits from our investments
in corporate owned life insurance.
Comprehensive income. During the 2002 quarter, our investment portfolio
generated pre-tax unrealized gains of $92, compared to unrealized losses of
$3,961 in the 2001 quarter. After accounting for deferred taxes from these
losses and gains, shareholders' equity increased by $11,952 from comprehensive
income during the 2002 quarter, compared to losses of $878 in the 2001 quarter.
Six Months Ended June 30, 2002 and 2001
(amounts in thousands, except per share data)
Premiums. Total premium revenue earned in the six month period ended June 30,
2002 (the "2002 period"), including long-term care, disability, life and
Medicare supplement, decreased 9.6% to $168,142, compared to $186,058 in the
same period in 2001 (the "2001 period").
19
Total first year premiums earned in the 2002 period decreased 89.2% to
$3,551, compared to $32,816 in the 2001 period. First year long-term care
premiums earned in the 2002 period decreased 90.2% to $3,077, compared to
$31,524 in the 2001 period. We experienced significant reductions in new premium
sales due to the cessation of new business generation in all states and due to
market concerns regarding our insurance subsidiaries' statutory surplus. As a
result, we expect to experience similar declines in future quarters compared to
comparable prior periods. Under our Plan, which was approved by the Department
in the first quarter 2002, we recommenced sales in certain states, but intend to
limit new business growth to levels that will allow us to maintain sufficient
statutory surplus. See "Liquidity and Capital Resources."
Effective September 10, 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. Upon the approval by the Department of the Plan in February
2002, we recommenced new sales in 23 states. We have since recommenced sales in
four additional states, including Florida, which has historically represented
25% of our new business sales. We are actively working with remaining states in
order to recommence sales in all jurisdictions.
Total renewal premiums earned in the 2002 period increased 7.4% to
$164,591, compared to $153,242 in the 2001 period. Renewal long-term care
premiums earned in the 2002 period increased 9.4% to $159,250, compared to
$145,502 in the 2001 period. This increase reflects renewals of a larger base of
in-force policies. We may experience reduced renewal premiums in the future if
policies lapse, especially given our recent premium rate increases that are
anticipated to cause additional policy lapses. 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 2002 period
increased 41.7% to $19,707, from $13,910 for the 2001 period.
As a result of our new reinsurance agreement, substantially all of our
investable assets from business written prior to December 31, 2001, were
transferred to the reinsurer. The reinsurer maintains a notional experience
account on our behalf in the event that the reinsurance agreement is later
commuted. As discussed above in "Overview," the notional account is credited
with an investment credit equal to the most recent yield to maturity of a series
of benchmark indices and hedges, which are designed to closely match the
duration of our liabilities. See "Liquidity and Capital Resources."
Our average yield on invested assets at cost, including cash and cash
equivalents, was 6.48% and 5.42%, respectively, in the 2002 and 2001 periods.
The higher yield in the 2002 period resulted from having investments only in
higher yielding bonds (including the makeup of the underlying experience account
indices, which have a duration of approximately 11 years), rather than in bonds
and common stocks as were present in the 2001 period. The investment income
component of our experience account investment credit generated $18,593 in the
2002 period.
Net Realized Capital Gains and Trading Account Activity. During the 2002 period,
we recognized capital gains of $14,564, compared to capital losses of $854 in
the 2001 period. The gains recognized in the 2002 period resulted from the
transfer of substantially all of our invested assets to our reinsurer. The
results in the 2001 period were recorded as a result of our normal investment
management operations.
20
During the 2001 period, we classified our convertible bond portfolio as
trading account investments. Changes in trading account investment market values
were recorded in our statement of operations during the period in which the
change occurred, rather than as an unrealized gain or loss recorded directly
through equity. As a result, we recorded a trading account loss in the 2001
period of $1,324, which reflected the unrealized and realized loss of our
convertible portfolio that arose during that period. No investments were
classified as trading during the 2002 period.
Market gain (loss) on experience account. We recorded a market loss on our
experience account balance of $8,654 in the 2002 period.
As discussed in "Net Investment Income" above, the reinsurer of our new
reinsurance agreement maintains a notional experience account for our benefit in
the event of future recapture. The notional experience account will receive an
investment credit based upon the total return of a series of benchmark indices
and derivative hedges, which are designed to closely match the duration of our
reserve liabilities. Periodic changes in the market values of the benchmark
indices and derivative hedges are recorded in our financial statements as a
realized gain or loss in the period in which they occur. As a result, our future
financial statements are subject to significant volatility.
Other Income. We recorded $7,814 in other income during the 2002 period, up from
$4,765 in the 2001 period. The increase is attributable primarily 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 2002 period
increased 7.8% to $142,702, compared to $132,372 in the 2001 period. Our loss
ratio, or policyholder benefits to premiums, was 84.9% in the 2002 period,
compared to 71.1% in the 2001 period.
During the first quarter of 2002, we experienced a change in the
composition of our aggregate policyholder base. The resultant composition
included more policies with inflation protection, shorter elimination periods
and type of care protection than we had previously seen. As a result, during the
2002 period, we are holding higher reserves per policy than in the 2001 period.
This change in composition has caused us to hold approximately $16,500 in
additional benefit reserves.
As discussed in "Overview" and the 2002 quarter "Benefits to Policyholders"
above, we establish reserves for current claims based upon current and
historical experience of our policyholder benefits, including an expectation of
claims incidence and duration, as well as the establishment of a reserve for
claims that have been incurred but are not yet reported ("IBNR"). We
continuously monitor our experience to determine the best estimate of reserves
to be held for future payments of these claims. As a result, we periodically
refine our process to incorporate the most recent known information in
establishing these reserves.
21
We are currently completing a continuance study of our historical claims
duration. We expect to use this study in the future refinement of our claim
reserve determination. Prior to the completion of this study, we have
established our reserves for current claims based upon our best estimate of
future claims development after evaluating historical claims patterns. We
believe that the completion of our continuance study will enable us to our
process for establishing individual claim reserves.
Also, amounts are established for IBNR based upon our best estimates and
are generally calculated as a percentage of other known pending claim reserves.
Our most recent analysis suggested that this percentage historically varies in
different quarters as a result of seasonal incidence of claims and the delay in
reporting these claims to the Company. Our analysis also included a review of
the seasonality of our claims incidence over the past several years. This
analysis indicated that the incidence of claims varies throughout the year, as
does the delay in the reporting of the claims by the policyholders. We have
reflected the impact of the seasonality in our reserving estimates, which served
to partially offset the increase in reserves indicated by the lag study
discussed above. We have included, and will continue to include, this
expectation in the establishment of IBNR in the 2002 quarter and in subsequent
quarters.
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 third
quarter 2001, we filed for 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 currently received approval for
more than 90% of the rate increases requested. We have been generally
successful in the past in obtaining state insurance department approvals for
increases. If we are unsuccessful in obtaining future 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 46.5% to $24,507 in the 2002
period, compared to $45,824 in the 2001 period.
First year commissions on accident and health business in the 2002 period
decreased 89.9% to $2,175, compared to $21,560 in the 2001 period, 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
61.3% in the 2002 period and 66.7% in the 2001 period. We believe that the
decrease in the first year commission ratio is primarily attributable to the
increased sale of our Secured Risk policy, which pays a lower, limited
commission. Our Secured Risk policy provides limited benefits to higher risk
policyholders at a substantially increased premium rate. We believe that we are
likely to experience an increase in the sale of these policies when we reenter
sales in many states as a result of our lower financial ratings.
Renewal commissions on accident and health business in the 2002 period
decreased 5.1% to $23,982, compared to $25,269 in the 2001 period, due to the
decrease in renewal premiums discussed above. The ratio of renewal accident and
health commissions to renewal accident and health premiums was 14.7% in the 2002
period and 17.0% in the 2001 period. This ratio reflects the sale of more
Secured Risk and Medicare Supplement policies in the 2001 period, which pay no
or reduced renewal commissions. Also, we do not pay commissions on premium
revenue that results from rate increases. As a result of premium rate increases
for which implementation began in the 2002 quarter, commission ratios are
reduced.
22
During the 2002 period, we reduced commission expense by netting $1,426
from override commissions affiliated insurers paid to our agency subsidiaries.
During the 2001 period, we reduced commissions by $2,081.
Net policy acquisition costs deferred. The net deferred policy acquisition costs
in the 2002 period increased to a net amortization of costs of $4,451, compared
to a net deferral of expense of $3,647 in the 2001 period.
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 that 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 2002 period produced significantly less expense deferral to
offset amortized costs.
General and administrative expenses. General and administrative expenses in the
2002 period decreased 15.6% to $21,585, compared to $25,591 in the 2001 period.
The 2002 and 2001 periods include $3,061 and $3,370, respectively, of general
and administrative expenses related to United Insurance Group expense. The ratio
of total general and administrative expenses to premium revenues, excluding
United Insurance Group, was 11.0% in the 2002 period, compared to 11.9% in the
2001 period.
Expenses have declined as a result of reduced new premium sales, related
underwriting and policy issuance expenses and management initiatives to reduce
operating expenses. However, we believe that if we remain unable to write new
business in certain states where we have ceased new production, or if we are
unable to utilize our existing staff and infrastructure capacity to generate
additional premiums, we will need to decrease production expenses further.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance
agreement provides the reinsurer with annual expense and risk charges, which are
charged against our experience account in the event of future commutation of the
agreement. The annual charge consists of a fixed cost and a variable component
based upon reserve and capital levels needed to support the reinsured business.
In the 2002 period, we accrued $7,154 for this charge. In addition, we are
subject to an excise tax for premium payments made to a foreign reinsurer. We
recorded $1,373 for excise tax expenses in the 2002 period.
Provision for federal income taxes. As a result of current losses, our provision
for federal income taxes for the 2002 period decreased 1,696% to an income tax
benefit of $880, compared to an income tax provision of $49 for the 2001 period.
The effective tax rate of 34% in the 2002 and 2001 periods is below the normal
federal corporate rate as a result of anticipated credits from our investments
in corporate owned life insurance that are partially offset by non-deductible
goodwill amortization and other non-deductible expenses.
23
Cumulative effect of accounting change. We recognized an impairment loss of
$5,151 in the 2002 period as a result of our transitional impairment test of
goodwill. See "New Accounting Principles."
Comprehensive income. During the 2002 period, our investment portfolio generated
pre-tax unrealized losses of $542, compared to unrealized gains of $1,180 in the
2001 period. After accounting for deferred taxes from these losses and gains,
shareholders' equity decreased by $16,830 from comprehensive losses during the
2002 period, compared to comprehensive income of $2,280 in the 2001 period.
Liquidity and Capital Resources
Our consolidated liquidity requirements have historically been created and
met from the operations of our insurance subsidiaries, from our agency
subsidiaries and from funds raised in the capital markets. Our primary sources
of cash are premiums, investment income and maturities of investments. We have
obtained, and may in the future obtain, cash through public and private
offerings of our common stock, the exercise of stock options and warrants, other
capital markets activities or debt instruments. Our primary uses of cash are
policy acquisition costs (principally commissions), payments to policyholders,
investment purchases and general and administrative expenses.
In the 2002 period, our cash flows were attributable to cash provided by
operations, cash used in investing and cash provided by financing. Our cash
decreased $89,850 in the 2002 period primarily due to payments made to our
reinsurer and from the purchase of $20,184 in bonds and equity securities. Cash
was provided primarily from the maturity and sale of $482,592 in bonds and
equity securities. These sources of funds were supplemented by $14,114 from
operations. The major source of cash from operations was premium and investment
income received.
Our cash decreased $62,187 in the 2001 period primarily due to the purchase
of $183,256 in bonds and equity securities. Cash was provided primarily from the
maturity and sale of $47,494 in bonds and equity securities. These sources of
funds were supplemented by $51,701 from operations. The major provider of cash
from operations was premium revenue used to fund reserve additions of $52,593.
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. As of June 30, 2002, shareholders' equity was increased by $611 due to
unrealized gains of $926 in the investment portfolio. As of December 31, 2001,
shareholders' equity was increased by $10,581 due to unrealized gains of $16,032
in the investment portfolio.
Subsidiary Operations
Our insurance subsidiaries are regulated by various state insurance
departments. In its ongoing effort to improve solvency regulation, the National
Association of Insurance Commissioners ("NAIC") has adopted Risk-Based Capital
("RBC") requirements for insurance companies to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks,
such as asset quality, mortality and morbidity, asset and liability matching,
benefit and loss reserve adequacy, and other business factors. The RBC formula
is used by state insurance regulators as an early warning tool to identify, for
the purpose of initiating regulatory action, insurance companies that
potentially are inadequately capitalized. In addition, the formula defines
minimum capital standards that an insurer must maintain. Regulatory compliance
is determined by a ratio of the enterprise's regulatory Total Adjusted Capital,
to its Authorized Control Level RBC, as defined by the NAIC. Companies below
specific trigger points or ratios are classified within certain levels, each of
which may require specific corrective action depending upon the insurer's state
of domicile.
24
Our subsidiaries are required to hold statutory surplus that is, at a
minimum, above a level at which the Department would be required to place our
subsidiaries under regulatory control, leading to rehabilitation or liquidation.
At December 31, 2000, our primary insurance subsidiary, representing 94% of our
direct premium, had Total Adjusted Capital at the Regulatory Action level. As a
result, it was required to file a Plan with the insurance commissioner.
On February 12, 2002, the Department approved the Plan. As a primary
component of the Plan, effective December 31, 2001, we entered a reinsurance
transaction to reinsure, on a quota share basis, substantially all of our
respective long-term care insurance policies then in-force. The agreement is
subject to certain coverage limitations, including an aggregate limit of
liability that is a function of certain factors and that may be reduced in the
event that the rate increases that the reinsurance agreement may require are not
obtained. The agreement meets the requirements to qualify as reinsurance for
statutory accounting, but not for generally accepted accounting principles.
The initial premium of the treaties was approximately $619,000, comprised
of $563,000 of cash and qualified securities transferred in February 2002, and
$56,000 as funds held due to the reinsurer. The initial premium and future cash
flows from the reinsured policies, less claims payments, ceding commissions and
risk charges, is credited to a notional experience account, which is held for
our benefit in the event of commutation and recapture on or after December 31,
2007. The notional experience account balance receives an investment credit
based upon the total return from a series of benchmark indices and derivative
hedges that are intended to match the duration of our reserve liability.
The agreement contains commutation provisions and allows us to recapture
the reserve liabilities and the current experience account balance as of
December 31, 2007 or on December 31 of any year thereafter. If we choose not to
or are unable to commute the agreement as planned, our financial results would
likely suffer a materially adverse impact due to an escalation of the charges
paid to the reinsurer. Additionally, our reinsurance provisions contain
significant covenants and conditions that, if breached, could result in a
significant loss, requiring a payment of $2.5 million per quarter from the
period of the breach through December 31, 2007. Any breach of the reinsurance
agreement may also result in the immediate recapture of the reinsured business,
which would have a negative on our subsidiaries' statutory surplus. Management
has completed an assessment of its ability to avoid any breach through 2002 and
believes that the insurance subsidiaries will remain compliant. In addition, the
reinsurer has been granted warrants to acquire convertible preferred stock in
the event we do not commute the agreements that, if converted, would represent
an additional 20 percent of the common stock then outstanding.
25
The Plan requires our subsidiary to comply with certain other agreements at
the direction of the Department, including, but not limited to:
o New investments are limited to NAIC 1 or 2 rated securities.
o Affiliated transactions are limited and require Department approval.
o An agreement to increase statutory reserves; the reinsurance agreement has
provided the capacity to accommodate this increase and will provide an
additional $65,000 throughout 2002, 2003 and 2004, such that our insurance
subsidaries' policy reserves will be based on new, current claims
assumptions and will not include any rate increases. These claim
assumptions are applied to all policies, regardless of issue year, and are
assumed to have been present since the policy was first issued.
Effective September 10, 2001, we determined to discontinue the sale
nationally of all new long-term care insurance policies until the Plan was
approved by the Department. The 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 our status by many
states in which we are licensed to conduct business. The form of our cessation
varied by state, ranging from no action to certificate suspensions.
Upon the approval by the Department of the Plan in February 2002, we
recommenced new sales in 23 states. We have since recommenced sales in four
additional states, including Florida, which has historically accounted for
approximately 25% of our new sales. We are actively working with remaining
states in order to recommence sales in all jurisdictions.
The majority of our insurance subsidiaries' cash flow results from our
existing long-term care policies, which will be ceded to the reinsurer under
this agreement. Our subsidiaries' ability to meet additional liquidity needs and
fixed expenses in the future is highly dependent upon our ability to issue new
policies and to control expense growth.
Our future growth is dependent upon our ability to continue to expand our
historical markets, retain and expand our network of agents and effectively
market our products and our ability to fund our marketing and expansion while
maintaining minimum statutory levels of capital and surplus required to support
such growth.
We are unlikely in the foreseeable future to be able to make dividend
payments from our two largest insurance subsidiaries. Additionally, the Plan
requires Department approval of all dividend requests, regardless of statutory
allowances. However, our New York subsidiary is not subject to the Plan and was
permitted by New York statute to make a dividend payment following December 31,
2001. During the 2002 period, we received a dividend from our New York
subsidiary of $651.
Our subsidiaries' debt currently consists primarily of a mortgage note in
the amount of approximately $1,540 that was issued by a former subsidiary and
assumed by us 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%.
26
Parent Company Operations
Our parent company is a non-insurer that directly controls 100% of the
voting stock of our insurance 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 subsidiaries could be
materially affected.
On April 27, 2001, we distributed rights to our shareholders and holders of
our 6.25% convertible subordinated notes due 2003 ("Rights Offering") 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 11,547 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 subsidiaries.
Parent company debt currently consists of $74,750 of 6.25% Convertible
Subordinated Notes due 2003. The convertible subordinated notes, issued in
November 1996, are convertible into common stock at $28.44 per share until
maturity in December 2003. 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. The convertible subordinated notes
carry a fixed interest coupon of 6.25%, payable semi-annually. Because we do not
have sufficient cash flow to retire the debt upon maturity, and the conversion
price of $28.44 per share is not likely to be met, we expect that we will need
to refinance our 6.25% Convertible Subordinate Notes on or before maturity in
2003.
On August 7, 2002, the Company announced that its board of directors had
authorized an offer of up to $74,750 in aggregate principal amount of 6-1/4%
Convertible Subordinated Notes due 2008 in exchange for up to all of its
outstanding 6-1/4% Convertible Subordinated Notes due 2003. Under the proposed
terms of the exchange, the new notes would have terms similar to the current
notes but would mature in October 2008 and would be convertible into shares of
the Company's common stock at a conversion price of $5.31. The current notes
mature in December 2003 and are convertible into shares of the Company's common
stock at a conversion price of $28.44. In addition, beginning in October 2004,
the new notes would be mandatorily convertible if, at any time, the 15-day
average closing price of the Company's common stock exceeds 110% of the
conversion price. The Company expects to make all necessary filings with the
Securities and Exchange Commission by August 31, 2002 and to commence the
exchange offer as soon as practicable thereafter.
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 December 31,
2001. The remainder of the purchase was paid in cash. The total outstanding
balance of the note was repaid in January 2002.
27
At June 30, 2002, our total debt and financing obligations through 2006
were as follows:
Lease
Debt Commitments Total
---- ----------- -----
2002 $ -- $ 245 $ 245
2003 76,288 344 76,632
2004 -- 252 252
2005 -- 18 18
2006 -- 18 18
------- ------- -------
Total $76,288 $ 877 $77,165
======= ======= =======
Amounts subsequent to 2006 are immaterial.
In December 1999, we contributed $1,000 to initially capitalize another
subsidiary, which concurrently lent us $750 in exchange for a demand note, which
is still outstanding.
As part of our reinsurance agreement, effective December 31, 2001, the
reinsurer was granted four tranches of warrants to purchase shares of non-voting
convertible preferred stock. The first three tranches of warrants to purchase
are exercisable through December 31, 2007 at common stock equivalent prices
ranging from $4.00 to $12.00 per share. If exercised for cash, at the
reinsurer's option, the warrants could yield additional capital and liquidity of
approximately $20,000 and the convertible preferred stock would represent, if
converted, approximately 15% of the outstanding shares of our common stock. If
the agreement is not commuted on or after December 31, 2007, the reinsurer may
exercise the fourth tranche of convertible preferred stock purchase warrants at
a common stock equivalent price of $2.00 per share, potentially generating
additional capital of $12,000 and, if converted, the convertible preferred stock
would represent an additional 20% of the then outstanding common stock. No
assurance can be given that the reinsurer will exercise any or all of the
warrants granted or that it will pay cash in connection with their exercise.
Cash flow needs of the parent company primarily include interest payments
on outstanding debt and limited operating expenses. The funding is primarily
derived from the operating cash flow of our agency subsidiary operations and
dividends from the insurance subsidiaries. However, as noted above, the dividend
capabilities of the insurance subsidiaries are limited and the only insurance
company that can pay dividends is American Independent Network Insurance Company
of New York. While we intend to sell this insurance subsidiary in order to
generate additional parent company liquidity, we cannot assure that this will be
accomplished during 2002. In the event the sale is not completed, we may need to
rely upon the dividend capabilities of our agency subsidiaries to meet current
liquidity needs. These sources of funds, however, are expected to be
insufficient to meet our future needs beyond June 30, 2003, including the
repayment of $74,750 million of long-term debt in December 2003.
In March 2002, we completed a private placement of 510 shares of common
stock for net proceeds of approximately $2,400. The common stock was sold to
several current and new institutional investors, at $4.65 per share. The
offering price was a 10 percent discount to the 30-day average price of our
common stock prior to the issuance of the new shares. Our common stock is listed
on the New York Stock Exchange. We filed a registration statement with the
Securities and Exchange Commission on June 5, 2002 to register these shares for
resale. However, the proceeds of the private placement provided sufficient
additional liquidity to the parent company to meet our debt obligations prior to
the maturity of the convertible debt in 2003. The proceeds, together with
currently available cash sources, will not be sufficient to meet the December
2003 final interest requirement of the convertible debt or to retire the debt
upon maturity.
28
In June 2002, we completed a private placement of 30 shares of common stock
as compensation to our financial advisor. We filed a registration statement for
these additional shares with the Securities and Exchange Commission on June 5,
2002.
Our liquidity projections, while based upon our best estimates and
containing excess margin for our estimated needs, may not be sufficient to meet
our obligations throughout 2003. We cannot assure that we will not need
additional funding in the event that our liquidity projections are insufficient
to meet our future cash needs.
New Accounting Principles
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, "Goodwill and Other Intangible Assets," primarily addresses
the accounting for goodwill and intangible assets subsequent to their
acquisition. We adopted SFAS No. 142 on January 1, 2002 and ceased amortizing
goodwill at that time. During the second quarter 2002, we completed an
impairment analysis of goodwill, in accordance with FASB No. 142. Our goodwill
was recorded as a result of the purchase of its agencies and its insurance
subsidiaries. As part of our evaluation, we completed numerous steps in
determining the revocerability of our goodwill. The first required step was the
measurement of total enterprise fair value versus book value. Because our fair
market value, as measured by our stock price, was below book value at January 1,
2002, goodwill was next evaluated at a reporting unit level, which comprised our
insurance agencies and insurance subsidiaries.
Upon completion of our evaluation, we determined that the goodwill
associated with the agency purchases was fully recoverable. The deficiency of
current market value to book values was assigned to the insurance subsidiary
values. As a result, we determined that the goodwill associated with our
insurance subsidiaries was impaired and recognized an impairment loss of $5,151
from our transitional impairment test of goodwill, which we recorded as a
cumulative effect of change in accounting principle. The impairment has been
recorded effective January 1, 2002. Management has completed an assessment of
other intangible assets and has determined to continue to amortize these assets
so as to closely match the future profit emergence from these assets.
29
Forward Looking Statements
Certain statements made by the Company may be considered forward-looking
within the meaning of the Private Securities Litigation Reform Act of 1995.
Although the Company believes that its expectations are based upon reasonable
assumptions within the bounds of its knowledge of its business and operations,
there can be no assurance that actual results of the Company's operations will
not differ materially from its expectations. Factors which could cause actual
results to differ from expectations include, among others, the acceptance of the
terms of the exchange offer by current debt holders, the Company's ability to
comply with the Corrective Action Plan, the Florida Consent Order, the orders or
directives of other states in which the Company does business or any special
provisions imposed by states in connection with the resumption of writing
business, the Company's ability to eventually commute its reinsurance agreement
and to recapture its reinsured policies and accumulated experience account
balance, whether its Corrective Action Plan will be accepted and approved by all
states, the Company's ability to meet its future risk-based capital goals, the
adverse financial impact of suspending new business sales, the Company's ability
to raise adequate capital to meet the requirements of anticipated growth and the
cost associated with recommencing new business sales, liquidity needs and debt
obligations, the adequacy of the Company's loss reserves and the recoverability
of its unamortized deferred policy acquisition cost asset, the Company's ability
to sell insurance products in certain states, the Company's ability to resume
generating new business in all states, the Company's ability to comply with
government regulations and the requirements which may be imposed by state
regulators as a result of the Company's capital and surplus levels, the ability
of senior citizens to purchase the Company's products in light of the increasing
costs of health care, the ability of the Company to retain its current
policyholder base, the ability of the Company to defend itself against adverse
litigation, and the Company's ability to recapture, expand and retain its
network of productive independent agents, especially in light of the suspension
of new business. For additional information, please refer to the Company's
reports 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 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.
As part of our reinsurance transaction, our reinsurer will maintain a
notional experience account for our benefit that includes the initial premium
paid, all future cash flows from the reinsured business and accumulated
investment earnings. The notional experience account balance will receive an
investment credit based upon the total return of a series of benchmark indices
and derivative hedges, which are designed to closely match the duration of our
reserve liabilities. Periodic changes in the market values of the benchmark
indices and derivative hedges are recorded in our financial statements as
investment gains or losses in the period in which they occur. As a result, our
future financial statements have been and will continue to be subject to
significant volatility.
We currently have an interest rate swap on our mortgage, 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 both financial instruments are with the same bank, no credit or
financial risk is carried with the swap.
30
Our financial instruments are held for purposes other than trading. Our
portfolio does not contain any significant concentrations in single issuers
(other than U.S. treasury and agency obligations), industry segments or
geographic regions.
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 88.1% of total liabilities
and reinsurance receivables on unpaid losses represent 64.2% 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 June 30, 2002, including the value of our
experience account, but excluding insurance liabilities and other 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 $33,268,000 decrease in the net fair value of our financial
instruments. 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 June 30, 2002 would have resulted in an
approximate $62,912,000 decrease in the net fair value. If interest rates had
decreased by 100 and 200 basis points, there would have been an approximate
$37,367,000 and $79,377,000 net increase, respectively, in the net fair value of
our financial instruments.
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 June 30, 2002.
PART II OTHER INFORMATION
Item 1. Legal Proceedings
Our subsidiaries are parties to various lawsuits generally arising in the
normal course of their business. We do not believe that the eventual outcome of
any of the suits to which we are party will have a material adverse effect on
our financial condition or results of operations. However, the outcome of any
single event could have a material impact upon the quarterly or annual financial
results of the period in which it occurs.
The Company and certain of our key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by our shareholders, on
their own behalf and on behalf of a putative class of similarly situated
shareholders who purchased shares of the Company's common stock between July 23,
2000 through and including March 29, 2001.
31
The consolidated amended class action complaint seeks damages in an
unspecified amount for losses allegedly incurred as a result of misstatements
and omissions allegedly contained in our periodic reports filed with the SEC,
certain press releases issued by us, and in other statements made by our
officials. The alleged misstatements and omissions relate, among other matters,
to the statutory capital and surplus position of our largest subsidiary, Penn
Treaty Network America Insurance Company. On December 7, 2001, the defendants
filed a motion to dismiss the complaint, which was denied. We believe that the
complaint is without merit, and we will continue to vigorously defend the
matter.
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
The Company's Annual Meeting of Shareholders was held on May 24, 2002. At
this meeting, the following matters were voted upon by the shareholders,
receiving the number of affirmative, negative and withheld votes, as well as
abstentions and broker non-votes, set forth below each matter.
1. To elect three persons (Francis R. Grebe, Michael F. Grill and Gary E.
Hindes) to Penn Treaty's Board of Directors as Class III Directors to serve
until the 2005 Annual Meeting of Shareholders and until their successors
are elected and have been qualified.
For Against Abstentions
--- ------- -----------
16,270,194 0 576,213
2. To approve the 2002 Employee Incentive Stock Option Plan.
For Against Abstentions
--- ------- -----------
6,270,082 1,008,683 30,227
3. To ratify and approve the issuance of:
o Warrants to purchase shares of the Company's convertible preferred
stock,
o Shares of convertible preferred stock upon the proper exercise of the
warrants, and
o Shares of common stock upon proper conversion of the convertible
preferred stock,
All as provided in connection with the reinsurance agreement entered into
with Centre Solutions (Bermuda), Limited.
For Against Abstentions
--- ------- -----------
6,970,319 301,323 7,350
32
4. To ratify the selection of PricewaterhouseCoopers LLP as the independent
public accountants for the Company and its subsidiaries for the year ending
December 31, 2002.
For Against Abstentions
--- ------- -----------
16,639,089 12,572 194,746
5. To transact other business that properly comes before the Annual Meeting,
or any adjournments or postponements.
For Against Abstentions
--- ------- -----------
15,960,891 669,976 215,540
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
Exhibit Number Description
------------- -----------
99.1 Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act.
99.2 Certification of President and Chief Operating Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act.
99.3 Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act.
33
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: August 14, 2002 /s/ Irving Levit
--------------- ------------------------------------
Irving Levit
Chairman of the Board and
Chief Executive Officer
Date: August 14, 2002 /s/ Cameron B. Waite
--------------- ------------------------------------
Cameron B. Waite
Executive Vice President and
Chief Financial Officer
34
Exhibit 99.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Penn Treaty American Corporation (the
"Company") on Form 10-Q for the period ending June 30, 2002, as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Irving
Levit, Chairman and Chief Executive Officer of the Company, certify, pursuant to
18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of
2002, that:
(1) The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
/s/ Irving Levit
Irving Levit
Chairman and
Chief Executive Officer
August 14, 2002
35
Exhibit 99.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Penn Treaty American Corporation (the
"Company") on Form 10-Q for the period ending June 30, 2002, as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, William
W. Hunt, President and Chief Operating Officer of the Company, certify, pursuant
to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act
of 2002, that:
(1) The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
/s/ William W. Hunt
William W. Hunt
President and
Chief Operating Officer
August 14, 2002
36
Exhibit 99.3
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Penn Treaty American Corporation (the
"Company") on Form 10-Q for the period ending June 30, 2002, as filed with the
Securities and Exchange Commission on the date hereof (the "Report"), I, Cameron
B. Waite, Executive Vice President and Chief Executive Officer of the Company,
certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the
Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of Section 13(a) or 15(d)
of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material
respects, the financial condition and results of operations of the Company.
/s/ Cameron B. Waite
Cameron B. Waite
Executive Vice President and
Chief Financial Officer
August 14, 2002
37