UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 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
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(Exact name of registrant as specified in its charter)
Pennsylvania 23-1664166
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3440 Lehigh Street 18103
Allentown, Pennsylvania ----------
---------------------------------------- (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (610) 965-2222
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Securities registered pursuant to Section 12(b) of the Act:
Common Stock, par value $.10 per share New York Stock Exchange
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(Title of Class) (Name of each exchange
on which registered)
Securities registered pursuant to Section 12(g) of the Act: None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (section 229.405 of this chapter) is not contained herein,
and will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [X]
Indicate by checkmark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act. Yes [ ] No [X]
Based upon the last sale price of the registrant's Common Stock on June 28,
2002, the aggregate market value of the 19,907,737 outstanding shares of voting
stock held by non-affiliates of the registrant was $89,584,817.
As of March 31, 2003, 19,907,737 shares of the registrant's Common Stock
were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following documents are incorporated by reference in this
Annual Report on Form 10-K:
1) The registrant's definitive Proxy Statement for its Annual Meeting of
Stockholders to be filed not later than 120 days after the close of
the fiscal year (incorporated into Part III).
2) Other documents incorporated by reference on this report are listed in
the Exhibit Index.
Table of Contents
Page
PART I
------ 3
ITEM 1. BUSINESS 3
ITEM 2. PROPERTIES 42
ITEM 3. LEGAL PROCEEDINGS 42
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS 43
PART II
------- 44
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS 44
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA 45
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 49
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK 79
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 81
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE 81
PART III
-------- 82
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 82
ITEM 11. EXECUTIVE COMPENSATION 82
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 82
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 82
PART IV
------- 82
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
REPORTS ON FORM 8-K 82
PART I
ITEM 1. BUSINESS
Certain statements made by us in this filing may be considered
forward-looking within the meaning of the Private Securities Litigation Reform
Act of 1995. Although we believe that our expectations are based on reasonable
assumptions within the bounds of our knowledge of our business and operations,
there can be no assurance that our actual results of operations will not differ
materially from our expectations. Factors which could cause actual results to
differ from expectations include those described in the risk factors.
(a) Penn Treaty American Corporation
We are a leading provider of long-term care insurance in the United States.
Our principal products are individual, defined benefit accident and health
insurance policies covering long-term skilled, intermediate and custodial
nursing home and home health care. Our policies are designed to provide
meaningful benefits if and when the insured is no longer capable of functioning
independently. We also own insurance agencies that sell senior-market insurance
products issued by us as well as other insurers.
We introduced our first long-term nursing home insurance product in 1972
and our first home health care insurance product in 1983. Since then we have
innovated several new products designed to meet the changing needs of our
customers that were the first of their kind in the long-term care industry. Our
primary product offerings are:
o The Assisted Living(R)policy, which provides coverage for all
levels of facility care and includes a home health care rider;
o The Personal Freedom(R)policy, which provides comprehensive
coverage for facility and home health care; and
o The Independent Living(R)policy, which provides coverage for home
and community based care furnished by licensed care providers, as
well as unlicensed caregivers, homemakers or companions.
Although nursing home and home health care policies accounted for
approximately 96% of our total annualized premiums in-force as of December 31,
2002, we also market and sell life, disability and Medicare supplement products.
We maintain and administer one of the largest individual long-term care
insurance portfolios in the country. Our sales and marketing efforts through our
independent agency distribution channels were very successful between 1995 and
2000 as total in-force premiums grew at a compound annual rate of approximately
29% from $102 million to $360 million. Our total in-force premiums were $345
million at December 31, 2002.
Our premium growth led to diminished surplus levels due to the statutory
surplus strain arising from new business generation. In 2001, we ceased new
policy sales nationwide as a result of our surplus levels until we formulated a
Corrective Action Plan (the "Plan") with the Pennsylvania Insurance Department
(the "Department"). Upon the Department's approval of the Plan in February 2002,
we recommenced new policy sales in 23 states, including Pennsylvania. We have
now recommenced new policy sales in 10 additional states, including Florida,
Virginia and Texas, which have historically represented approximately 18%, 7%
and 5% of our new policy sales, respectively. We are actively working with the
remaining states to recommence new policy sales in all jurisdictions. We have
recently agreed upon terms for the recommencement of sales in California, which
is pending upon the completion of certain conditions. California has
historically represented approximately 15% of our new policy sales.
3
As part of the Plan, effective December 31, 2001, we entered into a
reinsurance agreement with Centre Solutions (Bermuda) Limited 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
and an aggregate limit of liability, which may be reduced if we are unable to
obtain premium rate increases required by the agreement. The agreement meets the
requirements to qualify as reinsurance for statutory accounting, but not for
generally accepted accounting principles.
The Long-Term Care Insurance Industry
The long-term care insurance market has grown rapidly in recent years.
According to studies by Conning & Co. and LifePlans, Inc., the long-term care
insurance market experienced a compound average growth rate of 20.1% from 1994
to 1999, rising from approximately $1.7 billion of net written premiums in 1994
to approximately $4.2 billion of net written premiums in 1999. We expect this
growth to continue based on the projected demographics of the United States
population, the rising costs of health care and a regulatory environment that
supports the use of private long-term care insurance.
The population of senior citizens (people age 65 and over) in the United
States is projected to grow from an estimated level of approximately 35 million
in 2002 to approximately 70 million by 2030, according to a 2000 U.S. Census
Bureau report. Furthermore, health and medical technologies are improving life
expectancy and, by extension, increasing the number of people requiring some
form of long-term care. The projected growth of the target population indicates
a substantial growth opportunity for companies providing long-term care
insurance products. We believe that the rising cost of nursing home and home
health care services, along with the increasing strain these services are having
on the state and federally-financed Medicaid system (which is the largest payer
of long-term care services) makes long-term care insurance an attractive means
to pay for these services. According to a 2001 report by the Centers for
Medicare and Medicaid Services, the combined cost of home health care and
nursing home care was $20.0 billion in 1980. By 2001, this cost had risen to
$132.1 billion. These costs are projected to rise to $158.8 billion by 2004.
Our Strategy
We seek to enhance shareholder value by strengthening our position as a
leading provider of long-term care insurance. Our value proposition incorporates
innovative product development, stratification of risk, efficient and effective
underwriting and an individualized service culture for agents and policyholders.
We expect that these characteristics will provide for the reengagement of
currently licensed agents and the recruitment of new agents to generate new
policy sales. We intend to achieve our goal of profitable growth by executing
the following strategies:
Recommencement of sales and marketing efforts in all states. In 2001, we
ceased new policy sales nationwide as a result of diminished surplus levels. We
have recommenced new policy sales in 33 states, and have recently agreed upon
terms for the recommencement of sales in California. We are working closely with
the insurance departments of the remaining states to recommence new policy sales
in all jurisdictions.
4
The sale of our current policies, which we believe are priced with
appropriate profit margins, is an important component of our earnings per share
growth in the future. We have reached this conclusion because over the past
year, we have evaluated the profitability of our in-force business and the
policies we currently sell with the assistance of our in-house and consulting
actuaries. Although the in-force business we sold prior to 2002, including our
agency subsidiaries, remains marginally profitable, sales of new policies are
expected to be the driving force in generating profits in the future.
Reengagement of our existing sales force and the expansion of distribution
opportunities. In connection with our efforts to recommence sales, we have also
been actively involved in reengaging our network of agents. We recognize that
our ability to generate new policy sales is highly dependent on experienced and
talented agents who understand the needs of our target market. We intend to
continue to recruit agents as we recommence new policy sales throughout the
United States.
Besides providing innovative products, competitive commissions and
personalized service, our strategy to reengage our sales force is highly
dependent upon our claims paying ability, ratings from independent rating
agencies, our financial strength, and reputation with agents and policyholders.
We believe that the actions taken pursuant to the Plan, which includes the
additional statutory capital provided by the issuance of new Convertible
Subordinated Notes due 2008, will enhance the likelihood that rating agencies
will increase our ratings. In addition, we plan to continue our focus on agent
communication and education by providing our sales force with periodic updates
regarding the progress achieved in the execution of the Plan.
Enhancement of our leadership team and financial management capability. We
have significantly strengthened our leadership team through the addition of
individuals with the experience and skills necessary to create value for all of
the Company's stakeholders, which include our investors, policyholders, agents
and employees.
Our senior executives have a wide breadth of financial services industry
experience. We recently added a new Chief Accounting Officer. At our last annual
meeting, shareholders elected a new outside member to the Board of Directors who
brings over 25 years of capital markets experience and is a Managing Director at
a New York investment firm. Our President and Chief Operating Officer was
recruited in May 2001 and appointed to his current position in May 2002. We
hired our Vice President and Chief Actuary in June 2001. In November 2002 and
February 2003, respectively, we hired two additional internal actuaries.
In addition to our efforts to grow our business and serve our agents and
policyholders, our management team will be focusing on our business via the
utilization of customized actuarial models and other financial projection tools.
5
Increase our operational efficiency through technological improvements. We
have embarked on a system replacement project ("SRP") that will redesign our
long-term care administration systems over the next three years. Our SRP
includes the assessment of each major task performed in our daily operations and
the identification of value and non-value added functions. As part of our SRP,
we are redesigning each major process within our business model in order to gain
operational efficiency through the redesign and deployment of Company resources.
Our SRP design is specific to the processing and administration of long-term
care insurance and, we believe, is unique in the industry. Each program
component is modular and allows us to custom design its functionality. We expect
to recuop our initial expenses for the program through consistent underwriting,
policy issuance and claims processing efficiencies.
Upon completion of the SRP, we expect to use our new long-term care
insurance administration system not only to provide our Company with a more
efficient and effective business model, but also to provide third-party
administration services for other long-term care insurance carriers. We expect
this service will diversify our future revenue and profit streams by
capitalizing on our core competencies as a leader in the long-term care
insurance marketplace.
Development and approval of new products. We have sold long-term care
insurance for over 30 years. As an innovator in nursing home and home health
care insurance products, we have introduced many new policies over the years,
including four new products in the last six years. We continually discuss
long-term care insurance needs with our agency sales force and policyholders. As
a result, we are able to design new products and offer what we believe to be the
most comprehensive benefit features in the industry. The development of new
products enables us to generate new business and provide advancements in the
benefits we offer. We are currently in the process of developing the next
generation of insurance products designed to meet the needs of policyholders and
their families. We anticipate introducing these products in 2003.
Risk Factors
Our business would be materially adversely affected if we were unable to
continue selling policies or are unsuccessful in recommencing new policy sales
in a few key states.
Historically, our business has been concentrated in a few key states. Over
the past four fiscal years, approximately half of our premiums came from sales
of policies in California, Florida and Pennsylvania. Although, we have since
recommenced new policy sales in 33 states, including Pennsylvania and Florida
and are pending final approval in California, we have not yet recommenced new
policy sales in 16 other states. We are working with the remaining states to
recommence sales in all jurisdictions.
We have agreed to conditions for the recommencement of business in
Pennsylvania and Florida. We recently agreed to conditions, which when met will
permit us to recommence sales in California. If we were found not to be in
compliance, we could be forced to stop new policy sales. Each state insurance
department may impose conditions on our recommencing or continuing new policy
sales in its state. If we are unable to continue selling new policies in our key
states or we are unsuccessful in recommencing new policy sales in any of our
remaining key states, our financial condition and results of operations could be
materially adversely affected.
6
We may not have enough statutory capital and surplus to continue to write
business.
Our continued ability to write business is dependent on maintaining
adequate levels of statutory capital and surplus to support the policies we
write. Our new business writing typically results in net losses on a statutory
basis during the early years of a policy, due primarily to differences in
accounting practices between statutory accounting principles and generally
accepted accounting principles. The resulting reduction in statutory surplus, or
surplus strain, limits our ability to seek new business due to statutory
restrictions on premium to surplus ratios and statutory surplus requirements. If
we cannot generate sufficient statutory surplus to maintain minimum statutory
requirements through increased statutory profitability, reinsurance or other
capital generating alternatives, we will be limited in our ability to realize
additional premium from new business writing, which could have a material
adverse effect on our financial condition and results of operations, or, in the
event that our statutory surplus is not sufficient to meet minimum premium to
surplus and risk based capital ratios in any state, we could be prohibited from
writing new policies in such state.
We may be unable to service and repay our debt obligations, which could cause a
payment default.
We are an insurance holding company whose assets principally consist of the
capital stock of our operating subsidiaries. Our ability to redeem, repurchase
or make interest payments on our outstanding debt is dependent upon the ability
of our subsidiaries to pay cash dividends or make other cash payments to us. Our
insurance subsidiaries are subject to state laws and regulations and an order of
the Department, which restrict their ability to pay dividends and make other
payments to us.
We believe that we have sufficient funds to service our debt obligations
through April 2004. However, we may not have sufficient funds to make our
interest payment in October 2004. If we are unable to generate sufficient funds
through operations or raise additional capital to meet our debt service
obligations in October 2004 or if our assumptions about our ability to service
our debt prior to 2004 are not correct, we may default on our debt obligations.
We could suffer a loss if our premium rates are not adequate and we are
unable to obtain necessary state approvals for premium rate increases.
We set our premiums based on assumptions about numerous variables,
including our estimate of the probability of a policyholder's making a claim,
the severity and duration of such claim, the mortality rate of our
policyholders, the persistency or renewal of our policies in-force, and the
amount of interest we expect to earn from the investment of premiums. In setting
premiums, we consider historical claims information, industry statistics, and
other factors.
7
Based on our recent studies, we believe that policy forms being offered and
currently sold are priced to provide a satisfactory profit margin. However,
those studies also suggest that some of our older policies are only marginally
profitable and some are unprofitable. As a result we are commencing efforts to
obtain rate increases on such polices, which may include some policies that
previously received a rate increase. If our actual experience proves to be less
favorable than we assumed and we are unable to raise our premium rates, our
financial condition and results of operations could be materially adversely
affected.
We generally cannot raise our premiums in any state unless we first obtain
the approval of the insurance regulator in that state. Although we have sought
and received approval for rate increases in the past, we cannot assure you that
we will be able to obtain approval for premium rate increases from existing
requests or requests filed in the future. Consequently, if we are unable to
raise our premium rates because we fail to obtain approval for a rate increase
in one or more states, our financial condition and results of operations could
be materially adversely affected.
As a result of any premium rate increases permitted by state regulators, we
could experience anti-selection, which is the lapsation of policies held by
healthier policyholders. Anti-selection could cause our actual claims to exceed
our expectations based on the higher risk of the remaining policyholders. As a
result, our financial condition and results of operations could be materially
adversely affected.
Our reserves for current and future claims may be inadequate and any increase to
such reserves may have a material adverse effect on our financial condition.
We calculate and maintain reserves for current and future claims using
assumptions about numerous variables, including our estimate of the probability
of a policyholder's making a claim, the severity and duration of such claim, the
mortality rate of our policyholders, the persistency or renewal of our policies
in-force, and the amount of interest we expect to earn from the investment of
premiums. The adequacy of our reserves depends on the accuracy of our
assumptions. We cannot assure you that actual experience will not differ from
the assumptions used in the establishment of reserves. Any variance from these
assumptions could have a materially adverse effect on our financial condition
and results of operations in the future. For a discussion of prior additions to
our reserves, see "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
Our unamortized deferred policy acquisition cost asset may not be fully
recoverable, which would result in an impairment charge and could materially
adversely affect our financial condition and results of operations.
In connection with the sale of our insurance policies, we defer and
amortize the policy acquisition costs over the related premium paying periods
throughout 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. In
addition, we periodically review and update the assumptions underlying DAC and
our policy reserves to reflect current assumptions. In the event that we would
determine that our DAC is not fully recoverable, we would impair the value of
our DAC and would fully expense the impaired amount. As a result, our financial
condition and results of operations could be materially adversely affected. At
December 31, 2002, unamortized DAC was $171 million. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations Overview."
8
Declines in the value of, or the yield on, our notional experience account or
our investment portfolio may adversely affect our financial condition and
results of operations.
Our reinsurance agreement with Centre Solutions (Bermuda) Limited reinsures
(for statutory purposes), on a quota share basis, substantially all of our
long-term care insurance policies in-force at December 31, 2001. The transaction
resulted in the transfer of approximately $563 million of securities to the
reinsurer. The reinsurer maintains a notional experience account for our benefit
in the event of commutation. The notional experience account reflects the
initial premium paid, future premiums collected net of claims, expenses and
accumulated investment earnings. The notional experience account balance
receives an investment credit based on the total return of a series of benchmark
indices and hedges, which are designed to match closely the duration of reserve
liabilities. As a result, we have experienced, and may continue to experience,
significant volatility in our financial condition and results of operations. See
"Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for a
discussion of the market value sensitivitiy and volatility of our investments
and experience account to changes in market interest rates.
Income from our investment portfolio is an element of our overall net
income. We are susceptible to changes in market interest rates when cash flows
from maturing investments are reinvested at prevailing market rates. If our
investments do not perform well, our financial condition and results of
operations could be materially adversely affected.
In addition, in establishing the level of our reserves for future policy
claims and benefits, we make assumptions about the performance of our
investments. If our investment income or the capital gains in our portfolio are
lower than expected, we may have to increase our reserves, which could
materially adversely affect our financial condition and results of operations.
Our reinsurance agreement with Centre Solutions (Bermuda) Limited is subject to
an aggregate limit of liability, which, if exceeded, could adversely impact our
financial condition and results of operations.
Our reinsurance agreement with Centre Solutions (Bermuda) Limited is
subject to certain coverage limitations and an aggregate limit of liability.
Moreover, the aggregate limit of liability may be reduced if we are unable to
obtain premium rate increases deemed necessary by the provisions of the
agreement and if certain other events occur.
Also, our Plan with the Department requires us to increase our statutory
reserves by an additional $125 million, of which $48 million remains to be
increased throughout the 2003-2004 period. Although the reinsurance agreement
currently provides us with the capacity to accomplish this increase, if the
aggregate limit of liability is expected to be exceeded, we would be unable to
receive full statutory credit for the cession of our reserves, resulting in the
reduction of our statutory surplus and the possible breach of this provision of
the Plan.
9
In the event that (1) the reinsurer's limit of liability is reduced or
exceeded, (2) the reinsurance agreement is cancelled, or (3) our reinsurer is
not able to satisfy its obligations to us, our financial condition, results of
operations and statutory surplus could be materially adversely affected.
We may have insufficient capital and surplus to commute our reinsurance
agreement with Centre Solutions (Bermuda) Limited, which could adversely impact
our financial results and cause substantial dilution to shareholders.
We are entitled to commute (i.e., recapture the reserve liabilities on the
underlying policies) our reinsurance agreement with Centre Solutions (Bermuda)
Limited on December 31, 2007 or any December 31 thereafter. To be able to do so,
we would be required to have amounts of statutory capital and surplus which
would support recapturing the statutory liability for such policies. We do not
currently have enough statutory capital and surplus to do so. However, we
believe, based upon our most recent projections and modeling, it is probable
that our business will be sufficiently profitable in the future and that we will
have a sufficient amount of statutory capital and surplus to do so by December
31, 2007 or that viable alternatives, such as additional capital issuance or new
reinsurance opportunities, are available to enable us to commute the agreement.
If we do not have a sufficient amount of statutory capital and surplus to
commute the agreement on December 31, 2007, the amounts credited against our
experience account to Centre Solutions (Bermuda) Limited under the reinsurance
agreement will be substantially increased. In addition, in such circumstances,
Centre Solutions (Bermuda) Limited would become entitled to exercise a tranche
of warrants. The warrants are exercisable for convertible preferred stock which,
if converted, and when combined with the conversion of preferred stock issuable
upon exercise of the first three tranches of warrants, would result in the
issuance to Centre Solutions (Bermuda) Limited of approximately 35% of our
common stock outstanding after such issuance on a fully diluted basis. The
issuance of such shares would dilute the interest of our existing security.
Our reinsurers may not satisfy their obligations to us, which could materially
adversely affect our financial condition and results of operations.
We obtain reinsurance from unaffiliated reinsurers, in addition to Centre
Solutions (Bermuda) Limited, on certain of our policies. Although each reinsurer
is liable to us to the extent the risk is transferred to such reinsurer,
reinsurance does not relieve us of liability to our policyholders. Accordingly,
we bear credit risk with respect to all of our reinsurers. We cannot assure you
that our reinsurers will pay all of our reinsurance claims or that they will pay
our reinsurance claims on a timely basis. The failure of our reinsurers to make
such payments may have a material adverse effect on our financial condition or
results of operations.
We may not be able to compete successfully with insurers that have greater
financial resources or better financial strength ratings.
10
We sell our products in highly competitive markets. We compete with large
national insurers, smaller regional insurers and specialty insurers. Many
insurers are larger than we are and many have greater resources and better
financial strength ratings than we do. Most insurers also have not experienced
the regulatory problems we have faced. In addition, we are subject to
competition from insurers with broader product lines. We also may be subject,
from time to time, to new competition resulting from changes in Medicare
benefits, as well as from insurance carriers introducing products similar to
those offered by us. Also, the removal of regulatory barriers (including as a
result of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999)
could result in new competitors entering the long-term care insurance business.
These new competitors may include diversified financial services companies that
have greater financial resources than we do and that have other competitive
advantages, such as large customer bases and extensive branch networks for
distribution.
The financial strength ratings assigned to our insurance company
subsidiaries by A.M. Best Company, Inc. and Standard & Poor's Insurance Rating
Services, two independent insurance industry rating agencies, affect our ability
to expand and to attract new business. A.M. Best's ratings for the industry
range from "A++ (superior)" to "F (in liquidation)." Standard & Poor's ratings
range from "AAA (extremely strong)" to "CC (extremely weak)." A.M. Best and
Standard & Poor's insurance company ratings are based upon factors of concern to
policyholders and insurance agents and are not directed toward the protection of
investors. Our subsidiaries that are rated have A.M. Best ratings of "B- (fair)"
and/or Standard & Poor's ratings of "B- (weak)."
Certain distributors will not sell our products unless we have a financial
strength rating of at least "A-." Similarly, certain prospective customers may
decline to purchase new policies because of a perceived risk of non-payment of
policy benefits due to our financial condition. Our inability to achieve
increased ratings could have a material adverse effect on our financialcondition
or results of operations.
We may suffer reduced income if governmental authorities change the regulations
applicable to the insurance industry.
Our insurance subsidiaries are subject to comprehensive regulation by state
insurance regulatory authorities. The laws of the various states establish
insurance departments with broad powers with respect to such things as licensing
companies to transact business, licensing agents, prescribing accounting
principles and practices, admitting statutory assets, mandating certain
insurance benefits, regulating premium rates, approving policy forms, regulating
unfair trade, regulating market conduct and claims practices, establishing
statutory reserve requirements and solvency standards, limiting dividends,
restricting certain transactions between affiliates and regulating the types,
amounts and statutory valuation of investments. The primary purpose of such
regulation is to protect policyholders, not shareholders.
State legislatures, state insurance regulators and the National Association
of Insurance Commissioners ("NAIC") continually reexamine existing laws and
regulations, and may impose changes in the future that materially adversely
affect our financial condition and results of operations and could make it
difficult or financially impracticable to continue doing business. Some states
limit rate increases on long-term care insurance products and other states have
considered doing so. Because insurance premiums are our primary source of
income, our financial condition and results of operations may be negatively
affected by any of these changes.
11
Certain legislative proposals could, if enacted or further refined,
adversely affect our financial condition and results of operations. These
include the implementation of minimum consumer protection standards for
inclusion in all long-term care policies, including: guaranteed premium rates;
protection against inflation; limitations on waiting periods for pre-existing
conditions; setting standards for sales practices for long-term care insurance;
and guaranteed consumer access to information about insurers, including lapse
and replacement rates for policies and the percentage of claims denied. In
addition, recent Federal financial services legislation requires states to adopt
laws for the protection of consumer privacy. Compliance with various existing
and pending privacy requirements also could result in significant additional
costs to us.
We may not be able to compete successfully if we cannot recruit and retain
insurance agents.
We distribute our products principally through independent agents whom we
recruit and train to market and sell our products. We also engage marketing
general agents from time to time to recruit independent agents and develop
networks of agents in various states. We compete vigorously with other insurance
companies for productive independent agents, primarily on the basis of our
financial position, support services, compensation and product features. When we
ceased sales in 2001, many of our agents continued the sale of long-term care
insurance products issued by our competitors. We may not be able to attract (or
in the case of agents who have begun writing long-term care products for our
competitors, to re-engage) and retain independent agents to sell our products,
especially if we are unable to obtain permission to recommence new policy sales
in the 16 states where we are not currently offering new policies. Because our
future profitability depends primarily on new policy sales, our business and
ability to compete would suffer if we are unable to recruit and retain insurance
agents or if we lost the services provided by our marketing agents.
Litigation may result in financial losses or harm our reputation and may divert
management resources.
Current and future litigation may result in financial losses, harm our
reputation and require the dedication of significant management resources. We
are regularly involved in litigation. The litigation naming us as a defendant
ordinarily involves our activities as an insurer. In recent years, many
insurance companies have been named as defendants in class actions relating to
market conduct or sales practices, and other long-term care insurance companies
have been sued when they sought to implement premium rate increases.
Our Company and its subsidiary, Penn Treaty Network America Insurance
Company, are defendants in an action in the United States District Court, Middle
District of Florida, Ocala Division. Plaintiffs filed this matter on January 10,
2003 in the Fifth Judicial Circuit of the State of Florida in and for Marion
County, Civil Division, on behalf of themselves and a class of similarly
situated Florida long term care policyholders. We removed this case from the
Florida state court to Federal Court on February 6, 2003. Plaintiffs claim
wrongdoing in connection with the sale of long term care insurance policies to
the Plaintiffs and the Class. Plaintiffs allege claims for reformation, breach
of fiduciary duty, breach of the implied duty of good faith and fair dealing,
negligent misrepresentation, fraudulent misrepresentation, and restitution. We
filed motions to dismiss for failure to state a claim, lack of personal
jurisdiction against the Company, and a motion to strike certain allegations of
the Complaint as irrelevant and improper. Plaintiffs filed a motion to remand on
March 7, 2003. Briefing is continuing on all of these motions. While we cannot
predict the outcome of this case, the results could have a material adverse
impact upon our financial condition and results of operations. However, we
believe that the Complaint is without merit and intend to continue to defend the
matter vigorously.
12
Our 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 shareholders of the
Company, on their own behalf and on behalf of a putative class of similarly
situated shareholders who purchased shares of our common stock between 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 our periodic
reports filed with the SEC, certain of our press releases, and in other
statements made by us. 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 July 1, 2002, the
defendants filed an answer to the complaint, denying all liability. Plaintiffs
filed a motion for class certification on August 15, 2002, which is currently
pending. On February 26, 2003, the parties reached an agreement in principle to
settle the litigation for $2.3 million, to be paid entirely by our directors and
officers liability insurance carrier. The settlement remains subject to
documentation and court approval.
Our Company and two of our subsidiaries, Penn Treaty Network America
Insurance Company and Senior Financial Consultants Company, are defendants in an
action instituted on June 5, 2002 in the United States District Court for the
Eastern District of Pennsylvania by National Healthcare Services, Inc. The
complaint seeks compensatory damages in excess of $150,000 and punitive damages
in excess of $5 million for an alleged breach of contract and misappropriation.
The claims arise out of a joint venture related to the AllRisk Healthcare
program, which was marketed first by Penn Treaty Network America Insurance
Company and then later by Senior Financial Consultants Company. The defendants
have denied the allegations of the complaint and will continue to defend the
matter vigorously. We believe that any resolution of this action will be
immaterial to our financial condition or results of operations.
Certain anti-takeover provisions in state law and our Articles of Incorporation
may make it more difficult to acquire us and thus may depress the market price
of our common stock.
Our Restated and Amended Articles of Incorporation, the Pennsylvania
Business Corporation Law of 1988, as amended, and the insurance laws of states
in which our insurance subsidiaries do business contain certain provisions which
could delay or impede the removal of incumbent directors and could make a
merger, tender offer or proxy contest involving us difficult, even if such a
transaction would be beneficial to the interests of our shareholders, or
discourage a third party from attempting to acquire control of us. In
particular, the classification and three-year terms of our directors could have
the effect of delaying a change in control. Insurance laws and regulations of
Pennsylvania and New York, our insurance subsidiaries' states of domicile,
prohibit any person from acquiring control of us, and thus indirect control of
our insurance subsidiaries, without the prior approval of the insurance
commissioners of those states.
13
Corporate Background
Penn Treaty American Corporation ("Penn Treaty") is registered and approved
as a holding company under the Pennsylvania Insurance Code. Penn Treaty was
incorporated in Pennsylvania on May 13, 1965 under the name Greater Keystone
Investors, Inc. and changed its name to Penn Treaty American Corporation on
March 25, 1987. Our primary business is the sale of long-term care insurance,
which we conduct through the following subsidiaries:
o Penn Treaty Network America Insurance Company--a Pennsylvania
based insurance company, formed from the merger of Penn Treaty
Life (formerly Greater Keystone Investors, Inc.) and Network
America Life Insurance Companies (formerly Amicare Insurance
Company, which we purchased in 1989);
o American Network Insurance Company--a Pennsylvania based
insurance company we acquired in 1996; and
o American Independent Network Insurance Company of New York--a New
York based insurance company we incorporated in 1998.
We also conduct insurance agency operations through the following
subsidiaries:
o Senior Financial Consultants Company--a Pennsylvania based
insurance agency brokerage company we incorporated in 1988;
o United Insurance Group Agency, Inc.--a Michigan based consortium
of long-term care insurance agencies we acquired in 1999; and
o Network Insurance Senior Health Division--a Florida based
insurance agency brokerage company we purchased in 2000.
In 1999, we incorporated Penn Treaty (Bermuda), Ltd., a Bermuda based
reinsurer, for the purpose of reinsuring affiliated long-term insurance
contracts at a future date. We are in the process of closing our operations and
dissolving Penn Treaty (Bermuda), Ltd., and anticipate that this will be
completed during the second quarter of 2003. This will not have a material
impact on our financial condition or results of operations.
(b) Insurance Products
Since 1972, we have developed, marketed and sold defined benefit accident
and health insurance policies designed to be responsive to changes in:
o the characteristics and needs of the senior insurance market;
14
o governmental regulations and governmental benefits available for
senior citizens; and
o the health care and long-term care delivery systems.
As of December 31, 2002, approximately 96% of our total annualized premiums
in-force were derived from long-term care policies, which include nursing home
and home health care policies. Our other lines of insurance include life,
disability and Medicare supplement products. We solicit input from both our
independent agents and our policyholders with respect to the changing needs. In
addition, our representatives regularly attend regulatory meetings and seminars
to monitor significant trends in the long-term care industry.
Our focus on long-term care insurance has enabled us to gain expertise in
claims and underwriting which we have applied to product development. Through
the years, we have continued to build on our brand names by offering the
independent agency channel a series of differentiated products.
15
The following table sets forth, at the dates indicated, information related
to our policies in force:
(annualized premiums in $000's)
Year ended December 31,
--------------------------------------------------------------------
2002 2001 2000
---- ---- ----
Long-term facility, home and comprehensive coverage:
Annualized premiums $ 344,771 95.7% $ 351,268 95.0% $ 360,600 95.1%
Number of policies 204,429 242,644 242,075
--------- --------- ---------
Average premium per policy $ 1,687 $ 1,448 $ 1,490
========= ========= =========
Disability insurance:
Annualized premiums $ 2,529 0.7% $ 6,415 1.7% $ 6,634 1.8%
Number of policies 6,187 13,226 13,502
--------- --------- ---------
Average premium per policy $ 409 $ 485 $ 491
========= ========= =========
Medicare supplement:
Annualized premiums $ 9,726 2.7% $ 8,449 2.3% $ 7,314 1.9%
Number of policies 8,566 8,216 7,696
--------- --------- ---------
Average premium per policy $ 1,135 $ 1,028 $ 950
========= ========= =========
Life insurance:
Annualized premiums $ 2,957 0.8% $ 3,310 0.9% $ 3,785 1.0%
Number of policies 5,282 5,756 6,315
--------- --------- ---------
Average premium per policy $ 560 $ 575 $ 599
========= ========= =========
Other insurance:
Annualized premiums $ 424 0.1% $ 398 0.1% $ 609 0.2%
Number of policies 2,445 2,459 3,900
--------- --------- ---------
Average premium per policy $ 173 $ 162 $ 156
========= ========= =========
Total annualized premiums in force $ 360,407 100% $ 369,840 100% $ 378,942 100%
Total Policies 226,909 272,301 273,488
We received an insurance license in 1972, which permitted us to write
insurance in 12 states. In 1974, we offered our first long-term care policy,
which provided a five year benefit for nursing facility coverage care. This was
the first long-term care insurance product to cover all levels of facility care,
including skilled, intermediate and custodial care, and with an extended five
year benefit period.
In 1983, we began the sale of home health care riders, which pay for
licensed nurses, certified nurses' aides and home health care workers who
provide care/assistance in the policyholder's home. In 1987, we began offering a
stand-alone home care policy, which was the first in the industry to include a
limited benefit for homemaker care provided by an unskilled, unlicensed
individual such as a friend or neighbor.
In 1986, we began the use of table-based underwriting, which enables higher
risk policyholders to receive coverage at a risk-adjusted premium rate. The
table-based underwriting method considers medical conditions and the likelihood
of inability to perform daily activities to determine appropriate premium
levels. Multiple rate classes enabled us to penetrate an untapped market in
long-term care insurance sales.
16
In 1994, we introduced the Independent Living(R) policy--the first to
provide benefits for care provided by family members, subject to our
preapproval. In 1996, we introduced the Personal Freedom(R) product line. This
comprehensive policy provides benefits for both nursing facility and home health
care based upon one "pool" of benefit dollars, to be used for either type of
care, as needed. In 1997, we offered our Pledge and Promise, committing to allow
policyholders the ability to convert their policy from non-tax qualified to
qualified in the event benefit payments were determined to be taxable for a
non-tax qualified plan. In 1998, we introduced the Secured Risk(R) product, a
highly underwritten, limited benefit policy, designed solely for previously
uninsurable risks.
Long-Term Nursing Home Care. Our long-term nursing home care policies
provide a benefit payable during periods of nursing facility confinement
prescribed by a physician or necessitated by the policyholder's cognitive
impairment or inability to perform two or more activities of daily living (such
as bathing or dressing). These policies also include built-in benefits for
alternative plans of care, waivers of premiums after 90 days of benefit payments
on a claim, and restoration of the policy's maximum benefit period. All levels
of nursing care, including skilled, intermediate and custodial (assisted
living), are covered and benefits continue even when the policyholder's required
level of care changes. Skilled nursing care refers to professional nursing care
provided by a medical professional (a doctor or registered or licensed practical
nurse) located at a licensed facility that cannot be provided by a non-medical
professional. Intermediate nursing care is designed to cover situations that
would otherwise fall between skilled and custodial care and includes situations
in which an individual may require skilled assistance on a sporadic basis.
Custodial care generally refers to non-medical care, which does not require
professional treatment and can be provided by a non-medical professional with
minimal or no training.
Our current long-term nursing home care policies provide benefits that are
payable for defined benefit periods ranging from one to five years, or the
lifetime of the policyholder. Certain of these policies provide for a maximum
daily benefit on an expense-incurred basis or on an indemnity basis ranging in
either case from $60 to $300 per day. We also offer a policy that provides
comprehensive coverage for nursing home and home health care, offering benefit
"pools of coverage" ranging from $75,000 to $500,000, as well as unlimited
coverage.
Long-Term Home Health Care. Our home health care policies generally provide
a benefit payable on an expense-incurred basis during periods of home care
prescribed by a physician or necessitated by the policyholder's cognitive
impairment or inability to perform two or more activities of daily living. These
policies cover the services of registered nurses, licensed practical nurses,
home health aides, physical therapists, speech therapists, medical social
workers, and unlicensed or unskilled homemakers. Benefits for our currently
marketed home health care policies are payable for defined benefit periods
ranging from six months to five years, or the lifetime of the policyholder, and
provide from $60 to $300 per day. Our home health care policies generally also
include built-in benefits for waivers of premiums after 90 days of benefit
payments, and unlimited restoration of the policy's maximum benefit period.
17
We currently offer the following products:
Personal Freedom(R) policy. Our Personal Freedom(R) policy (offered since
1996) provides comprehensive coverage through a pool of money which is available
to pay for long-term care in services received in a nursing facility, an
assisted living facility, or the policyholder's home.
Assisted Living(R) policy. The Assisted Living(R) policy (offered since
1999) provides facility coverage in either a traditional nursing home setting or
in an assisted living facility. This policy is a lower priced alternative to the
Personal Freedom(R) policy. When, coupled with an optional home health care
rider, the Assisted Living(R) policy offers benefits similar to those of the
Personal Freedom(R) policy, but with the flexibility to determine how much
coverage is available for each type of care.
Independent Living(R) policy. The Independent Living(R) policy (offered
since 1994) provides coverage for all levels of care received at home. Besides
covering skilled care and care by home health care aides, this policy pays for
care provided by unlicensed, unskilled homemakers. This care includes assistance
with instrumental activities of daily living, such as cooking, shopping and
housekeeping when determined to be medically necessary. Family members also may
be reimbursed for any training costs incurred to provide in-home care.
Secured Risk(R) policy. Our Secured Risk(R) policy (offered since 1998)
provides limited facility care benefits to people who would most likely not
qualify for long-term care insurance under traditional policies. Table-based
underwriting allows us to examine these applicants based on their level of
activity and independence. This policy provides coverage for all types of care,
but with limited benefits for home health care. This policy includes coverage
limitations and longer elimination period (initial time period not covered by
insurance) requirements than our other policies.
Post Acute Recovery policy. The PAR policy was introduced in 1999 and
offers short-term benefits for long-term care services. The plan is generally
purchased as a supplemental coverage provider due to its limited benefits and
reduced price.
Riders. We offer numerous riders to our base policies, including inflation
protection, which provides escalating benefit amounts, and a non-forfeiture
benefit that guarantees certain paid-up benefits in the event the policy lapses
in the future. Our return of premium benefit rider provides for the return of a
portion of the previously paid premium amount in the event of death.
Tax qualified and non-qualified policies. With the enactment of the Health
Insurance Portability and Accountability Act of 1996, we began offering a tax
qualified policy, which was narrowly defined by the United States Congress and
allowed for certain income tax deductions for premium payments and stipulated
that benefit payments would not be subject to tax. A tax qualified policy only
pays benefits for claims that are expected to exceed 90 days and includes
restrictive benefit triggers.
Congress did not provide guidance as to the taxation of benefit payments
made on non-tax qualified policies, leading to policyholder concern about the
taxation of future benefits for these non-qualified plans. In response, we
designed the Pledge and Promise program, which allows policyholders to convert
from a less restrictive non-qualified plan to a tax qualified plan in the future
in the event that the United States Congress determines that benefit payments
would be otherwise taxable. We continue to offer both types of plan.
18
(c) Marketing
Markets. The following chart shows premium revenues by state (dollar
amounts in thousands):
($000)
---------------------------- Current
Year Ended December 31, Year %
Year ----------------------------
State Entered 2002 2001 2000 of Total
-------- ---- ---- ---- --------
Arizona (2) 1988 $14,267 $15,677 $15,677 4.3%
California (3) 1992 48,899 50,165 50,165 14.7%
Colorado 1969 4,646 3,564 3,564 1.4%
Florida 1987 58,990 71,588 71,588 17.6%
Georgia (2) 1990 4,610 4,764 4,764 1.4%
Illinois 1990 17,472 19,748 19,748 5.2%
Iowa 1990 4,960 5,097 5,097 1.5%
Maryland 1987 3,445 3,896 3,896 1.0%
Michigan (2) 1989 6,058 6,357 6,357 1.8%
Missouri (2) 1990 3,619 4,391 4,391 1.1%
Nebraska (2) 1990 4,024 4,358 4,358 1.2%
New Jersey (2) 1996 7,695 7,856 7,856 2.3%
New York 1998 3,902 2,665 2,665 1.2%
North Carolina (2) 1990 9,919 9,690 9,690 3.0%
Ohio (2) 1989 10,664 11,935 11,935 3.2%
Pennsylvania 1972 40,247 48,692 48,692 12.1%
Texas 1990 16,587 16,105 16,105 5.0%
Virginia 1989 21,442 22,370 22,370 6.4%
Washington 1993 10,407 9,814 9,814 3.1%
All Other States (1) 41,790 31,659 38,381 12.5%
------ ------ ------ -----
All States $333,643 $350,391 $357,113 100.0%
======== ======== ======== ======
------------------
(1) Includes all states in which premiums comprised less than one percent
of total premiums in 2002.
(2) We have not recommenced new policy sales in these states or in eight
other unlisted states (which are included in All Other States).
(3) We have recently agreed upon terms for the recommencement of sales in
California, subject to the completion of certain conditions.
Historically, our business has been concentrated in a few key states. Over
the past four fiscal years, approximately half of our premiums came from sales
of policies in California, Florida and Pennsylvania. Our premium growth led to
diminished surplus levels due to the statutory surplus strain arising from new
business generation. In 2001, we ceased new policy sales nationwide as a result
of our surplus levels until we formulated a Corrective Action Plan (the "Plan")
with the Pennsylvania Insurance Department (the "Department"). Upon the
Department's approval of the Plan in February 2002, we recommenced new policy
sales in 23 states, including Pennsylvania. We have now recommenced new policy
sales in 10 additional states, including Florida, Virginia and Texas, which have
historically represented approximately 18%, 7% and 5% of our new policy sales,
respectively. We are actively working with the remaining states to recommence
new policy sales in all jurisdictions. We have recently agreed upon terms for
the recommencement of sales in California, subject to certain conditions.
California has historically represented approximately 15% of our new policy
sales.
19
The following table summarizes our sales of new policies in the periods
indicated (in thousands):
2002 2001 2000
---- ---- ----
Number of new policies sold 3 20 65
Annualized premiums $5,274 $34,786 $111,572
Our goal is to strengthen our position as a leader in providing long-term
care insurance by marketing and selling our products throughout the United
States. We focus our marketing efforts primarily in those states where we have
successfully developed networks of agents and that have the highest
concentration of individuals whose financial status and insurance needs are
compatible with our products.
Agents. We market our products principally through independent agents. We
also employ agents through our subsidiary agencies selling our products as well
as the products of other insurance companies. We provide assistance to our
agents through seminars, underwriting training and field representatives who
consult with agents on underwriting matters, assist agents in research and
accompany agents on marketing visits to current and prospective policyholders.
Each independent agent must be authorized by contract to sell our products
in each state in which the agent and our companies are licensed. Some of our
independent agents are large general agencies with many sales persons
(sub-agents), while others are individuals operating as sole proprietors. Some
independent agents sell multiple lines of insurance, while others concentrate
primarily or exclusively on accident and health insurance. We do not have
exclusive agency agreements with any of our independent agents and they are free
to sell policies of other insurance companies, including our competitors.
We generally do not impose production quotas or assign exclusive
territories to single agents; however, some commission levels are subject to
production requirements. We periodically review and terminate our agency
relationships with non-producing or under-producing agents and agents who do not
comply with our guidelines and policies with respect to the sale of our
products.
We are actively engaged in recruiting and training new agents. Sub-agents
are recruited by the general agents. Independent agents are generally paid
higher commissions than those employed directly by insurance companies, in part
to account for the expenses of operating as an independent agent. We believe
that the commissions we pay to independent agents are competitive with the
commissions paid by other insurance companies selling similar policies. The
independent agent's right to renewal commissions is vested and commissions are
paid as long as the policy remains in-force, provided the agent continues to
abide by the terms of the contract. We provide assistance to our independent
agents in connection with the processing of paperwork and other administrative
services.
20
We have developed a proprietary agent sales system for long-term care
insurance, LTCWorks!(R), which enables agents to sell products utilizing
downloadable software. We believe that LTCWorks!(R) increases the potential
distribution of our products by enhancing agents' ability to present the
products, assist policyholders in the application process and submit
applications over the Internet. LTCWorks!(R) provides agents who specialize in
the regular sale of long-term care insurance products with a unique and easy to
use sales tool and enables agents who are less familiar with long-term care
insurance to present our products and to do preliminary underwriting when they
are discussing other products such as life insurance or annuities.
Marketing General Agents. We selectively use marketing general agents for
the purpose of recruiting independent agents and developing networks of agents
in various states. Marketing general agents receive an override commission on
business written in return for recruiting, training and motivating the
independent agents. No single grouping of agents accounted for more than 10% of
our new premiums or renewal premiums written in 2002, 2001 or 2000. We have not
delegated any underwriting or claims processing authority to any agents.
Franchise Insurance. We sell franchise insurance, which is a series of
individually underwritten policies sold to an association or group. Although
franchise insurance is generally presented to groups that endorse the insurance,
policies are issued to individual group members. Each application is
underwritten and issuance of policies is not guaranteed to members of the
franchise group.
(d) Administration
Underwriting
We believe that the underwriting process through which we choose to accept
or reject an applicant for insurance is critical to our success. We have offered
long-term care insurance products for 30 years and we believe we have benefited
significantly from our longstanding focus on this specialized line. Through our
experience with this family of products, we have been able to establish a system
of underwriting designed to permit us to process our new business and assess the
risks presented with new applications more effectively and efficiently. This
experience has also enabled us to devise a risk stratification system whereby we
can accept a broad array of risks with correspondingly appropriate premium
levels.
Applicants for insurance must complete detailed medical questionnaires. All
long-term care applications are reviewed by our underwriting department and all
applicants are also interviewed by members of our underwriting department via
telephone. This "personal history interview" is aimed at not only confirming the
information disclosed on the application, but also at gaining more insight into
the applicant's physical abilities, activity level and cognitive functioning.
21
We consider age, cognitive status and medical history, among other factors,
in deciding whether to accept an application for coverage and, if accepted, the
appropriate rate class for the applicant. Applicants between ages 65-74 and
younger applicants seeking high benefit amounts are screened for cognitive
impairment, a major contributor to future claims, using the Minnesota Cognitive
Acuity Score performed by an outside vendor. In addition, applicants 75 and over
are assessed by a visiting nurse and the cognitive test is performed in person.
We frequently require medical records and attending physician statements as
well. Pre-existing conditions disclosed on an application for new long-term
nursing home care and most home health care policies are covered immediately
upon approval of the policy. Undisclosed pre-existing conditions are covered
after six months in most states and two years in certain other states. Our
underwriting process extends beyond current conditions, however, and takes into
account how existing health conditions are likely to progress and to what degree
the independence of the applicant is likely to change as the applicant ages.
We use table-based underwriting, or multiple rate classifications, as a
means to approve a greater number of applicants by obtaining the premiums for
appropriate additional risk levels. Applicants are placed in different risk
classes for acceptance and premium calculation based on medical conditions and
level of activity during the underwriting process. In conjunction with the
development of our LTCWorks!(R) system, we developed an underwriting
credit-scoring system, which provides consistent underwriting and rate
classification for applicants with similar medical histories and conditions. We
currently offer Preferred, Premier, Select, Standard and Secured risk
classifications. If we determine that we cannot offer the requested coverage, we
may suggest an alternative product suitable for coverage for higher risk
applicants. Accepted policies are usually issued within seven working days from
receipt of the information necessary to underwrite the application.
Claims
Claims for policy benefits, except with respect to Medicare supplement
claims, are processed by our claims department, which includes nurses employed
or retained as consultants. We use third party administrators to process our
Medicare supplement claims due to the large number of claims and the small
benefit amount typically paid for each claim.
For nursing home claims, a personal claims assistant is assigned to review
all necessary documentation, including verification of the claimant's
confinement and continued care. A claims examiner verifies eligibility of the
claim under the policy. Every effort is made to facilitate the processing of the
claim, recognizing that service efficiency provides substantial value to the
policyholder and his or her family. The personal claims assistant verifies the
continued residence of the policyholder in the facility each month and expedites
payment of the claim by obtaining required information without placing this
burden on the policyholder.
We frequently use the services of "care managers" to review certain claims,
particularly those filed under home health care policies. When a claim is filed,
we may engage a care manager to review the claim, including the specific health
problem of the insured and the nature and extent of the health care services
being provided. This review may include visiting the claimant to conduct a face
to face assessment of his or her current condition. The care manager assists the
insured and us by ensuring that the services provided to the insured, and the
corresponding benefits paid, are appropriate under the circumstances. The care
manager then follows the claimant's progress with periodic contact to ensure
that the plan of care, which sets forth the type, frequency and duration of
services, continues to be appropriate and that it is adjusted if warranted by
improvement in the claimant's condition.
22
Home care claims require the greatest amount of diligent overview and we
have used care management tools for nearly ten years. Our policies with home
care benefits provide an incentive, via increased benefits, to work with one of
our care managers to develop and maintain an ongoing plan of care. Over 95% of
our home care claims received in 2002 involved some form of care management.
Most of these services are performed by our in-house care management unit, which
is comprised of over a dozen registered nurses. We also use external care
management firms when face to face assessments are warranted.
Systems Operations
We maintain our own computer system for most aspects of our operations,
including policy issuance, billing, claims processing, commission reports,
premium production (by agent, state, and product), and general ledger. We
consider it critical to continue to provide the quality of service for which we
are known by our policyholders and agents. We believe that our overall systems
are an integral component in delivering that service. Accordingly, Penn Treaty
has started development of the System Replacement Project ("SRP"). This is a
three phase project estimated to cost between $7.5 and $9.0 million. This effort
will essentially reengineer the application infrastructure of the entire
business. We believe this process will result in annual savings once the entire
system is in place. These savings are expected to be achieved through
productivity improvements, labor avoidance costs, and a reduction in the
transaction error rates. In addition, we believe the SRP will allow us to be a
third party administrator and offer back office support to other insurance
carriers on a transaction fee basis.
The SRP expected to provide us with a system that will support our business
plan, allow us to grow the business without a significant increase in staffing,
transform our existing processes from clerical-based to knowledge based, and
allow us to continue to provide and improve our services to both agents and
policyholders. We believe the SRP will position us to be the leader in the
long-term care insurance market arena by allowing us to reduce policy issue time
from 5-13 days to 3 days, to reduce claims processing time from 7-10 days to 3
days, and to reduce our transaction error rates.
We expect phase 1 of this project to be completed during the second quarter
of 2003. Benefits associated with phase 1 are expected to start to accrue during
the third and fourth quarters of 2003. We believe the project and anticipated
benefits will be fully implemented by the end of 2004.
We have an outsourcing agreement with a computer services vendor providing
for the daily operations of our systems, future program development and
assurance of continued operations in the event of a disaster or business
interruption. We believe that this vendor can provide better expertise in the
evolving arena of information technology than we can provide.
(e) Premiums
Our long-term care policies provide for guaranteed renewability, at the
option of the insured, at then current premium rates. The insured may elect to
pay premiums on a monthly, quarterly, semi-annual or annual basis. In addition,
we offer an automatic payment feature that allows policyholders to have premiums
automatically withdrawn from a checking account.
Premium rates for all lines of insurance are subject to state regulation.
Premium regulations vary greatly among jurisdictions. Rates for our insurance
policies are established by our actuarial staff with the assistance of our
actuarial consultants. All rates, including changes to previously approved
rates, must be approved by the insurance regulatory authorities in each state.
However, regulators may not approve the increases we request, may approve them
only with respect to certain types of policies, or may approve increases that
are smaller than those we request.
As a result of minimum statutory loss ratio standards imposed by state
regulations, the premiums on our accident and health polices are subject to
reduction and/or corrective measures in the event insurance regulatory agencies
in states where we do business determine that our loss ratios either have not
reached or will not reach required minimum levels.
In the past, we have filed with and received approval from certain state
insurance departments to increase policy premium rates. These rate increases
have resulted from a) claims experience that has differed from our expectations
at time of original policy issuance, b) development of alternative forms of
facility care (assisted living centers) which were not contemplated at time of
original policy issuance, but which we have frequently made payment under the
terms of our existing facility-based policy forms.
We have recently filed and implemented additional premium rate increases
averaging approximately 20% on approximately 70% of our in force policies. Based
upon our most recent experience and assumptions relating to future claims
experience, we believe that it will be necessary for us to file rate increases
in the future.
(f) Future Policy Benefits and Claims Reserves
Our insurance policies are accounted for as long duration contracts. As a
result, there are two components of policyholder liabilities. The first is a
policy reserve liability for future policyholder benefits, represented by our
estimate of the present value of future benefits less future premium collection.
These reserves are calculated based on assumptions that include estimates for
mortality, morbidity, interest rates, premium rate increases and persistency.
The assumptions are based on industry experience, our historical results and
recent trends.
23
The second is a reserve for claims which have already been incurred,
whether or not they have yet been reported. The amount of reserves relating to
reported and unreported claims incurred is determined by periodically evaluating
statistical information with respect to the number and nature of historical
claims. We regularly review our claims reserves, and any adjustments to
previously established claims reserves are recognized in operating income in the
period that the need for such adjustments becomes apparent.
We use an in-house actuarial staff and an independent firm of actuarial
consultants to assist us in establishing reserves. Additionally, actuaries
assist us in the documentation of our reserve methodology and in determining the
adequacy of our reserves and their underlying assumptions, a process that has
resulted in adjustments to our reserve levels from time to time. Although we
believe that our reserves are adequate to cover all policy liabilities, we
cannot assure you that reserves are adequate or that future claims experience
will be similar to, or accurately predicted by, our past or current claims
experience.
24
(g) Reinsurance
Reinsurance Agreements with Centre Solutions (Bermuda) Limited
Effective December 31, 2001, we entered into a reinsurance agreement with
Centre Solutions (Bermuda) Limited to reinsure, on a quota share basis,
substantially all of our long-term care insurance policies then in-force. The
following is a summary of the reinsurance agreement and is qualified in its
entirety by reference to the reinsurance agreement which has been filed with the
Securities and Exchange Commission. The agreement is subject to certain coverage
limitations and an aggregate limit of liability which may be reduced if we are
unable to obtain premium rate increases. This agreement does not qualify for
reinsurance treatment in accordance with Generally Accepted Accounting
Principles ("GAAP") because, based on our analysis, the agreement does not
result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to a number of factors related to the agreement,
including experience refund provisions, expense and risk charges that will be
credited against our experience account by the reinsurer and the aggregate limit
of liability. However, this agreement meets the requirements to qualify for
reinsurance treatment under statutory accounting rules.
The initial premium paid by us under the agreement was approximately $619
million, comprised of $563 million of cash and securities, and $56 million held
as funds due to the reinsurer. Such withheld funds are scheduled to be released
to the reinsurer in increments between December 31, 2003 and December 31, 2008,
subject to Centre Solutions (Bermuda) Limited's right to demand that the
withheld funds be released in their entirety at any time by giving us fifteen
business days prior written notice. The initial premium and future cash flows
from the reinsured policies, less claims payments, ceding commissions and risk
charges, will be 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 also receives an investment credit
based upon the total return of a series of benchmark indices and hedges, which
are designed to closely match the duration of our reserve liabilities.
For each of the first seven years of the reinsurance agreement, Centre
Solutions (Bermuda) Limited will credit against our experience account an annual
base fee of $2.8 million plus 0.4% of the statutory reserves ceded to it.
Thereafter, the fees rise to a maximum in year twelve and each year thereafter
of $5.4 million plus 0.8% of the statutory reserves ceded to it. In addition,
the fees include amounts for capital to support the business, certain brokerage,
maintenance and asset security fees. These fees are to be deducted from the
notional experience account on a quarterly basis and are not payable to the
reinsurer until, and if, the agreement is commuted.
We receive a monthly payment based on a yearly reinsurance allowance equal
to approximately 19.7% of the net premiums received by Centre Solutions
(Bermuda) Limited, subject to certain adjustments for premium rate increases
implemented in 2003 and thereafter and actual commissions paid in 2002, plus
3.5% of certain incurred net losses and statutory claim reserves. The yearly
reinsurance allowance is not permitted to exceed 25% of the net premiums
received in the applicable calendar year. We will also receive a fixed amount of
$2 million for each of the 2002 and 2003 calendar years and we will pay $1.2
million for each of the 2004, 2005, 2006 and 2007 calendar years.
25
The reinsurance agreement excludes certain losses from coverage, including
liabilities arising from (1) our actions or failure to act, (2) insolvency
funds, (3) nuclear hazards, (4) terrorism, and (5) war or military action.
The reinsurance agreement is subject to certain coverage limitations,
including an aggregate limit of liability, which is the sum of (1) $200 million,
(2) the initial premium of approximately $619 million, (3) net premiums received
and retained by the reinsurer on or after December 31, 2001, less reinsurance
allowance and taxes related to such premiums, and (4) 4.5% of (1) through (3),
less certain losses and rate increase shortfalls as described below.
The reinsurance agreement requires us to review the performance of our
policies to ascertain their actual to expected loss experience at least every
six months and to conduct an analysis of our underlying actuarial assumptions to
ascertain the future morbidity experience at least once a year. If we have
reason to believe that future experience is likely to be worse than projected at
the later of December 31, 2002 or the date of the most recent rate increase
approval, and that such deterioration in expected experience would justify an
increase in premium rates of 5% or more on any individual policy form, we are
required to file for and obtain increases in premium rates. Failure to obtain
such increases will constitute a breach under the agreement, resulting in a
reduction in the aggregate limit of liability. We are in the process of
completing the most recent analysis required by the reinsurance agreement. We
anticipate that in light of our recent assumption and process changes for claims
and reserves premium rate increases are likely to be required on a majority of
our existing policy forms.
The reinsurance agreement contains commutation provisions and allows us to
recapture the reserve liabilities and the notional experience account balance as
of (1) a change in control of our subsidiaries, Penn Treaty Network America
Insurance Company or American Network Insurance Company, (2) an insolvency of
either of these subsidiaries, (3) our material breach of the reinsurance
agreement, or (4) December 31, 2007 or December 31 of any year thereafter. We
intend to commute the reinsurance agreement on December 31, 2007; therefore, we
are accounting for the reinsurance agreement in anticipation of this
commutation. In the event we do not commute the reinsurance agreement on
December 31, 2007, we will be subject to escalating expenses and a fourth
tranche of warrants held by Centre Solutions (Bermuda) Limited will become
exercisable for Penn Treaty convertible preferred stock that, if converted,
would represent approximately 20% of the outstanding common stock following such
conversion on a fully diluted basis (and approximately 35% of the outstanding
common stock following such conversion on a fully diluted basis if all four
tranches of warrants have been exercised).
26
Our current modeling and actuarial projections suggest that we are likely
to be able to commute the agreement, as planned, on December 31, 2007. In order
to commute the agreement, our statutory capital following commutation must be
sufficient to support the reacquired business in compliance with all statutory
requirements. Upon commutation, we would receive cash or other liquid assets
equaling the value of our experience account from the reinsurer. We would also
record the necessary reserves for the recaptured business in our statutory
financial statements. Our ability to commute the agreement is highly dependent
upon the market value of the experience account exceeding the level of required
reserves to be established. In addition to the performance of the reinsured
policies from now until 2007, the experience account value is susceptible to
market interest rate changes. A market interest rate increase of 100 basis
points could reduce the market value of the current experience account by
approximately $70 million and jeopardize our ability to commute as planned. As
we approach the intended commutation date, the sensitivity of our experience
account to market interest rate movement will decline as the duration of the
benchmark indices becomes shorter, however the amount of assets susceptible to
such interest sensitivity will continue to grow as additional net cash flows are
added to the experience account balance prior to commutation. We intend to give
notice to the reinsurer of our intention to commute on December 31, 2007 at such
time as we are highly confident of our ability to support the recaptured
policies. The reinsurer has agreed to fix the market value of the experience
account upon such time of notice, and to then invest the assets in a manner that
we request in order to minimize short term volatility.
As a result of our intention to commute the agreement on December 31, 2007,
we assessed only the reinsurer's expense and risk charges, anticipated prior to
the commutation date in our most recent DAC recoverability analysis and are not
recording the potential of future escalating charges in our current financial
statements. In addition, we are recognizing the up front costs of entering into
the agreement, including the fair value of the warrants granted to the
reinsurer, over the period of time to the expected commutation date.
In the event we determine that commutation of the reinsurance agreement is
unlikely on December 31, 2007, but is likely at some future date, we will
include additional annual charges in our DAC recoverability analysis. As a
result, we could impair the value of our DAC asset and record the impairment in
our financial statements. However, we currently believe that we will have a
sufficient amount of statutory capital and surplus to commute by December 31,
2007 or that sufficient alternatives, such as additional capital issuance or new
reinsurance opportunities, are available to enable us to commute the agreement
as planned.
The reinsurance agreement also granted the reinsurer an option to
participate in reinsuring new business sales on a quota share basis. In August
2002, the reinsurer exercised its option to reinsure up to 50% of future sales,
subject to a limitation of the reinsurer's risk. The reinsurer may continue this
level of participation on the next $100 million in new policy premium issued
after January 1, 2002. The final agreement, which was entered into in December
2002, further provides the reinsurer the option to reinsure a portion of the
next $1 billion in newly issued long-term care annual insurance premium, subject
to maximum quota share amounts of up to 40% as additional policies are written.
In 2002, approximately $5 million of newly issued premium was subject to this
agreement.
This agreement does not qualify for reinsurance treatment in accordance
with Generally Accepted Accounting Principles ("GAAP") because, based on our
analysis, the agreement does not result in the reasonable possibility that the
reinsurer may realize a significant loss. This is due to an aggregate limit of
liability that reduces the likelihood of the reinsurer realizing a significant
loss on the agreement. However, this agreement meets the requirements to qualify
for reinsurance treatment under statutory accounting rules.
27
In February 2003, the reinsurer notified us that it may, for reasons
unrelated to us, discontinue its quota share reinsurance of new long-term care
insurance policies issued on or after September 1, 2003. The Company's separate
agreement with the reinsurer to reinsure existing policies issued prior to
December 31, 2001 will be unaffected by any determination made by the reinsurer
regarding newly issued policies.
Pennsylvania insurance regulations require that funds ceded for reinsurance
provided by a foreign or "unauthorized" reinsurer must be secured by funds held
in a trust account, funds held as a payable to the reinsurer or by a letter of
credit. In 2002 our funds ceded for reinsurance were properly secured in
compliance with these regulations. In 2001 we received permission from the
Pennsylvania Insurance Department to receive credit for $29 million of Letters
of Credit that were dated subsequent to December 31, 2001.
General
We purchase reinsurance to increase the number and size of the policies we
may underwrite and as a tool to manage statutory surplus strain associated with
new business growth. Reinsurance is purchased by insurance companies to insure
their liability under policies written to their insureds. By transferring, or
ceding, certain amounts of premium (and the risk associated with that premium)
to reinsurers, we can limit our exposure to risk. However, if a reinsurance
company becomes insolvent or otherwise fails to honor its obligations under any
reinsurance agreements, we would remain fully liable to the policyholder.
We have entered into a reinsurance agreement with Cologne Life Reinsurance
Company ("Cologne") with respect to home health care policies with benefit
periods exceeding 36 months. No new policies have been reinsured under this
agreement since 1998. Cologne has notified us that they believe we are in breach
of our current agreement as a result of entering our agreement for existing
policies with Centre Solutions (Bermuda), Inc. without the prior written
approval of Cologne. We have contested this assertion of breach and are
continuing discussions with Cologne to reach an equitable resolution, including,
but not limited to, the recapture of the excess home health care coverage and
reserves, premium rate increases, or additional reinsurance business in the
future. Reinsurance recoverables related to this treaty were $10,175 and $7,726
at December 31, 2002 and 2001, respectively.
Our life insurance policies are currently reinsured for benefits in excess
of $30,000 with Hannover Reassurance Company of America and Transamerica
Occidental Life Insurance Company. Credit life policies are reinsured with
Employer's Reassurance Corporation for benefits in excess of $15,000.
We had ceded, through a fronting arrangement, 100% of certain whole life
and deferred annuity policies to Provident Indemnity Life Insurance Company
("Provident Indemnity"). No new policies have been ceded under this arrangement
since December 31, 1995. We have recently entered an agreement with an
unaffiliated insurer to cede 100% of these policies and related reserves of $3.1
million on an assumption basis effective December 31, 2002 and have terminated
our agreement with Provident Indemnity. Upon approval from state insurance
departments in which the policies were issued, or policyholder approval as may
be prescribed by state regulation, we will no longer record these policies in
our financial statements. No gain or loss was recognized from the cession of
these policies to the new insurer.
28
We also entered into a reinsurance agreement to cede 100% of certain life,
accident, health and Medicare supplement insurance policies to Life and Health
of America. These fronting arrangements are used when one insurer wishes to take
advantage of another insurer's ability to procure and issue policies. As the
fronting company, we remain ultimately liable to the policyholder, even though
all of our risk is reinsured. Therefore, the agreements require the maintenance
of securities in escrow for our benefit in the amount equal to our statutory
reserve credit.
In the past, we have also entered into funds withheld financial reinsurance
treaties, which allow us to temporarily increase statutory surplus. These
agreements did not qualify for reinsurance treatment in accordance with GAAP
because, based on our analysis, the agreements did not result in the reasonable
possibility that the reinsurer could realize a significant loss. As a result,
our accounting and results of operations reflect only the annual fee paid to the
reinsurer. Since the contracts were funds withheld, there was no reinsurance
recoverable or payable on a GAAP basis on the balance sheet. However, the
agreements met the requirements to qualify for reinsurance treatment under
statutory accounting rules. We commuted all existing financial reinsurance
treaties December 31, 2001, which reduced statutory surplus by approximately $20
million. There was no impact from financial reinsurance treaties during 2002.
In 2001, we ceded substantially all of our disability policies to Assurity
Life Insurance Company on a 100% quota share basis. The reinsurer may assume
ownership of the policies as a sale upon various state and policyholder
approvals. We received a ceding allowance of approximately $5 million and paid
the reinsurer an amount equal to the ceded reserves of approximately $10.2
million. We deferred the resultant gain of approximately $5 million, which we
are amortizing to income as departmental or policyholder approval for the
assumption of the policies is received. Historically, we had stop-loss
reinsurance on our disability business that limited our liability in aggregate
for the life of the policy or above monthly loss amounts. This coverage was
ceded to Employer's Reassurance Corporation, Reassure America Life Insurance
Company and Lincoln National Life Insurance Company. Since January 1, 2000, no
new policies have been ceded to Employer's Reassurance Corporation, which has
historically provided the majority of our stop-loss reinsurance.
29
The following table shows our historical use of reinsurance, excluding
financial reinsurance:
Reinsurance Recoverable
-----------------------
Company A.M. Best Rating December 31, 2002 December 31, 2001
------- ---------------- ----------------- -----------------
(in thousands)
General and Cologne Life Re of America A+ $16,608 $10,365
Assurity Life Insurance Company A- 5,828 8,403
Provident Indemnity Life Insurance Company NR3 3,099 4,362
Lincoln Heritage A- - -
Lincoln National Life Insurance Company (1) A+ - 999
Employer's Reassurance Corporation (1) A+u 379 510
Reassure America Life Insurance Company (1) A++ 413 426
Life and Health of America NR - 388
Transamerica Occidental Life Insurance Company A+ 13 30
Hanover Life Reassurance Company of America A 7 15
Swiss Reassurance Life and Health America A++ 223 7
---------------------
(1) We determine the amount of reinsurance recoverable in accordance with
GAAP on an aggregate basis for multiple companies that provide
reinsurance on our disability business. In order to segregate the risk
by reinsurer, we have listed the amount reported for Reassure America
Life Insurance Company and Lincoln National Life Insurance Company for
reserve credits as calculated under statutory accounting principles as
of December 31, 2002, December 31, 2001 and December 31, 2000. The
amounts reported for Employer's Reassurance Corporation include the
net differences between statutory and GAAP reporting for our
disability reinsurance.
(h) Investments
We have categorized all of our 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 total shareholders'
equity on the balance sheet. As of December 31, 2002, shareholders' equity was
increased by approximately $1.1 million due to unrealized gains of approximately
$1.7 million in the investment portfolio. The amortized cost and estimated
market value of our available for sale investment portfolio as of December 31,
2002 and 2001 are as follows:
30
December 31, 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 $ 15,689 $ 16,861 $ 164,712 $ 172,063
Obligations of states and
political sub-divisions - - 572 612
Mortgage backed securities 1,603 1,681 42,587 43,331
Debt securities issued by
foreign governments 205 216 11,954 12,089
Corporate securities 9,278 9,696 243,793 250,513
Equities - - 8,760 9,802
Policy Loans 238 238 181 181
---- ---- ---- ---
Total Investments $ 27,013 $ 28,692 $ 472,559 $ 488,591
========= ========= ========== =========
Net unrealized gain 1,679 16,032
------ ------
$ 28,692 $ 488,591
========= =========
Our investment portfolio, excluding our notional experience account,
consists primarily of investment grade fixed income securities. Income generated
from this portfolio is largely dependent on prevailing levels of interest rates.
Due to the duration of our investments (approximately 3.1 years), investment
income does not immediately reflect changes in market interest rates.
In 2001, we classified our convertible portfolio as trading account
investments. Changes in trading account investment market values are recorded in
our statement of operations during the period in which the change occurs, rather
than as an unrealized gain or loss recorded directly through equity. We recorded
a trading account loss in 2001 of $3.4 million, which reflects the unrealized
and realized loss of our convertible portfolio that arose during the year ended
December 31, 2001. At December 31, 2001, we had liquidated our entire trading
portfolio.
In connection with our first reinsurance agreement with Centre Solutions
(Bermuda) Limited, during the first quarter of 2002, we transferred
substantially our entire investment portfolio to the reinsurer as the initial
premium payment. The initial and future premium for the reinsured policies, less
claims payments, ceding commissions and risk charges is credited to a notional
experience account, the balance of which also receives an investment credit. The
notional experience account balance represents an amount to be paid to us in the
event of commutation of the agreement. Based on our analysis of SFAS No. 133, we
believe that the experience account represents a hybrid instrument, containing
both a fixed debt host contract and an embedded derivative.
31
1. The fixed debt host yields a fixed return based upon the yield to
maturity of the underlying benchmark indices. The return on the fixed debt host
is reported as investment income in the Statement of Operations.
2. The change in fair value of the embedded derivative represents the
percentage change in the underlying indices applied to the notional experience
account, similar to that of an unrealized gain/loss on a bond. The change in the
fair value of the embedded derivative is reported as a market gain on experience
account in the Statement of Operations.
As a result, our results of operations 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. The benchmark indices are comprised of
United States treasury strips, agencies and investment grade corporate bonds,
with weightings of approximately 25%, 15% and 60%, respectively, and have a
duration of approximately 11 years.
(i) Selected Financial Information: Statutory Basis
The following table shows certain ratios derived from our insurance
regulatory filings with respect to our accident and health policies presented in
accordance with accounting principles prescribed or permitted by insurance
regulatory authorities ("SAP"), which differ from the presentation under
generally accepted accounting principles ("GAAP") and, which also differ from
the presentation under SAP for purposes of demonstrating compliance with
statutorily mandated loss ratios.
Year ended December 31,
2002 2001 2000
---- ---- ----
Loss Ratio (1) (4) 75.8% 154.4% 67.1%
Expense ratio (2) (4) -8.2% -201.3% 114.4%
----- ------- ------
Combined loss and expense ratio 67.6% -46.9% 181.5%
Persistency (3) 85.6% 88.0% 86.4%
--------------------------
(1) Loss ratio is defined as incurred claims and increases in policy reserves
divided by collected premiums.
(2) Expense ratio is defined as commissions and expenses, net of ceding
allowances from reinsurers, divided by collected premiums.
(3) Persistency represents the percentage of premiums renewed, which we
calculate by dividing the total annual premiums in-force at the end of each
year (less first year premiums for such 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 a result
of non-renewal policies, including those policies that have terminated by
reason of death, lapse due to nonpayment of premiums and/or conversion to
other policies offered by us. In 2002, we implemented premium rate
increases that, if applied, would suggiest greater persistency than was
actually realized. For 2002, we have calculated persistency of policies,
rather than premium in-force.
(4) The 2002, 2001 and 2000 loss ratios and expense ratios are significantly
affected by the reinsurance of approximately $326 million, $408 million and
$226 million, respectively, in premium on a statutory basis under financial
and other reinsurance treaties. Reserves are accounted for as offsetting
negative benefits and negative premium, causing substantial deviation in
reported ratios.
32
Statutory accounting practices. State insurance regulators require our
insurance subsidiaries to have statutory surplus at a level sufficient to
support existing policies and new business growth. Under SAP, we charge costs
associated with sales of new policies against earnings as such costs are
incurred. These costs, together with required reserves, generally exceed first
year premiums and accordingly, cause a reduction in statutory surplus during
periods of increasing first year sales. The commissions paid to agents are
generally higher for new policies than for renewing policies. Because statutory
accounting requires commissions to be expensed as paid, rapid growth in first
year policies generally results in higher expense ratios.
Effective December 31, 2001, we entered a reinsurance transaction with
Centre Solutions (Bermuda) Limited that, according to Pennsylvania insurance
regulation, required the reinsurer to provide us with Letters of Credit in order
for us to receive statutory reserve and surplus credit from the reinsurance. The
Letters of Credit were dated subsequent to December 31, 2001, as a result of the
final closing of the agreement. In addition, the initial premium paid for the
reinsurance included investment securities carried at amortized cost but valued
at market price for purposes of the premium transfer and the experience account.
The Pennsylvania Insurance Department permitted us to receive credit of $29
million for the Letters of Credit, and to accrue the anticipated, yet unknown,
gain of $18 million from the sale of securities at market value, in our
statutory financial results for December 31, 2001. The impact of these permitted
practices served to increase the statutory surplus of our insurance subsidiaries
by approximately $47 million at December 31, 2001. Had we not been granted
permitted practices, our statutory surplus would have been negative as of
December 31, 2001. As of December 31, 2002, permitted practices were no longer
required due to our receipt of the Letters of Credit prior to March 31, 2002.
(j) Insurance Industry Rating Agencies
Our subsidiaries have A.M. Best financial strength ratings of "B- (fair)"
and Standard & Poor's financial strength ratings of "B- (weak)." A.M. Best and
Standard & Poor's ratings are based on a comparative analysis of the financial
condition and operating performance for the prior year of the companies rated,
as determined by their publicly available reports. Penn Treaty has a financial
strength rating of "CCC- (weak)" from Standard & Poor's but has no rating from
A.M. Best. A.M. Best's classifications range from "A++ (superior)" to "F (in
liquidation)." Standard & Poor's ratings range from "AAA (extremely strong)" to
"CC (extremely weak)." A.M. Best and Standard & Poor's ratings are based upon
factors of concern to policyholders and insurance agents and are not directed
toward the protection of investors and are not recommendations to buy, hold or
sell a security. In evaluating a company's financial and operating performance,
the rating agencies review profitability, leverage and liquidity, as well as
book of business, the adequacy and soundness of reinsurance, the quality and
estimated market value of assets, the adequacy of reserves and the experience
and competence of management.
33
Certain distributors will not sell our group products unless we have a
financial strength rating of at least an "A-." The inability of our subsidiaries
to obtain higher A.M. Best or Standard & Poor's ratings could adversely affect
the sales of our products if customers favor policies of competitors with better
ratings. In addition, a downgrade in our ratings may cause our policyholders to
allow their existing policies to lapse. Increased lapsation would reduce our
premium income and would also cause us to expense fully the deferred policy
costs relating to lapsed policies in the period in which those policies lapsed.
Recent downgrades or further downgrades in our ratings also may lead some
independent agents to sell less of our products or to cease selling our policies
altogether.
(k) Competition
We operate in a highly competitive industry. We believe that competition is
based on a number of factors, including service, products, premiums, commission
structure, financial strength, industry ratings and name recognition. We compete
with a large number of national insurers, smaller regional insurers and
specialty insurers, many of whom have considerably greater financial resources,
higher ratings from A.M. Best and Standard and Poor's and larger networks of
agents than we do. Many insurers offer long-term care policies similar to those
we offer and utilize similar marketing techniques. In addition, we are subject
to competition from insurers with broader product lines. We also may be subject,
from time to time, to new competition resulting from changes in Medicare
benefits.
We also actively compete with other insurers in attracting and retaining
agents to distribute our products. Competition for agents is based on quality of
products, commission rates, underwriting, claims service and policyholder
service. We continuously recruit and train independent agents to market and sell
our products. We also engage marketing general agents from time to time to
recruit independent agents and develop networks of agents in various states. Our
business and ability to compete may suffer if we are unable to recruit and
retain insurance agents and if we lose the services provided by our marketing
general agents.
We also compete with non-insurance financial services companies such as
banks, securities brokerage firms, investment advisors, mutual fund companies
and other financial intermediaries marketing insurance products, annuities,
mutual funds and other retirement-oriented investments. The Gramm-Leach-Bliley
Financial Services Modernization Act of 1999 implemented fundamental changes in
the regulation of the financial services industry, permitting mergers that
combine commercial banks, insurers and securities firms under one holding
company. The ability of banks to affiliate with insurers may adversely affect
our ability to remain competitive.
The insurance industry may undergo further change in the future and,
accordingly, new products and methods of service may also be introduced. In
order to keep pace with any new developments, we may need to expend significant
capital to offer new products and to train our agents and employees to sell and
administer these products and services. Our ability to compete with other
insurers depends on our success in developing new products.
(l) Government Regulation
General
Insurance companies are subject to supervision and regulation in all states
in which they transact business. Penn Treaty is registered and approved as a
holding company under the Pennsylvania Insurance Code. Our insurance company
subsidiaries are chartered in the states of Pennsylvania and New York.
34
The extent of regulation of insurance companies varies, but generally
derives from state statutes which delegate regulatory, supervisory and
administrative authority to state insurance departments. Although many states'
insurance laws and regulations are based on models developed by the National
Association of Insurance Commissioners ("NAIC"), and are therefore similar,
variations among the laws and regulations of different states are common.
The NAIC is a voluntary association of all of the state insurance
commissioners in the United States. The primary function of the NAIC is to
develop model laws on key insurance regulatory issues that can be used as
guidelines for individual states in adopting or enacting insurance legislation.
While the NAIC model laws are accorded substantial deference within the
insurance industry, these laws are not binding on insurance companies unless
adopted by states, and variation from the model laws within states is common.
The Pennsylvania Insurance Department, the New York Insurance Department
and the insurance regulators in other jurisdictions have broad administrative
and enforcement powers relating to the granting, suspending and revoking of
licenses to transact insurance business, the licensing of agents, the regulation
of premium rates and trade practices, the content of advertising material, the
form and content of insurance policies and financial statements and the nature
of permitted investments. In addition, regulators have the power to require
insurance companies to maintain certain deposits, capital, surplus and reserve
levels calculated in accordance with prescribed statutory standards. The NAIC
has developed minimum capital and surplus requirements utilizing certain
risk-based factors associated with various types of assets, credit, underwriting
and other business risks. This calculation, commonly referred to as RBC, serves
as a benchmark for the regulation of insurance company solvency by state
insurance regulators. The primary purpose of such supervision and regulation is
the protection of policyholders, not investors.
Most states mandate minimum benefit standards and policy lifetime loss
ratios for long-term care insurance policies and for other accident and health
insurance policies. A significant number of states, including Pennsylvania and
Florida, have adopted the NAIC's proposed minimum loss ratio of 60% for both
individual and group long-term care insurance policies. Certain states,
including New Jersey and New York, have adopted a minimum loss ratio of 65% for
long-term care. The states in which we are licensed have the authority to change
these minimum ratios, the manner in which these ratios are computed and the
manner in which compliance with these ratios is measured and enforced.
In December 1986, the NAIC adopted the Long-Term Care Insurance
Model Act ("Model Act"), to promote the availability of long-term care insurance
policies, to protect applicants for such insurance and to facilitate flexibility
and innovation in the development of long-term care coverage. The Model Act
establishes standards for long-term care insurance, including provisions
relating to disclosure and performance standards for long-term care insurers,
incontestability periods, nonforfeiture benefits, severability, penalties and
administrative procedures. Model regulations were also developed by the NAIC to
implement the Model Act. Some states have also adopted standards relating to
agent compensation for long-term care insurance. In addition, from time to time,
the federal government has considered adopting standards for long-term care
insurance policies, but it has not enacted any such legislation to date.
35
Some state legislatures have adopted proposals to limit rate increases on
long-term care insurance products. In the past, we have been generally
successful in obtaining rate increases when necessary. We currently have rate
increases on file with various state insurance departments and anticipate that
increases on other products will be required on a majority of our policies in
the future. If we are unable in the future to obtain rate increases, or in the
event of legislation limiting rate increases, we believe it would have a
negative impact on our future earnings.
In September 1996, Congress enacted the Health Insurance Portability and
Accountability Act ("HIPAA"), which permits premiums paid for eligible long-term
care insurance policies after December 31, 1996 to be treated as deductible
medical expenses for federal income tax purposes. The deduction is limited to a
specified dollar amount ranging from $200 to $2,500, with the amount of the
deduction increasing with the age of the taxpayer. In order to qualify for the
deduction, the insurance contract must, among other things, provide for
limitations on pre-existing condition exclusions, prohibitions on excluding
individuals from coverage based on health status and guaranteed renewability of
health insurance coverage. Although we offer tax-deductible policies, we will
continue to offer a variety of non-deductible policies as well. We have
long-term care policies that qualify for tax exemption under HIPAA in all states
in which we are licensed.
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles ("Codification") guidance, which replaced the current Accounting
Practices and Procedures manual as the NAIC's primary guidance on statutory
accounting as of January 1, 2001. The Codification provides guidance for areas
where statutory accounting has been silent and changes current statutory
accounting in some areas, including the recognition of deferred income taxes.
The Pennsylvania and New York Insurance Departments have adopted the
Codification guidance, effective January 1, 2001. The Codification guidance
serves to reduce the insurance subsidiaries' surplus, primarily due to certain
limitations on the recognition of goodwill and electronic data processing
equipment and the recognition of other than temporary declines in investments.
These reductions are partially offset by certain other items, including the
recognition of deferred tax assets subject to certain limitations. In 2001, our
statutory surplus was reduced by approximately $2 million as a result of the
Codification guidance.
We are also subject to the insurance holding company laws of Pennsylvania
and of the other states in which we are licensed to do business. These laws
generally require insurance holding companies and their subsidiary insurers to
register and file certain reports, including information concerning their
capital structure, ownership, financial condition and general business
operations. Further, states often require prior regulatory approval of changes
in control of an insurer and of intercompany transfers of assets within the
holding company structure. The Pennsylvania Insurance Department and the New
York Insurance Department must approve the purchase of more than 10% of the
outstanding shares of our common stock by one or more parties acting in concert,
and may subject such party or parties to the reporting requirements of the
insurance laws and regulations of Pennsylvania and New York and to the prior
approval and/or reporting requirements of other jurisdictions in which we are
licensed. In addition, our officers, directors and 10% shareholders and those of
our insurance subsidiaries are subject to the reporting requirements of the
insurance laws and regulations of Pennsylvania and New York, as the case may be,
and may be subject to the prior approval and/or reporting requirements of other
jurisdictions in which they are licensed.
36
States also restrict the dividends our insurance subsidiaries are permitted
to pay. Dividend payments will depend on profits arising from the business of
our insurance company subsidiaries, computed according to statutory formulae.
Under the insurance laws of Pennsylvania and New York, where our insurance
subsidiaries are domiciled, insurance companies can pay ordinary dividends only
out of earned surplus. In addition, under Pennsylvania law, our Pennsylvania
insurance subsidiaries (including our primary insurance subsidiary) must give
the Department at least 30 days' advance notice of any proposed "extraordinary
dividend" and cannot pay such a dividend if the Department disapproves the
payment during that 30-day period. For purposes of that provision, an
extraordinary dividend is a dividend that, together with all other dividends
paid during the preceding twelve months, exceeds the greater of 10% of the
insurance company's surplus as shown on the company's last annual statement
filed with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to the immediate or
accelerated recognition of all costs associated with premium growth and benefit
reserves. Additionally, our Plan requires the Department to approve all dividend
requests made by Penn Treaty, regardless of normal statutory requirements for
allowable dividends. We believe that the Department is unlikely to consider any
dividend request in the foreseeable future, as a result of Penn Treaty's current
statutory surplus position. Although not stipulated in the Plan, this
requirement is likely to continue until such time as Penn Treaty meets normal
statutory allowances, including reported net income and positive cumulative
earned surplus.
Under New York law, our New York insurance subsidiary (American Independent
Network Insurance Company of New York) must give the New York Insurance
Department 30 days' advance notice of any proposed dividend and cannot pay any
dividend if the regulator disapproves the payment during that 30-day period. In
addition, our New York insurance company must obtain the prior approval of the
New York Insurance Department before paying any dividend that, together with all
other dividends paid during the preceding twelve months, exceeds the lesser of
10% of the insurance company's surplus as of the preceding December 31 or its
adjusted net investment income for the year ended the preceding December 31.
37
Penn Treaty Network America Insurance Company and American Network
Insurance Company have not paid any dividends to Penn Treaty for the past three
years and are unlikely in the foreseeable future to be able to make dividend
payments due to insufficient statutory surplus and anticipated earnings.
However, our New York subsidiary is not subject to the Plan and in March 2002,
we received a dividend from our New York subsidiary of $651,000. American
Network Insurance Company was permitted to make a special dividend payment of $5
million following December 31, 2001 to Penn Treaty Network America Insurance
Company.
Periodically, the Federal government has considered adopting a national
health insurance program. Although it does not appear that the Federal
government will enact an omnibus health care reform law in the near future, the
passage of such a program could have a material impact on our operations. In
addition, other legislation enacted by Congress could impact our business. Among
proposals sometimes considered are the implementation of certain minimum
consumer protection standards for inclusion in all long-term care policies,
including guaranteed renewability, protection against inflation, and limitations
on waiting periods for pre-existing conditions. These proposals would also
prohibit "high pressure" sales tactics in connection with long-term care
insurance and would guarantee consumers access to information regarding
insurers, including lapse and replacement rates for policies and the percentage
of claims denied. As with any pending legislation, it is possible that any laws
finally enacted will be substantially different from the current proposals.
Accordingly, we are unable to predict the impact of any such legislation on our
business and operations.
Compliance with multiple Federal and state privacy laws may affect our
profits. Congress enacted the Gramm-Leach-Bliley Financial Services
Modernization Act in 1999. Federal agencies have adopted regulations to
implement this legislation. The Gramm-Leach-Bliley Act empowers states to adopt
their own measures to protect the privacy of consumers and customers of insurers
that are covered by the Gramm-Leach-Bliley Act, so long as those protections are
at least as stringent as those required by the Gramm-Leach-Bliley Act. If states
do not enact their own insurance privacy laws or adopt regulations, the privacy
requirements of the Gramm-Leach-Bliley Act will apply to insurers, although no
enforcement mechanism has yet been adopted for insurers. The Department of
Health and Human Services has adopted privacy rules, which will also apply to at
least some of our products. The NAIC has adopted the Insurance Information and
Privacy Model Act, but no state has yet adopted this model act. Individual state
insurance regulators have indicated that their states may adopt privacy laws or
regulations that are more stringent than the NAIC's model act and those provided
for under federal law. Compliance with different laws in states where we are
licensed could prove extremely costly.
We monitor economic and regulatory developments that have the potential to
affect our business. Recently enacted federal legislation will allow banks and
other financial organizations to have greater participation in securities and
insurance businesses. This legislation may present an increased level of
competition for sales of our products. Furthermore, the market for our products
is enhanced by the tax incentives available under current law. Any legislative
changes that lessen these incentives could negatively impact the demand for
these products.
38
Recent State Regulatory Actions
Our insurance subsidiaries are regulated by various state insurance
departments. In its ongoing effort to improve solvency regulation, the 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.
Our insurance subsidiaries, Penn Treaty Network America Insurance Company,
American Network Insurance Company, and American Independent Network Insurance
Company of New York (representing approximately 94%, 5% and 1% of our in-force
premium, respectively), are each required to hold statutory surplus that is,
above a certain required level. If the statutory surplus of either of our
Pennsylvania subsidiaries falls below such level, the Department would be
required to place such subsidiary under regulatory control, leading to
rehabilitation or liquidation. At December 31, 2000, Penn Treaty Network America
Insurance Company had Total Adjusted Capital below the Regulatory Action level.
As a result, it was required to file a Corrective Action Plan ("the Plan") with
the Pennsylvania Insurance Commissioner.
On February 12, 2002, the Department approved the Plan.
The Corrective Order requires Penn Treaty to comply with certain 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 by an additional $125
million by December 31, 2004, of which $48 million remains to be
added as of December 31, 2002, such that our subsidiaries' 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. The
reinsurance agreement entered with Centre Solutions (Bermuda),
Limited for business issued prior to December 31, 2001 has
provided the capacity to accommodate this increase;
o Enter into a reinsurance treaty with Centre Solutions (Bermuda)
Limited through which Penn Treaty Network America Insurance
Company and American Network Insurance Company reinsure 100% of
their individual long term care insurance business in effect on
December 31, 2001;
39
o File copies of the fully executed reinsurance agreement and trust
agreement with the Department no later than ten days after
execution;
o File with the Department monthly statements of the balance of the
trust account required under the trust agreement among them,
Centre Solutions (Bermuda) Limited, and The Bank of New York
within five days of receipt of any such statement;
o Compute contract and unearned premium reserves using the initial
level net premium reserve methodology;
o Notify the Department within five days of the date of the
Corrective Order of the licensing status of Penn Treaty Network
America Insurance Company and American Network Insurance Company
in all jurisdictions in which they are authorized to write
insurance;
o Submit to the Department all filings with the Securities and
Exchange Commission made by Penn Treaty, and all press releases
issued by Penn Treaty, Penn Treaty Network America Insurance
Company or American Network Insurance Company;
o Not enter into any new reinsurance contract or treaty, or amend,
commute or terminate any existing reinsurance treaty without the
prior written approval of the Department, such approval not to be
unreasonably withheld;
o Not make any new special deposits or make any changes to existing
special deposits without the prior written approval of the
Department, such approval not to be unreasonably withheld;
o Not enter into any new agreements or amend any existing
agreements with Penn Treaty or any affiliate in excess of
$100,000 or make any dividends or distributions to Penn Treaty or
any affiliate without the prior written approval of the
Department, such approval not to be unreasonably withheld; and
o Notify the Department within five days of receiving notification
of default on Penn Treaty debt requiring acceleration of
repayment.
We are in compliance with all terms of the Corrective Order as of the date
of this filing. If we fail to continue to comply with the terms of the
Corrective Order, the Department could take action to suspend our ability to
continue to write new policies, or impose other sanctions on us.
The Florida Department of Insurance issued a Consent Order dated July 30,
2002, as amended, reinstating Penn Treaty's Certificate of Authority in Florida
as a foreign insurer The Consent Order sets forth the following obligations
which Penn Treaty Network America Insurance Company must satisfy to maintain its
Certificate of Authority in Florida:
40
o Maintain compliance with Florida laws which establish minimum
surplus required for health and life insurers;
o Comply, by December 31, 2002 (as later amended to January 31,
2003), with Florida laws which establish a maximum writing ratio
limitation on accident and health premiums to policyholders'
capital/surplus. Subsequent to December 31, 2002, we contributed
$16 million to our subsidiary's statutory surplus, which we
believe placed our subsidiary in compliance with Florida statute
for gross premium to surplus levels;
o Submit monthly financial statements to the Department of
Insurance;
o Maintain compliance with Florida laws governing investments in
subsidiaries and related corporations;
o Limit direct premiums on new business in the State of Florida so
as not to exceed $4 million during 2002 (which we will not have
exceeded) and $15 million during 2003;
o Limit direct premium growth in Florida to ten percent annually
after 2003 unless otherwise approved in writing by the Department
of Insurance based upon evidence of adequate capitalization;
o Maintain a Risk Based Capital ratio in excess of 2.0; and
o Submit quarterly reports to the Department of Insurance
demonstrating all claims that have been assumed by Centre
Solutions (Bermuda) Limited.
In the event that Penn Treaty Network America Insurance Company fails to
maintain compliance with Florida laws or the above requirements, the Department
of Insurance will notify Penn Treaty Network America Insurance Company and could
require it to take corrective action. If the Department of Insurance determines
that the corrective action is not timely, Penn Treaty Network America Insurance
Company's Certificate of Authority could be suspended and it could be required
to cease writing new direct business in Florida, until such time as it took any
required corrective action.
In March 2003, we received approval from the California Insurance
Department to recommence sales in California subject to certain conditions to be
met prior to recommencement of sales and in order to continue to write new
policies in the future. The additional conditions included:
o The review and approval of its long-term care products and rates
for compliance with California's adoption of new disclosure and
pricing standards.
41
o The additional certification of the Company's reserves for 2002,
and annually thereafter by May 1, to be performed by an
independent actuary of the Department's choice. The Company will
bear the cost of additional certifications.
o The Company's commitment that if an unqualified actuarial opinion
is not received as of any subsequent year-end, it will
voluntarily discontinue writing new business in California until
that condition is corrected.
(m) Employees
As of December 31, 2002, we had approximately 300 full-time employees (not
including independent agents). We are not a party to any collective bargaining
agreements.
ITEM 2. PROPERTIES
Our principal offices in Allentown, Pennsylvania occupy two buildings,
totaling approximately 33,000 square feet of office space in a 40,000 square
foot building and all of an 16,000 square foot building. We own both buildings
and a 2.42 acre undeveloped parcel of land located across the street from our
home offices. We also lease additional office space in Michigan and New York.
ITEM 3. 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.
Our 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 our common stock between 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 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 July
1, 2002, the defendants filed an answer to the complaint, denying all liability.
Plaintiffs filed a motion for class certification on August 15, 2002, which is
currently pending. On February 26, 2003, the parties reached an agreement in
principle to settle the litigation for $2.3 million, to be paid entirely by our
directors and officers liability insurance carrier. The settlement remains
subject to documentation and court approval.
42
Our Company and its subsidiary, PTNA, are defendants in an action in the
United States District Court, Middle District of Florida, Ocala Division.
Plaintiffs filed this matter on January 10, 2003 in the Fifth Judicial Circuit
of the State of Florida in and for Marion County, Civil Division, on behalf of
themselves and a class of similarly situated Florida long term care
policyholders. We removed this case from the Florida state court to Federal
Court on February 6, 2003. Plaintiffs claim wrongdoing in connection with the
sale of long term care insurance policies to the Plaintiffs and the Class.
Plaintiffs allege claims for reformation, breach of fiduciary duty, breach of
the implied duty of good faith and fair dealing, negligent misrepresentation,
fraudulent misrepresentation, and restitution. We filed motions to dismiss for
failure to state a claim, lack of personal jurisdiction as against the Company,
and a motion to strike certain allegations of the Complaint as irrelevant and
improper. Plaintiffs filed a motion to remand on March 7, 2003. Briefing is
continuing on all of these motions. We believe that the Complaint is without
merit and intend to continue to defend the matter vigorously.
Our Company and two of our subsidiaries, Penn Treaty Network America
Insurance Company and Senior Financial Consultants Company, are defendants in an
action instituted on June 5, 2002 in the United States District Court for the
Eastern District of Pennsylvania by National Healthcare Services, Inc. The
complaint seeks compensatory damages in excess of $150,000 and punitive damages
in excess of $5,000,000 for an alleged breach of contract and misappropriation.
The claims arise out of a joint venture related to the AllRisk Healthcare
program, which was marketed first by Penn Treaty Network America Insurance
Company and then later by Senior Financial Consultants Company. The defendants
have denied the allegations of the complaint and will continue to defend the
matter vigorously.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF OUR STOCKHOLDERS
No matters were submitted during the fourth quarter of the fiscal year
ended December 31, 2002 to a vote of security holders.
43
PART II
ITEM 5. MARKET FOR OUR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange under the symbol
"PTA." As of February 12, 2003, there were approximately 439 record holders of
our common stock. The following table indicates the high and low sale prices of
our common stock as reported on the New York Stock Exchange during the periods
indicated.
High Low
---- ---
2002
1st Quarter $ 6.71 $ 4.10
2nd Quarter 6.85 3.75
3rd Quarter 4.78 3.35
4th Quarter 4.05 1.65
2001
1st Quarter $ 19.75 $ 8.80
2nd Quarter 9.70 2.15
3rd Quarter 4.29 2.10
4th Quarter 6.42 2.70
2000
1st Quarter $ 18.13 $ 12.25
2nd Quarter 19.94 13.13
3rd Quarter 18.81 14.88
4th Quarter 21.56 15.63
We have never paid any cash dividends on our common stock and do not intend
to do so in the forseeable future. It is our present intention to retain any
future earnings to support the continued growth of our business. Any future
payment of dividends is subject to the discretion of the board of directors and
is dependency, in part, on any dividends we may receive from our subsidiaries.
The payment of dividends by our subsidiaries is dependent on a number of
factors, including their respective earnings and financial conditionm, business
needs and capital and surplus requirements, and is also subject to certain
regulatory restrictions and the effect that such payment would have on their
financial strength ratings. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources,"
"Business--Insurance Industry Rating Agencies" and Business--Government
Regulation."
44
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated statement of operations data and
balance sheet data as of and for the years ended December 31, 1998, 1999, 2000,
2001 and 2002 have been derived from our Consolidated GAAP Financial Statements.
1998 1999 2000 2001 2002
---- ---- ---- ---- ----
Statement of Operations Data:
----------------------------------------------------------------
Revenues:
Total premiums $223,692 $292,516 $357,113 $350,391 $333,643
Net investment income 20,376 22,619 27,408 30,613 40,107
Net realized (losses) gains 9,209 5,393 652 (4,367) 15,663
Trading account loss - - - (3,428) -
Market gain on experience account (1) - - - - 56,555
Other income 885 6,297 8,096 9,208 11,585
-------- -------- -------- -------- --------
Total revenues 254,162 326,825 393,269 382,417 457,553
-------- -------- -------- --------- --------
Benefits and expenses:
Benefits to policyholders (2) 154,300 200,328 243,571 239,155 371,998
Commissions 80,273 96,752 102,313 76,805 45,741
Net acquisition costs amortized (deferred) (3) (46,915) (51,134) (43,192) 9,860 7,594
Impairment of net unamortized policy
acquisition costs (4) - - - 61,800 1,100
General and administrative expenses 26,069 40,736 49,973 49,282 46,473
Expense and risk charge and excise tax (5) - - - 5,635 17,227
Loss due to impairment of property
and equipment (6) - 2,799 - - -
Change in reserve for claim litigation - - 1,000 (250) -
Interest expense 4,809 5,187 5,134 4,999 5,733
-------- ------- -------- -------- --------
Total benefits and expenses 218,536 294,668 358,799 447,286 495,866
-------- -------- -------- -------- --------
Income (loss) before federal income taxes and
cumulative effect of accounting change 35,626 32,157 34,470 (64,869) (38,313)
Provision (benefit) for federal income taxes 11,578 10,837 11,720 (16,280) (13,026)
-------- ------- -------- -------- --------
Net (loss) income before cumulative effect
of accounting change (7) $ 24,048 $ 21,320 $ 22,750 $(48,589) $ (25,287)
======== ======== ======== ======== =========
Net income (loss) $ 24,048 $ 21,320 $ 22,750 $(48,589) $ (30,438)
======== ======== ======== ======== =========
Net income (loss) adjusted for accounting change (8) $ 24,048 $ 21,975 $ 23,603 $(47,736) $ (25,287)
======== ======== ======== ======== =========
Basic earnings per share before cumulative effect
of accounting change (7) $ 3.17 $ 2.83 $ 3.13 $ (3.41) $ (1.31)
======== ======== ======= ======== =========
Diluted earnings per share before cumulative effect
of accounting change (7) $ 2.64 $ 2.40 $ 2.61 $ (3.41) $ (1.31)
======== ======== ======= ======== =========
Basic earnings per share $ 3.17 $ 2.83 $ 3.13 $ (3.41) $ (1.58)
======== ======== ======= ======== =========
Diluted earnings per share $ 2.64 $ 2.40 $ 2.61 $ (3.41) $ (1.58)
======== ======== ======= ======== =========
Basic earnings per share adjusted for accounting change (8) $ 2.64 $ 2.92 $ 3.25 $ (3.35) $ (1.58)
======== ======== ======= ======== =========
Diluted earnings per share adjusted for accounting change (8) $ 2.64 $ 2.48 $ 2.70 $ (3.35) $ (1.31)
======== ======== ======= ======== ==========
Weighted average shares outstanding (9) 7,577 7,533 7,279 14,248 19,240
Weighted average diluted shares outstanding (10) 10,402 10,293 9,976 14,248 19,240
45
1998 1999 2000 2001 2002
---- ---- ---- ---- ----
GAAP Ratios:
Loss ratio (2) 69.0% 68.5% 68.2% 68.3% 111.5%
Expense ratio (11) 28.7% 31.3% 32.0% 59.0% 37.1%
----- ----- ----- ----- -----
Total (12) 97.7% 99.8% 100.2% 127.3% 148.6%
===== ===== ====== ====== =====
Return on average equity (13) 16.6% 13.5% 13.1% (25.5)% (17.5%)
Balance Sheet Data:
Total investments (14) $338,889 $373,001 $366,126 $488,591 $ 28,692
Total assets 580,552 697,639 856,131 940,367 1,080,200
Total debt 76,550 82,861 81,968 79,190 76,245
Shareholders' equity 157,670 158,685 188,062 192,796 155,180
Book value per share $ 20.79 $ 21.81 $ 25.81 $ 10.24 $ 7.99
Selected Statutory Data:
Net premiums written (15) $143,806 $208,655 $130,676 $(64,689) $ 22,440
Statutory surplus (beginning of period) $ 67,249 $ 76,022 $ 67,070 $ 30,137 $ 35,808
Ratio of net premiums written to
statutory surplus 2.1x 2.7x 1.9x (2.1)x .6x
Notes to Selected Financial Data (in thousands)
(1) Effective December 31, 2001, we entered into a reinsurance agreement
for substantially all of our long-term care insurance policies, which we are
accounting for as deposit accounting. The reinsurer maintains a notional
experience account for our benefit in the event of commutation. The notional
experience account receives an investment credit, derived from the separate
components of the notional experience account. This gain represents the income
from the embedded derivative portion of our notional experience account, similar
to that of an unrealized gain or loss on a bond.
(2) During the third quarter of 2002, we determined to refine certain of
our processes and assumptions in the establishment of our reserves for current
claims. As a result of this change, we increased our reserves for current claims
by approximately $83,000. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
(3) Effective September 10, 2001, we discontinued the sale, nationally, of
all new long-term care insurance policies until our Corrective ActionPlan was
completed and approved by the Pennsylvania Insurance Department. As a result,
there was a substantial reduction in the deferral of costs associated with new
policy issuance, while we continued to amortize existing deferred acquisition
costs.
(4) Our reinsurance agreement requires us to accrue an annual expense and
risk charge to the reinsurer. Primarily as a result of these anticipated
charges, we impaired the value of our net unamortized policy acquisition costs
by $61,800 in 2001. In the third quarter of 2002, we impaired the value of our
deferred acquisition cost asset by approximately $1,100 as a result of the
change in our assumptions regarding the future profitability of our existing
business in force. See "Management's Discussion and Analysis of Financial
Conditions and Results of Operations."
(5) As a result of our December 31, 2001 reinsurance agreement with a
foreign reinsurer, we must pay Federal excise tax of 1% on all ceded premium.
The 2001 expense represents excise taxes due for premiums transferred at the
inception of the contract. Beginning in 2002, we also accrue an annual expense
and risk charge payable to the reinsurer in the event of future commutation of
the agreement.
46
(6) During 1999, we discontinued the implementation of a new computer
system, for which we had previously capitalized $2,799 of licensing, consulting
and software costs. When we decided not to use this system, its value became
fully impaired. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
(7) Excludes $5,151 impairment charge of goodwill from the adoption of SFAS
Nos. 141 and 142, which was recorded as a cumulative effect from accounting
change. In 2002, in accordance with SFAS No. 142, we determined that the
goodwill associated with our insurance subsidiaries was impaired and recognized
an impairment loss of $5,151, net of related tax effect, which we recorded as a
cumulative effect of change in accounting principle.
(8) As a result of the adoption of SFAS No. 142 in 2002, we discontinued
the amortization of goodwill. We have provided a comparison of results to 2002
for the fiscal periods 1999, 2000 and 2001 that reflects the impact of this
accounting change in prior periods as though the SFAS No. 142 had been adopted
at that time. Net income would have been increased in each adjusted period by
$655, $853, $853 and $640, respectively.
(9) On May 25, 2001, we issued approximately 11,547 new shares of our
common stock, for net proceeds of $25,726, through a rights offering. We also
issued approximately 570 new shares in 2002 through a direct equity placement.
(10) Diluted shares outstanding includes shares issuable upon the
conversion of our existing convertible debt and exercise of options outstanding,
except in 2001 and 2002, for which the inclusion of such shares would be
anti-dilutive. The inclusion of converted shares from the our Convertible
Subordinated Notes due 2008 is expected to produce significant dilution in
earnings per share in future periods.
(11) Expense ratios exclude the impact of reduced commissions and increased
general and administrative expenses resulting from the 1999 and 2000
acquisitions of our agency subsidiaries. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
(12) We measure our combined ratio as the total of all expenses, including
benefits to policyholders, related to policies in-force divided by premium
revenue. This ratio provides an indication of the portion of premium revenue
that is devoted to the coverage of policyholder related expenses. We depend on
our investment returns to offset the amounts by which our combined ratio is
greater than 100%. In 2001, reduced premium revenue, the impairment of our DAC
asset in the fourth quarter (see note 4) and the payment of excise taxes on the
initial premium for our new reinsurance agreement (see note 5) increased our
combined ratio above what it otherwise would have been. For 2002, see note 2.
(13) Return on equity, which is the ratio of net income or losses to
average shareholders' equity, measures the current period return provided to
shareholders on invested equity. New or existing shareholders could be dissuaded
from future investment in our common stock and may choose to sell their common
stock if they are not satisfied with our return on equity.
(14) As a result of our reinsurance agreement, which was effective December
31, 2001, we transferred substantially all of our investable assets to the
reinsurer.
(15) Under statutory accounting principles, ceded reserves are accounted
for as offsetting negative benefits and negative premium. Our 2002, 2001 and
2000 premium is reduced by approximately $326,000, $408,000 and $226,000,
respectively from reinsurance transactions.
47
Quarterly Data
Our unaudited quarterly data for each quarter of 2002 and 2001 have been
derived from unaudited financial statements and include all adjustments,
consisting only of normal recurring accruals, which we consider necessary for a
fair presentation of the results of operations for these periods. Such quarterly
operating results are not necessarily indicative of our future results of
operations.
2002
---------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
(in thousands, except per share data and ratios)
Total premiums $ 84,236 $ 83,906 $ 83,635 $ 81,866
Net investment income 9,535 10,172 10,122 10,278
Net realized capital gains and losses and
other income (8,660) 22,384 67,193 2,886
-------- -------- -------- --------
Total revenues 85,111 116,462 160,950 95,030
-------- -------- -------- --------
Benefits to policyholders 80,187 62,515 164,170 65,127
Commissions & expenses 32,851 26,919 29,260 21,510
Net acquisition costs amortized (deferred) (3,326) 7,777 3,403 259
------- ------ ------- --------
Net (loss) income $(13,626) $ 11,918 $(24,471) $ 892
========= ======== ========= ========
GAAP loss ratio 95.2% 74.5% 196.3% 79.6%
GAAP expense ratio (excluding interest) 35.1% 41.4% 39.1% 32.2%
----- ----- ----- -----
Total 130.3% 115.9% 235.4% 111.8%
====== ====== ====== ======
Basic earnings per share $ (0.72) $ 0.62 $ (1.26) $ 0.05
Diluted earnings per share $ (0.72) $ 0.57 $ (1.26) $ 0.04
2001
---------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
(in thousands, except per share data and ratios)
Total premiums $ 96,019 $ 90,039 $ 80,588 $ 83,745
Net investment income 6,725 7,185 8,571 8,132
Net realized capital gains and losses and
other income (889) 3,476 728 (1,902)
-------- -------- -------- --------
Total revenues 101,855 100,700 89,887 89,975
-------- -------- -------- --------
Benefits to policyholders 72,137 60,235 47,220 59,563
Commissions & expenses 37,372 33,793 27,999 32,308
Net acquisition costs deferred (5,397) 1,750 7,255 68,052
-------- -------- ------ --------
Net income $(2,336) $ 2,430 $ 4,075 $(52,759)
======== ======== ======== ========
GAAP loss ratio 75.1% 66.9% 58.6% 71.1%
GAAP expense ratio (excluding interest) 33.3% 39.5% 43.7% 119.8%
----- ----- ----- ------
Total 108.4% 106.4% 102.3% 190.9%
====== ====== ====== ======
Basic earnings per share $ (0.32) $ 0.20 $ 0.22 $ (2.80)
Diluted earnings per share $ (0.32) $ 0.20 $ 0.22 $ (2.80)
See Notes to Selected Financial Data Table
48
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Significant Accounting Disclosure
(amounts inthousands, except per share data)
The preparation of financial statements in accordance with GAAP requires
management to make estimates and assumptions that affect the reported amounts
and related disclosures. Such estimates and assumptions significantly affect
various reported amounts of assets and liabilities. Management has made
estimates in the past that we believed to be appropriate but were subsequently
revised to reflect actual experience. If our future experience differs
materially from these estimates and assumptions, our results of operations and
financial condition could be affected. Management considers an accounting
estimate to be critical if:
o It requires assumptions to be made that were uncertain at the time the
estimate was made; and
o Changes in the estimate or different estimated amounts that could have
been selected could have a material impact on our results of
operations or financial condition.
Policy Reserves and Policy and Contract Claim Liabilities
Our policies are accounted for as long duration policies. As a result there
are two components to the liabilities associated with our policies. The first is
a liability for future policyholder benefits, represented by the present value
of future benefits less future premium collections. In calculating these
reserves we utilize assumptions, including estimates for persistency, morbidity
(claims expectations), mortality, interest rates, and premium rate increases.
These assumptions are estimated in the year a policy is issued. Once the
assumptions are established we continue to utilize those assumptions unless our
assessment of deferred acquisition costs indicates that the present value of
anticipated future premiums less future costs plus current reserves is less than
current unamortized DAC. Any variance from the assumptions established in the
year a policy is issued could have a material impact on our results of
operations and financial condition.
The second reserve we establish is for incurred, either reported or not yet
reported, policy and contract claims. This amount represents the benefits for
our current claims. The significant assumptions utilized in establishing the
policy and contract claims are expectations about the duration and incidence of
claims and the interest rate utilized to discount the claim reserves. These
assumptions are based on our past experience, industry experience and current
trends.
As part of our monitoring of policy and contract claims we compare actual
results to our expectations. Any deviations from our expectations are recorded
in the year in which the deviation occurs. During 2002 we increased our policy
and contract claim reserves by $83,000 based on new assumptions that have been
applied to both claims incurred during 2002 and to claims incurred prior to
2002. Any changes in our estimates in the future may have a material impact on
our financial condition and results of operations.
49
DAC Recoverability
We regularly assess the recoverability of deferred acquisition costs
through actuarial analysis. To determine recoverability, the present value of
anticipated future premiums less future costs and claims are added to current
reserve balances. If this amount is greater than the current unamortized DAC
then the DAC is deemed recoverable.
The DAC recoverability analysis includes assumptions for persistency,
morbidity (claims expectations), interest rates, and premium rate increases. The
recoverability of our DAC is dependent upon the assumption of future rate
increases.
Long-term care insurance has fixed annual premiums that can be adjusted
only upon approval of the insurance departments of the states where the premiums
were written. The adjustment of these fixed annual premium rates is referred to
as rate increases. The process for filing for rate increases requires the
company to demonstrate to the insurance department that expected claims
experience is anticipated to exceed original assumptions. The approval of rate
increases is at the discretion of the insurance department.
Over the past two years, we have had success in obtaining rate increases
for a majority of our products. However, we have a continuing need to obtain
rate increases on the remaining products that have not yet received rate
increases and, in certain cases, additional rate increases on products where we
have already received rate increases. There has been increased public and
regulatory scrutiny over the practice of obtaining rate increases on long-term
care insurance.
We base our rate increase assumptions on our past experience and our
expectations of the amounts of actual rate increases that we will be able to
achieve. If we are unsuccessful in obtaining the assumed level of rate
increases, we could recognize an impairment in the future, which could have a
material adverse effect on our results of operations and financial position.
Litigation and Contingencies
We are involved in lawsuits relating to our operations. These lawsuits
include, but are not limited to, allegations as to improper sales practices in
connection with the recent rate increases on our long-term care policies.
We are also involved in a dispute with one of our reinsurers over an
alleged breach of contract by the Company as a result of the Company entering
into the 2001 Centre reinsurance agreement without obtaining prior written
approval of the reinsurer.
We recognize an estimated loss for contingencies when we believe it is
probable that a loss has occurred and the amount of loss can be reasonably
estimated. However, it is difficult to measure the actual loss that might be
incurred related to litigation and contingency matters. As time passes and
additional facts and circumstances become known, our estimation of the
probability of loss as well as our ability to reasonably estimate a loss will
change. The ultimate outcome of litigation and other contingencies could have a
material adverse impact on our results of operations and financial position in
the future.
50
Deposit Accounting for 2001 Centre Reinsurance Agreement
The 2001 Centre reinsurance agreement is being accounted for utilizing
deposit accounting for reinsurance contracts. We are using deposit accounting
because we believe the reinsurance contract does not result in the reasonable
possibility that the reinsurer will suffer a significant loss. We assessed this
long-duration reinsurance contract using the reasonable possibility of
significant loss criteria due to certain contract provisions that limit the risk
to the reinsurer, including an aggregate limit of liability for the reinsurer,
experience refund provisions, and expense and risk charges provided to the
reinsurer. We also entered into the reinsurance agreement with the intent of
commuting the agreement at December 31, 2007, which further supports the use of
deposit accounting.
We have established the accounting model for this reinsurance agreement
assuming that we will commute the contract on December 31, 2007, the first
available commutation date. We intend, but are not required, to commute the
agreement on December 31, 2007. We have significant incentive to commute the
agreement on December 31, 2007 as the expense and risk charges applied to the
experience account for the benefit of the reinsurer begin to escalate after
December 31, 2007 and the reinsurer may exercise warrants at a common stock
equivalent price of $2.00 per share, representing approximately 20% of the then
outstanding common stock on a fully diluted basis.
Our current actuarial modeling and projections indicate that it is likely
that we will be able to commute the agreement, as planned, on December 31, 2007.
In order to commute the agreement, PTNA's and ANIC's (our Pennsylvania insurance
subsidiaries) statutory surplus following commutation must be sufficient to
support the reacquired business in accordance with statutory capital
requirements. Upon commutation, we will receive cash or other liquid assets
equalling the value of the experience account. For statutory reporting purposes,
we will also record the statutory-basis policy reserves and policy and contract
claim liabilities in our statutory financial statements. Accordingly, the
Company's ability to commute the agreement is highly dependent upon the value of
the experience account exceeding the level of required statutory-basis policy
reserves on December 31, 2007.
As of December 31, 2002, the statutory-basis policy reserves and policy and
contract claim liabilities of $905,330 exceed the value of the experience
account of $708,982. We expect that the growth in the experience account will
exceed the growth in the policy reserve and policy and contract claim
liabilities, such that the experience account value will exceed the policy and
contract claim liabilities at December 31, 2007. Our ability to commute is
dependent upon our assumptions regarding the future performance of the
underlying insurance policies from now until December 31, 2007. Additionally,
the experience account value is susceptible to market interest rate changes. A
market interest rate increase of 100 basis points could reduce the value of the
experience account by approximately $70,000 and jeopardize the Company's
ability to commute as planned. We cannot anticipate future increases or
decreases in market interest rates.
As a result of our intention to commute on December 31, 2007, we assessed
only estimated expense and risk charges prior to December 31, 2007 in our most
recent DAC recoverability analyses. We have not included any of the escalating
expense and risk charges beyond December 31, 2007. In addition, as part of the
consideration for the agreement, we provided the reinsurer with warrants valued
at approximately $15,855. This consideration is being recognized over the
anticipated life of the contract.
51
In the event we determine that commutation of the reinsurance
contract is unlikely on December 31, 2007, but likely at some future date, we
would include the additional annual expense and risk charges in our DAC
recoverability analysis. This would most likely result in an additional
impairment of our DAC. The amount of the impairment would be dependent on the
number of additional years beyond December 31, 2007 until commutation as well as
our best estimate of the other assumptions utilized in the DAC impairment
calculation (morbidity, mortality, interest rates, premium rate increases, and
withdrawls) at the date the analysis is performed.
Experience Account
Our 2001 Centre reinsurance agreement includes a provision for the
maintenance of an experience account for our benefit in the event we elect to,
and are able to, commute the reinsurance agreement in the future. The experience
account balances was $708,982 as of December 31, 2002. We receive a return on
the experience account that is based on a series on benchmark indices and
derivative hedges. The benchmark indices are comprised on US Treasury strips,
agencies, and investment grade corporate bonds with weightings of approximately
25%, 15% and 60%, respectively and a duration of approximately 11 years.
We believe the return on the notional experience account represents a
hybrid instrument, containing both a fixed debt host and an embedded derivative,
as defined in Statement of Financial Accounting Standards No. 133, "Accounting
for Derivative Instruments and Hedging Activities" (SFAS 133). In accordance
with SFAS 133, we are accounting for the investment return on the experience
account as follows:
o The fixed debt host yields a fixed return based on the yield to
maturity of the underlying benchmark indices. The fixed debt host is
reported as investment income in the Statement of Operations.
o The change in fair value of the embedded derivative, represented by
the percentage change in the underlying indices applied to the
notional experience account, is similar to that of an unrealized gain
or loss on a bond. The change in the fair value of the embedded
derivative is reported as a market gain (or loss) on experience
account in the Statement of Operations.
Our conclusion that the return on the notional experience account
represents a hybrid instrument with an embedded derivative is based on our
belief that the economic characteristics and risk of the fixed debt host
contract are not clearly and closely related to those of the embedded
derivative. When we determine the yield on the fixed debt host and the value of
the embedded derivate, we reconcile these amounts to the amount credited to the
experience account by the reinsurer, as we believe the actual return credited by
the reinsurer should equal the sum of the amounts recognized in our Statement of
Operations.
52
Goodwill
At December 31, 2002, the balance of our goodwill was $20,360. Effective
January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets." The adoption of SFAS 142 resulted in the
elimination of goodwill amortization, the allocation of the goodwill to
reporting units, and the establishment of an annual impairment test based on the
fair value of the reporting units to which the goodwill has been allocated.
Different valuation methods and assumptions can produce significantly different
results, which could affect the amount of any goodwill impairment charge.
We have identified two reporting units (agency operations and insurance
operations) as defined in SFAS 142. The goodwill was allocated between the two
reporting units as follows: agency operations $20620 and insurance operations
$5151. Our impairment analysis involved an assessment of the fair value of each
reporting unit utilizing a discounted cash flow analysis. Upon completion of the
analysis, we determined that the goodwill associated with the agency operations
was fully recoverable and that the goodwill allocated to the insurance
operations was impaired. As a result, we recognized an impairment loss of
approximately $5151 which has been recorded as a cumulative effect of change in
accounting principle.
The agency valuation assumed, among other things, future growth in our
agency business that is consistent with our growth in the past. In the event
that our actual growth and profitability does not meet our expectations, we may
realize a goodwill impairment in the future.
Overview
(amounts in thousands, except per share data)
Our principal products are individual, defined benefit accident and health
insurance policies that consist of nursing home care, home health care, Medicare
supplement, life and long-term disability insurance. We experienced significant
reductions in new premium sales during 2001 and 2002 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 claims, as well as estimated future benefits payable
under our insurance policies. These reserves must, at a minimum, comply with
mandated standards. Our reserves are certified annually by our consulting
actuary as to standards required by the insurance departments for our
domiciliary state and for the other states in which we conduct business. We
believe we maintained adequate reserves as mandated by each state in which we
are currently writing business at December 31, 2002.
53
Our results of operations are affected significantly by the following other
factors:
Level of required reserves for policies in-force. Our insurance policies
are accounted for as SFAS 60 long duration contracts. As a result, there are two
components of policyholder liabilities. The first is a policy reserve liability
as required by SFAS 60 for future policyholder benefits, represented by the
present value of future benefits less future premium collection. These reserves
are calculated based on assumptions that include estimates for mortality,
morbidity, interest rates, premium rate increases and policy persistency. The
assumptions are consistent with industry experience and historical results, as
modified for our own experience.
The second is a reserve for incurred, either reported or not yet reported,
policy and contract claims, which represents the benefits for current claims.
The amount of reserves relating to reported and unreported claims incurred is
determined by periodically evaluating statistical information with respect to
the number and nature of historical claims. We compare actual experience with
estimates and adjust our reserves on the basis of such comparisons to the extent
that our analysis suggests that adverse development is likely to continue in
future periods.
Additions to, or reductions in, reserves are recognized in our current
consolidated statements of operations and comprehensive income as expense or
income, respectively, through benefits to policyholders and are a material
component of our net income or loss. A portion of premium collected in each
period is set aside to establish reserves for future policy benefits.
Establishing reserves is based upon current assumptions and we cannot assure you
that actual claims expense will not differ materially from the claims expense
anticipated by the assumptions used in the establishment of reserves. Any
variance from these assumptions could affect our profitability in future
periods.
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. In addition, the assumptions underlying
DAC and our policy benefit reserves are periodically reviewed and updated to
reflect current assumptions. Whenever we determine that our DAC is not fully
recoverable, we impair the carrying value of our DAC through an expense to our
consolidated statement of operations and comprehensive income.
54
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.
Investment income and experience account. Our investment portfolio,
excluding our notional 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 3.1 years), investment income does not immediately
reflect changes in market interest rates.
In connection with our reinsurance agreement with Centre, we transferred
substantially all of our investment portfolio to the reinsurer as the initial
premium payment. The initial and future premium for the reinsured policies, less
claims payments, ceding commissions and risk charges is credited to a notional
experience account, the balance of which also receives an investment credit. The
notional experience account balance represents an amount to be paid to us in the
event of commutation of the agreement. Based on our analysis of SFAS 133, we
believe that the experience account represents a hybrid instrument, containing
both a fixed debt host contract and an embedded derivative.
1. The fixed debt host yields a fixed return based upon the yield to
maturity of the underlying benchmark indices. The return on the fixed debt host
is reported as investment income in the Statement of Operations.
2. The change in fair value of the embedded derivative represents the
percentage change in the underlying indices applied to the notional experience
account, similar to that of an unrealized gain/loss on a bond. The change in the
fair value of the embedded derivative is reported as market gain on experience
account in the Statement of Operations.
As a result, our results of operations are subject to significant
volatility. Recorded market value gains or losses, although recognized in
current earnings, are expected to be offset in future periods from the receipt
of the most recent market rates for all subsequent periods. The benchmark
indices are comprised of U.S. Treasury strips, agencies and investment grade
corporate bonds, with weightings of approximately 25%, 15% and 60%,
respectively, and have a duration of approximately 11 years.
Lapsation and persistency. Factors that affect our results of operations
include lapsation and persistency, both of which relate to the renewal of
insurance policies. Lapsation is the termination of a policy by non-renewal.
Lapsation is automatic if and when premiums become more than 31 days overdue
although, in some cases, a lapsed policy may be reinstated within six months.
Persistency represents the percentage of premiums renewed, which we calculate by
dividing the total annual premiums at the end of each year (less first year
premiums for that year) by the total annual premiums in-force for the prior
year. For purposes of this calculation, a decrease in total annual premiums
in-force at the end of any year would be the result of non-renewal of policies,
including policies that have terminated by reason of death, lapsed due to
nonpayment of premiums and/or been converted to other policies we offered. First
year premiums are premiums covering the first twelve months a policy is
in-force. Renewal premiums are premiums covering all subsequent periods.
55
Policies renew or lapse for a variety of reasons. We believe that our
efforts to address policyholder concerns or questions help to ensure policy
renewals. We work closely with our licensed agents, who play an integral role in
policy persistency and policyholder communication.
Economic cycles can influence a policyholder's ability to continue the
payment of insurance premiums when due. We believe that publicity regarding
newly enacted Federal and state tax legislation allowing medical deductions for
certain long-term care insurance premiums has raised public awareness of the
escalating costs of long-term care and the value provided to the consumer of
long-term care insurance. The ratings assigned to our insurance subsidiaries by
independent rating agencies also influence consumer decisions.
Lapsation and persistency can both positively and adversely affect future
earnings. Reduced lapsation 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 also lead to decreased claims in future periods.
Results of Operations
Twelve Months Ended December 31, 2002 and 2001 (amounts in thousands)
Premiums. Total premium revenue earned in the twelve months ended December
31, 2002 (the "2002 period"), including long-term care, disability, life and
Medicare supplement, decreased 4.8% to $333,643, compared to $350,391 in the
same period in 2001 (the "2001 period").
Total first year premiums earned in the 2002 period decreased
85.5% to $6,436, compared to $44,539 in the 2001 period. First year long-term
care premiums earned in the 2002 period decreased 86.9% to $5,501, compared to
$42,135 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
continued market concerns regarding our insurance subsidiaries' statutory
surplus. 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 policy 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 Department's approval of the Plan in
February 2002, we recommenced new policy sales in 23 states, including
Pennsylvania. We have now recommenced new policy sales in 10 additional states,
including Florida, Virginia and Texas, which have historically represented
approximately 18%, 7% and 5% of our new policy sales, respectively. We are
actively working with the remaining states to recommence new policy sales in all
jurisdictions. We have recently agreed upon terms for the recommencement of
sales in California, which is pending subject to certain conditions. California
has historically represented approximately 15% of our new policy sales.
56
Total renewal premiums earned in the 2002 period increased 7.0% to
$327,207, compared to $305,852 in the 2001 period. Renewal long-term care
premiums earned in the 2002 period increased 8.8% to $316,338, compared to
$290,632 in the 2001 period. The majority of this increase resulted from the
receipt of increased revenue following the implementation of premium rate
increases averaging approximately 20% on 70% of our policies in force. We may
experience reduced renewal premiums if policies lapse, especially given our
recent premium rate increases. Persistency decreased from 88% in the 2001 period
to 85.6% in the 2002 period. Current declines in first year premiums, as
discussed above, will negatively impact future renewal premium growth as well.
Net investment income. Net investment income earned for the 2002 period
increased 31.0% to $40,107, from $30,613 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 experience 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 5.91% and 5.62%, respectively, in the 2002 and 2001 periods.
Although market rates have declined, the higher yield in the 2002 period
resulted from a significant change in our portfolio. In 2002, primarily all of
our investment income is derived from the investment credit attributable to the
fixed debt host component of our experience account return, which has a duration
of approximately 11 years and correspondingly, a higher yield. In 2001, we held
a portfolio of bonds with a duration of approximately 5 years and common stocks.
The investment income component of our experience account investment credit
generated $38,375 in the 2002 period, with an average yield of 6.51%.
The total return of the Lehman Brothers US Aggregate Bond Index was 10.26%
and 8.44% for 2002 and 2001, respectively. The total return on our experience
account, which comprises the majority of our investible assets was 15.65% in the
2002 period and the total return of our fixed income portfolio in 2001 was
8.92%. Management attributes the favorable return achieved from its experience
account in 2002 to a longer duration of the underlying benchmark indices, which
were positively impacted by declining market interest rates during 2002. The
performance of our portfolio in 2001, which did not include an experience
account, was similar to the total return of the Lehman Brothers US Aggregate
Bond Index.
Net realized capital gains and trading account activity. During the 2002 period,
we recognized capital gains of $15,663, compared to capital losses of $4,367 in
the 2001 period. We accounted for the transfer of the securities portion of the
initial premium payment for our new reinsurance agreement as a sale of these
assets. Substantially all of the recognized capital gains in the 2002 period
resulted from the transfer of the initial premium of approximately $563,000 to
the reinsurer. The results in the 2001 period were recorded primarily due to the
impairment of all unrealized losses in our investment portfolio as other than
temporary declines. This determination resulted from our decision to transfer
substantially all of our investable assets to the reinsurer, which would prevent
the future recovery of these unrealized losses.
57
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 $3,428, 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 gain on our
experience account balance of $56,555 in the 2002 period.
As discussed in "Overview" and "Net Investment Income" above, the reinsurer
maintains a notional experience account for our benefit in the event of future
recapture. The notional experience account receives 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 (See Item 7A - "Disclosures About Market
Risk").
Other income. We recorded $11,585 in other income during the 2002 period, up
from $9,208 in the 2001 period. The increase is attributable primarily to the
recognition of a deferred gain from the sale of our disability business in the
2001 period. The sale was done as a 100% quota share agreement, in contemplation
of a subsequent assumption of the business, where actual ownership of the
policies would change. In the 2002 period, approximately 48% of the policies
were assumed and we recorded approximately $2,600 as other income.
Benefits to policyholders. Total benefits to policyholders in the 2002 period
increased 55.5% to $371,998 compared to $239,155 in the 2001 period. Our loss
ratio, or policyholder benefits to premiums, was 111.5% in the 2002 period,
compared to 68.3% in the 2001 period.
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 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.
58
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. 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. We compare actual experience with estimates and adjust reserves on the
basis of such comparisons.
We evaluate our prior year assumptions by reviewing the development of
reserves for the prior period. This amount of $80,948 and $8,845, in 2002 and
2001, respectively, from prior year-end reserve balances plus adjustments to
reflect actual versus estimated claims experience. These adjustments
(particularly when calculated as a percentage of the prior year-end reserve
balance) provide a relative measure of deviation in actual performance as
compared to our initial assumptions.
The adjustments to reserves for claims incurred in prior periods are
primarily attributable to claims incurred from our long-term care insurance
policies, which represent approximately 95% of our premium in-force.
To estimate reserves for future claims payments more precisely, we have
refined our assumptions and processes for developing these reserves. During the
third quarter, we completed an analysis of the adverse deviation recognized in
the past development of our reserves for current claims. As a result of this
analysis, our actuarial modeling suggested that future claim payments would
likely exceed our past assumptions, which, if unaddressed, could continue to
cause future adverse deviation.
As a result, we have made two modifications to our process for developing
claims reserves:
a) Redefinition of Claims:
Over the past 10 years, our percentage of policies-in-force offering
benefits for both nursing facility and in-home health care coverage has
increased. We have recorded claims that begin in one type of care and later
move to another type of care as two separate claims. Defining claims in
this manner has projected a greater number of expected claims from certain
types of policies, as well as a shorter expected length of individual
claims. We have now determined to define this as one claim, using the
earliest date of service as the incurral date. This redefinition of claims
results in fewer expected future claims, but anticipates that each claim
will last longer.
b) Continuance Assumptions:
Once a claim occurs, we develop claim reserves by using continuance
tables, which measure the likelihood of a claim continuing in the future.
Historically, we have applied every claim to a set of uniform continuance
tables. Our actuarial modeling suggests that this assumption and process no
longer reflects the increasing number of claims from policies with longer
benefit periods or increased benefit amounts. We have refined our
assumptions and processes by creating separate continuance patterns for
facility, home health and comprehensive care, as well as for tax qualified
and non-qualified plans. In addition, we have established separate
continuance tables for claims caused by cognitive impairment. As a result,
we believe that the duration of existing claims will be longer than was
previously expected and have adopted this assumption and process change.
59
By redefining these `multiple' claims as a single claim and by employing
new assumptions and processes for predicting the continuance of claims, we are
confident that we can predict future claims development with a much higher
degree of precision. By identifying trends earlier, we would have seen
substantially less adverse deviation from expected results in the development of
claims reserves. We believe that the new assumptions will serve to reduce future
reserve volatility by more closely predicting future claims development.
As a result of this redefinition of claims and employment of new
continuance tables for separate types of claims, we increased our policy and
contract claims by $83,000 in the third quarter of 2002, which is primarily
attributable to claims incurred prior to January 1, 2002. The new continuance
tables have been applied to all claims in the determination of our claims
reserves at December 31,2002. We expect to continue the evaluation of these
continuance tables in the future, making adjustments to our expectations as
further experience develops and is analyzed.
Our process to determine new continuance tables included the evaluation of
historical claims payments and duration. During our review, we recognized that
our claims experience had deteriorated in 2000 and 2001, and was improving
during the latter part of 2001 and 2002. Further examination in the fourth
quarter of 2002 indicated that several changes that we employed in our claims
management process have impacted the recent results of our claims and are
expected to improve our results in the future. These changes include 1) new
underwriting protocols, 2) further development of our internal care management
staff, which enables all new claims to be screened by nurses that are able to
assist the claimant in the development of a proper plan of care, 3) more
experienced claim staff that are better able to adjudicate new and exisiting
claims, and 4) the use of hospital and home health care provider networks that
offer discounted pricing for claimants using their services. In addition, we
have recently implemented a fraud prevention and quality assurance unit, that
while not yet fully developed, is expected to identify and terminate fraudulent
claims.
We believe that these and other changes currently contemplated could reduce
future claims below the levels anticipated as a result of our third quarter
analysis. In our year-end 2002 claim reserve analysis, we continued to see
positive trends. Accordingly, we have considered these trends in evaluating our
claims reserves. We estimate that the impact of the reflection of these trends
results in a reduction of our claims reserves approximately 1.5% or $4,800. This
$4,800 has increased earnings in the fourth quarter of 2002.
Further, by employing a lower discount rate of 5.7% in the 2002 period,
rather than the 6.5% that had been used in prior periods, we increased our
claims reserves by approximately $5,000. We believe that, as a result of lower
market interest rates, the lower discount rate more closely matches our
currently anticipated return from the investment of assets supporting these
reserves.
60
In 2001, two factors affected the reserves we held for claims incurred in
prior years. (1) Excluding $7,050 from the effect of imputed interest, we added
$8,845 to our claim reserves for 2000 and prior claim incurrals. Prior to 2001,
we based our expectations on claim continuance patterns determined from our
historical claims payments. In 2001, we engaged a new consulting actuary that
provided us with additional industry data to incorporate in our revised
continuance expectations (the probability that a claim in one duration will
continue to another). Our analysis of this supplemental data suggested that we
would recognize higher future payments on currently incurred claims than was
previously anticipated. As a result, we lengthened our continuance tables for
claim durations beyond the third year, and increased our reserves held for
claims incurred to record this liability. We believe that our experience for
claims in the first, second and third duration was consistent with industry data
and, therefore, did not alter this portion of our continuance tables. (2) In
2001, we reduced the discount rate used in the establishment of reserves to
appropriately reflect the current investment rate earned on assets supporting
this liability. As a result, reserves for claims incurred in prior years was
increased $1,582.
In 2001, we recognized a premium deficiency and unlocked our prior reserve
assumptions. These assumptions include interest rates, premium rates, shock
lapses and anti-selection of policyholder persistence. In 2002, we again
recognized a premium deficiency due to anticipated investment earnings rate
reductions and expected acceleration and amount of future claims payments,
primarily offset by increased expectations of premium rate increases. As a
result, we unlocked our prior reserve assumptions and employed new expectations
in the establishment of future reserves. Reserves were not reduced as a result
of this change in assumptions (See "Net policy acquisition costs amortized
deferred").
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 increased loss ratios
resulting from higher claims expectations 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. We may also be susceptible to
adverse selection in our claims experience resulting from the lapse of healthier
policyholders that do not elect to renew their policies at the higher premium
rates.
61
Commissions. Commissions to agents decreased 40.4% to $45,741 in the 2002
period, compared to $76,805 in the 2001 period.
First year commissions on accident and health business in the 2002 period
decreased 87.8% to $3,582, compared to $29,371 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
55.7% in the 2002 period and 67.4% 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 and Medicare Supplement policies as a
percentage of total sales. These policies pay a lower 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 as a percentage of new
sales when we recommence sales in many states as a result of our lower financial
ratings with A.M. Best and Standard and Poor's rating services.
Renewal commissions on accident and health business in the 2002 period
decreased 10.9% to $44,127, compared to $49,540 in the 2001 period. The ratio of
renewal accident and health commissions to renewal accident and health premiums
was 13.6% in the 2002 period and 16.6% in the 2001 period. We began the
implementation of premium rate increases averaging approximately 20% on 70% of
our policies in force at the end of the 2001 period, for which we do not pay
commissions. As a result, commission ratios are reduced. In addition, during
2001, we experienced the sale of a greater portion of higher-risk policies that
generally have a higher premium and reduced or no renewal commission structure.
The reduced commission ratio in the 2002 period is, in part, due to the impact
of these policies being renewed.
During the 2002 period, we reduced commission expense by netting, as an
intercompany elimination, $2,051 from override commissions affiliated insurers
paid to our agency subsidiaries. During the 2001 period, we reduced commissions
by $2,973.
Net policy acquisition costs amortized (deferred). The net deferred policy
acquisition costs in the 2002 period increased to a net amortization of costs of
$8,694, compared to $71,660 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.
62
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.
We regularly assess the recoverability of deferred acquisition costs
through actuarial analysis. To determine recoverability, the present value of
future premiums less future costs and claims are added to current reserve
balances. If this amount is greater than current unamortized deferred
acquisition costs, the unamortized amount is deemed recoverable. In the event
recoverability is not demonstrated, we reassess the calculation using
justifiable premium rate increases. If rate increases are not received or are
deemed unjustified, we will expense, as impaired, the attributed portion of the
deferred asset in the current period. If we conclude that the deferred
acquisition costs are impaired, we will record an impairment loss and a
reduction in the deferred acquisition cost asset. In the event of an impairment,
we will also evaluate our historical assumptions utilized in establishing the
policy reserves and deferred acquisition costs and may update those assumptions
to reflect current experience (referred to as "unlocking"). The primary
assumptions include persistency, claims expectations, interest rates and rate
increases.
During 2002, we recognized an impairment of our deferred acquisition costs
of approximately $1,100 due to our anticipation of reduced future investment
earnings rates and accelerated claims and higher ultimate claim payments,
substantially offset by increased premium rate expectations. In the event
planned premium rate increases are not achieved, we could recognize an
additional impairment of our deferred acquisition costs in the future, which
could have a material adverse affect upon our results of operations and
financial condition.
During 2001, we recognized an impairment of our deferred acquisition costs
of approximately $61,800. Effective December 31, 2001, we entered into a
reinsurance agreement covering substantially all of our long-term care policies.
The reinsurance agreement includes an annual expense and risk charge, which the
reinsurer credits against our experience account. Since we anticipate that we
will commute the reinsurance agreement, we include these expenses in our future
profit analysis. The reduction in the anticipated future gross profits resulting
from the expense and risk charges was the primary factor causing the 2001
impairment of the deferred acquisition costs.
General and administrative expenses. General and administrative expenses in the
2002 period decreased 5.7% to $46,473, compared to $49,282 in the 2001 period.
The 2002 and 2001 periods include $6,165 and $6,591, 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 13.9% in the 2002 period, compared to 12.2% in the
2001 period. As a result of the adoption of SFAS No. 142 (see "New Accounting
Principles"), 2002 expenses were reduced by $1,293, due to the cessation of
goodwill amortization.
Certain 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.
63
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance
agreement provides the reinsurer with annual expense and risk charges, which are
credited 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 incurred a charge of $14,308 for this charge.
In addition, we are subject to an excise tax for premium payments made to a
foreign reinsurer. We recorded $2,919 for excise tax expenses in the 2002 period
and recorded $5,635 in the 2001 period in connection with the effective date of
the agreement.
Provision for federal income taxes. As a result of current losses, our provision
for Federal income taxes for the 2002 period decreased 20.0% to an income tax
benefit of $13,026, compared to an income tax benefit of $16,280 for the 2001
period. The effective tax rate of 34% in the 2002 and 2001 periods is below the
normal Federal corporate income tax rate as a result of the tax-exempt nature of
income from our investments in corporate owned life insurance.
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 (loss). During the 2002 period, our investment portfolio
generated pre-tax unrealized gains of $1,310, compared to unrealized gains of
$11,606 in the 2001 period. The reduced unrealized gain at December 31, 2002 is
primarily attributable to the sale of the majority of our investment portfolio
in conjunction with the initial premium payment for our reinsurance agreement.
After accounting for deferred taxes from these gains, shareholders' equity
decreased by $39,931 from comprehensive losses during the 2002 period, compared
to comprehensive losses of $37,344 in the 2001 period.
Twelve Months Ended December 31, 2001 and 2000
(amounts in thousands)
Premiums. Total premium revenue earned in the twelve month period ended
December 31, 2001, including long-term care, disability, life and Medicare
supplement, decreased 1.9% to $350,391, compared to $357,113 in the twelve month
period ended December 31, 2000. Total premium in the 2001 period was reduced by
$10,009 as a result of premium ceded for the reinsurance of our disability
product line.
Total first year premiums earned in 2001 decreased 54.5% to $44,539,
compared to $97,888 in 2000. First year long-term care premiums earned in 2001
decreased 56.0% to $42,135, compared to $95,693 in 2000. We experienced
significant reductions in new premium sales due to the cessation of new business
generation in all states during the third and fourth quarters and as a result of
the market's concerns regarding our insurance subsidiaries' statutory surplus.
64
Effective September 10, 2001, we discontinued the sale, nationally, of all
new long-term care insurance policies until our Corrective Action 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 Corrective Action Plan and from increasing
concern regarding our financial status expressed by many states in which we are
licensed to conduct business. Under our Corrective Action Plan, we intend to
limit future new business growth to levels that will allow us to maintain
sufficient statutory surplus. See "Liquidity and Capital Resources." Since the
approval of our Corrective Action Plan on February 12, 2002, we have recommenced
sales in 26 states and are continuing efforts to recommence new policy sales in
all states upon individual state approvals.
Total renewal premiums earned in 2001 increased 18.0% to $305,852, compared
to $259,225 in 2000. Renewal long-term care premiums earned in 2001 increased
18.7% to $290,632, compared to $244,945 in 2000. This increase reflects renewals
of a larger base of in-force policies, as well as a continued increase in
policyholder persistency.
Net investment income. Net investment income earned during 2001 increased
11.7% to $30,613, from $27,408 for 2000. Management attributes this growth to an
increase in invested assets, which resulted from premium receipts and from the
investment of additional funds generated from the exercise of rights to purchase
shares of our common stock distributed to our shareholders and holders of our
Subordinated Notes. Our average yield on invested assets at cost, including cash
and cash equivalents, was 5.6% in 2001, compared to 6.2% in 2000. The average
yield is lower due to reduced market rates for reinvesting of maturing
investments and due to higher cash balances held during 2001.
The total return of the Lehman Brothers US Aggregate Bond Index was 8.44%
and 11.63% for 2001 and 2000, respectively. Including the effect of realized and
unrealized capital gains and losses and trading account results arising during
the period, the total return of our fixed income portfolio was 8.92% and 8.83%
in the 2001 and 2000 periods, respectively. While the performance in the 2001
was similar to the total return of the Lehman Brothers US Aggregate Bond Index,
our 2000 performance was below the benchmark index due primarily to significant
declines in the market value of three bonds during the year, totaling
approximately $5,100.
Net realized capital gains and trading account activity. During 2001, we
recognized capital losses of $4,367, compared to capital gains of $652 in 2000.
The results of both years were recorded due to realized gains and losses from
our normal investment management operations and from impairment losses of
approximately $5,800 in 2001 and $3,200 in 2000 on equity and debt securities,
which we deemed to be other than temporary. At December 31, 2001, we entered a
reinsurance agreement for which a substantial portion of our investment
portfolio was later ceded as the initial premium for this agreement. As a result
of this intended transfer or sale of assets, we determined that all gross
unrealized losses on our debt and equities securities would not be recovered and
therefore were deemed other than temporary impairments. We recognized a loss of
$3,867 from this determination.
We classified our convertible bond portfolio as trading account investments
as a result of Statement of Financial Accounting Standards No. 133 "Accounting
for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). Changes in
trading account investment market values are recorded in our statement of
operations during the period in which the change occurs, rather than as an
unrealized gain or loss recorded directly through equity. Therefore, we recorded
a trading account loss in 2001 of $3,428, which reflects the unrealized and
realized loss of our convertible portfolio that arose during the year ended
December 31, 2001. We sold all of our convertible bond investments during 2001.
65
Other income. We recorded $9,208 in other income during 2001, up from
$8,096 in 2000. The increase is attributable to an increase of commissions
earned by United Insurance Group on sales of insurance products underwritten by
unaffiliated insurers and to income generated from corporate owned life
insurance policies.
Benefits to policyholders. Total benefits to policyholders in 2001
decreased 1.8% to $239,115, compared to $243,571 in 2000. Our loss ratio, or
policyholder benefits to premiums, was 68.3% in 2001, compared to 68.2% in 2000.
We review the adequacy of our deferred acquisition costs on an annual
basis, utilizing assumptions for future expected claims and interest rates. If
we determine that the future gross profits of our in-force policies are not
sufficient to recover our deferred acquisition costs, we recognize a premium
deficiency and "unlock" (or change) our original assumptions and reset our
reserves to appropriate levels using new assumptions. During the second quarter
of 2001, we performed a DAC recoverability analysis on our existing business,
utilizing our most current assumptions. Upon the completion of the analysis, we
determined to record an impairment charge of approximately $300 and utilized the
new assumptions in the establishment of our current DAC and policy benefit
reserves, in accordance with SFAS 60. This reset of DAC and reserves resulted in
a decrease of approximately $7,600 to reserves and a decrease to DAC of
approximately $7,900, representing 2% and 4% of the respective balances. The
resultant net GAAP liability (reserves less DAC) is $300 higher than before the
impairment charge. We believe that the new levels of DAC and reserves more
appropriately represent the future anticipated development of both accounts.
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 adverse deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During 2001, we filed
premium rate increases on the majority of our policy forms in a majority of
states. These rate increases were sought as a result of higher claims
expectations and policyholder persistency than existed at the time of the
original form filings. The assumptions used in requesting and supporting the
premium rate increase filings are consistent with those incorporated in our
newest policy form offerings. We have been generally successful in the past in
obtaining state insurance department approvals for increases. If we are
unsuccessful in obtaining rate increases when deemed necessary, or if we do not
pursue rate increases when actual claims experience exceeds our expectations, we
could suffer a financial loss.
Due to the utilization of assumptions in establishing reserves, it has been
necessary in the past for us to increase the estimated liabilities reflected in
our reserves for claims and policy expenses. In the year in which a claim is
first incurred, we establish policy and contract claims reserves that are
actuarially determined to be the present value of all future payments required
for that claim. We assume that our current reserve amount and interest income
earned on invested assets will be sufficient to make all future payments. We
evaluate our prior year assumptions by reviewing the development of reserves for
the prior period. This amount of $17,477 and $13,427, in 2001 and 2000,
respectively, includes imputed interest from prior year-end reserve balances
plus adjustments to reflect actual versus estimated claims experience. These
adjustments (particularly when calculated as a percentage of the prior year-end
reserve balance) provide a relative measure of deviation in actual performance
as compared to our initial assumptions.
66
The adjustments to reserves for claims incurred in prior periods are
primarily attributable to claims incurred from our long-term care insurance
policies, which represent approximately 95% of our premium in-force.
We evaluate the assumptions utilized at the time the claim is incurred
compared to our most current assumptions. In 2001, two factors affected the
reserves we held for claims incurred in prior years. (1) Excluding $7,050 from
the effect of imputed interest, we added $8,845 to our claim reserves for 2000
and prior claim incurrals. Prior to 2001, we based our expectations on claim
continuance patterns determined from our historical claims payments. In 2001, we
engaged a new consulting actuary that provided us with additional industry data
to incorporate in our revised continuance expectations (the probability that a
claim in one duration will continue to another). Our analysis of this
supplemental data suggested that we would recognize higher future payments on
currently incurred claims than was previously anticipated. As a result, we
lengthened our continuance tables for claim durations beyond the third year, and
increased our reserves held for claims incurred to record this liability. We
believe that our experience for claims in the first, second and third duration
was consistent with industry data and, therefore, did not alter this portion of
our continuance tables. (2) In 2001, we reduced the discount rate used in the
establishment of reserves to appropriately reflect the current investment rate
earned on assets supporting this liability. As a result, reserves for claims
incurred in prior years was increased $1,582.
In 2000, excluding the effect of $6,863 from imputed interest, we added
$6,565 for claims incurred in prior years. While this increase in reserves for
prior year incurred claims of 4.8% does not reflect a material variance from our
expectations, we believe that the increases were attributable to the method we
employed for determining incurred but not reported claims ("IBNR"). This method
sought to project a ratio of incurred claims to earned premium based upon
historic experience and current trends. The actual number and type of claims
that were ultimately reported to us exceeded the amount of IBNR that we had
recorded at the original estimated date.
The establishment of reserves for claims liabilities incorporates
assumptions regarding the duration of claims, lag in reporting of claims, and
interest discount rates. We periodically reevaluate these assumptions based upon
actual results. Although we believe that our current reserves accurately reflect
our most recent assumptions, continued adverse claims experience could result in
additional future increases. Adverse development of our claim reserves, however,
will not generally be known until future payments occur or other evidence exists
to cause us to change our assumptions. As a result, we could experience positive
or negative deviation from the established reserves, which would impact our
results of operations.
Commissions. Commissions to agents decreased 24.9% to $76,805 in 2001,
compared to $102,313 in 2000.
67
First year commissions on accident and health business in 2001 decreased
54.9% to $29,371, compared to $65,117 in 2000, due to the decrease in first year
accident and health premiums. The mix of policyholder issue ages for new
business affects the percentage of commissions paid for new business due to our
age-scaled commission rates. Generally, sales to younger policyholders result in
a higher commission percentage. The ratio of first year accident and health
commissions to first year accident and health premiums was 67.4% in 2001 and
67.1% in 2000.
Renewal commissions on accident and health business in 2001 increased 25.8%
to $49,536, compared to $39,390 in 2000, consistent with the increase in renewal
premiums discussed above. The ratio of renewal accident and health commissions
to renewal accident and health premiums was 16.3% in 2001 and 15.7% in 2000,
which varies as a result of the weighting of policies written by agents with
differing contracts.
During 2001 and 2000, we reduced commission expense, as an intercompany
elimination, by netting $3,706 and $4,923, respectively, from override
commissions that affiliated insurers paid to our subsidiary agencies. The
reduction in commission overrides earned by these agencies in 2001 resulted from
our suspension of new sales in all states at varying times throughout 2001.
Net policy acquisition costs amortized (deferred) and impairment of DAC.
The net deferred policy acquisition costs in 2001 decreased 22.8% to a net
amortization of $9,860, compared to net deferrals of $43,192 in 2000.
Deferred costs typically include all costs that are directly related to,
and vary with, the acquisition of policies. These costs include the variable
portion of commissions, which are defined as the first year commission rate less
ultimate renewal commission rates, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based upon actuarial assumptions, including persistency of
policies in-force. In the event a policy lapses prematurely due to death or
termination of coverage, the remaining unamortized portion of the deferred
amount is immediately recognized as expense in the current period.
The amortization of deferred costs is generally offset largely by the
deferral of costs associated with new premiums generation. Lower new premium
sales during 2001 produced significantly less expense deferral to offset
amortized costs.
During 2001, with the assistance of our consulting actuary, we completed an
analysis to determine if existing policy reserves and policy and contract claim
reserves, together with the present value of future gross premiums, would be
sufficient to (1) cover the present value of future benefits to be paid to
policyholders and settlement and maintenance costs and (2) recover unamortized
deferred policy acquisition costs, referred to as recoverability analysis. We
determined that we would require premium rate increases on certain of our
existing products in order to fully recover our present deferred acquisition
cost asset from future profits. We perform the recoverability analysis each
quarter. During the second quarter we recognized an impairment charge of $300 as
a result of this analysis. Effective December 31, 2001, we entered a reinsurance
agreement for substantially all of our long-term care insurance policies. The
reinsurance agreement includes an annual expense and risk charges. These
additional expense and risk charges reduced our anticipated future gross profits
and resulted in a further impairment of our deferred policy acquisition cost
asset of $61,500. We also amortized approximately $10,000 more of deferred
acquisition cost asset during 2001 due to changing our future assumptions. "See
Premiums."
68
When an impairment occurs, the historical assumptions utilized in the
establishment of the reserves and DAC are "unlocked" and based on current
assumptions. Changes in policy reserves and unamortized deferred policy
acquisition costs will be based on these revised assumptions in future periods.
In determining the impairment, we evaluated future claims expectations, premium
rates and our ability to obtain future rate increases, persistency and expense
projections.
General and administrative expenses. General and administrative expenses in
2001 decreased 1.4% to $49,282, compared to $49,973 in 2000. The amounts for the
years ended 2001 and 2000, respectively, include $6,591 and $8,138 related to
United Insurance Group. The ratio of total general and administrative expenses,
excluding United Insurance Group expense, to premium revenues was 12.2% in 2001,
compared to 11.7% in 2000.
General and administrative expenses were increased during 2001 as a result
of supplemental accounting and actuarial fees, legal fees, depreciation expenses
and the recognition of $434 of compensation expense related to the variable
treatment of options granted to employees. The compensation expense represents
the December 31, 2001 market value of our common stock in excess of the grant
price of the options. Throughout 2001 we took certain actions to reduce costs,
including staff eliminations, marketing reductions and overhead eliminations. We
believe that if we remain unable to write new policies in states where we have
ceased new production, we will need to decrease production expenses further.
As a result of our December 31, 2001 reinsurance agreement with a foreign
reinsurer, we must pay federal excise tax of 1% on all ceded premium. At
December 31, 2001, we accrued $5,635 of excise tax, which represents the total
amount due for the transfer of premium at the inception of the agreement. This
amount was paid in the first quarter 2002.
Reserve for claim litigation. In the second quarter 2000, a jury awarded
compensatory damages of $24 and punitive damages of $2,000 in favor of the
plaintiff in a disputed claim case against one of our subsidiaries. We
subsequently appealed the decision. During the second quarter 2001, we agreed to
settle the claim for $750 rather than pursuing the appeal process.
Provision for Federal income taxes. Our provision for Federal income taxes
for 2001 decreased 276.8% to a tax benefit of $16,280, compared to a tax
provision of $11,720 for 2000 as a result of net losses in 2001. During 2001, we
determined that the net operating loss carryforward attributable to our non-life
parent may be impaired due to the life subsidiary's inability to utilize these
losses within the allowed future periods. As a result, we recognized a valuation
allowance of $5,775 to our deferred tax asset in 2001.
Comprehensive income. During 2001, our investment portfolio generated
pre-tax, unrealized gains of $11,606, compared to $10,350 in 2000. After
accounting for deferred taxes from these gains, shareholders' equity decreased
by $37,345 from comprehensive losses during 2001, compared to comprehensive
income of $29,151 in 2000.
69
Liquidity and Capital Resources
(amounts in thousands)
Our consolidated liquidity requirements have historically been 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 including the sale or exchange of debt instruments, payments to
policyholders, investment purchases and general and administrative expenses.
Our 2000 Report of Independent Accountants contained a going concern
opinion resulting from uncertainty regarding Penn Treaty liquidity and insurance
subsidiary statutory surplus. Our 2002 and 2001 Reports of Independent
Accountants do not contain a going concern opinion because of the steps that we
have taken to improve parent company liquidity and insurance subsidiary
statutory surplus, including the approval of our Corrective Action Plan by the
Pennsylvania Insurance Department, our reinsurance agreement with Centre
Solutions (Bermuda) Limited for policies issued prior to December 31, 2001 (see
"Subsidiary Operations"), the public and private placement of additional shares
of our Common Stock and the exchange of some of our convertible debt securities
and the issuance of new convertible debt securities (see "Penn Treaty
Operations"). However, we cannot make assurances that parent company liquidity
and insurance subsidiary statutory surplus will not cause uncertainty with
respect to our ability to continue as a going concern without additional
resources in the future. See "Penn Treaty Operations."
In the 2002 period, our cash flows were attributable to cash provided by
operations, cash used in investing and cash used in financing. Our cash
decreased $85,394 in the 2002 period primarily due to payments made to our
reinsurer of $614,052 and the purchase of $27,641 in bonds and equity
securities. Cash was provided primarily from the maturity and sale of $488,855
in bonds and equity securities. These sources of funds were supplemented by
$79,542 from operations. The major source of cash from operations was premium
and investment income received.
In 2001, our cash decreased by $1,996, primarily from funds used to
purchase bonds and equity securities of $263,388. Our cash was primarily
increased by proceeds from the sale and maturity of investment securities of
$128,881. These sources of funds were supplemented with $121,277 from operations
and $25,726 generated from the exercise of rights to purchase shares of our
common stock distributed to our shareholders and holders of our subordinated
notes.
In 2000, our cash increased by $99,249, primarily due to the maturity and
sale of $250,765 of our bond and equity securities portfolio. These sources of
funds were supplemented with $102,415 from operations. The major source of cash
from operations was premium revenue used to fund reserve additions of $116,227.
The primary uses of cash during 2000 were the purchase of $233,539 in bonds and
equity securities, $102,313 paid as agent commissions and $6,000 used to
purchase Network Insurance Senior Health Division.
70
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 December 31, 2002, shareholders' equity was increased by $1,090
due to unrealized gains of $1,679 in the investment portfolio. As of December
31, 2001, shareholders' equity was increased by $10,583 due to unrealized gains
of $16,032 in the investment portfolio.
Penn Treaty operations
Penn Treaty 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.
We have successfully engaged in capital markets activities, including
issuance of both debt and equity capital, over the past two years to fund our
liquidity and subsidiary capital needs. These equity activities have included:
1) 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.
2) In March 2002, we completed a private placement of 510 shares of common
stock for net proceeds of $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. We filed a registration statement with the
Securities and Exchange Commission on June 5, 2002 to register these shares for
resale.
3) In June 2002, we completed a private placement of 60 shares of common
stock as compensation to our financial advisor. We filed a registration
statement for 30 of these additional shares with the Securities and Exchange
Commission on June 5, 2002. In November 2002, we completed an additional private
placement of 20 shares of common stock to the same financial advisor.
At December 31, 2002, our debt primarily consisted of $11,407 of 6.25%
convertible subordinated notes due 2003 ("the 2003 Notes") and $63,343 of 6.25%
convertible subordinated notes due 2008 ("the Exchange Notes"), which are
described in more detail as follows:
71
o The 2003 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 any portion has not been
converted into common stock, we will have to repay their entire
principal amount in cash. The 2003 Notes carry a fixed interest
coupon of 6.25%, payable semi-annually.
o In September 2002, we commenced an offer of up to $74,750 in
aggregate principal amount of Exchange Notes in exchange for up
to all of our then outstanding 2003 Notes. Under the terms of the
exchange offer, the new notes would have terms similar to the
former notes but mature in October 2008 and would be convertible
into shares of our common stock at a conversion price of $5.31.
Prior to the termination of the exchange offer, we reduced the
conversion price to $4.50, then $2.50, and ultimately $1.75 in
February 2003.
o In addition, beginning in October 2005, the Exchange Notes are
mandatorily convertible if, at any time, the 15-day average
closing price of our common stock exceeds 110% of the conversion
price.
o We exchanged approximately $63,343 of the 2003 Notes for Exchange
Notes prior to December 31, 2002. During the first quarter of
2003, we exchanged an additional $3,450 of 2003 Notes for
Exchange Notes. We expect to retire any outstanding amount of the
2003 Notes on or before their contractual maturity in December
2003.
At December 31, 2002, our total debt and financing obligations through 2008
were as follows:
Lease
Debt Obligations Total
---- ----------- -----
2003 12,902 344 13,246
2004 - 252 252
2005 - 18 18
2006 - 18 18
2007 - 18 18
2008 63,343 18 63,361
-------- ----- --------
Total $ 76,245 $ 668 $ 76,913
======== ===== ========
Debt obligations in 2003 include a $1,494 mortgage obligation of our
subsidiary. Other amounts due after 2008 are immaterial.
In December 2002, we commenced the sale of up to $45,000 in 6.25%
Convertible Subordinated notes due 2008 ("the 2008 Notes"). The 2008 Notes were
originally offered, and were later modified, with identical terms to the
Exchange Notes. In February 2003, we completed the sale of 2008 Notes and
received proceeds of $28,722. We used $16,000 of the proceeds to satisfy the
premium to surplus requirements of our voluntary consent order with the Florida
Insurance Department. We intend to use the remaining proceeds to supplement
parent liquidity, retire our remaining 2003 Notes, and for general working
capital purposes. In March 2003, we issued an additional $3,550 of 2008 Notes,
issued under a new prospectus supplement.
72
After adjusting for the further exchange of 2003 Notes for
Exchange Notes in March 2003, and the issuance of 2008 Notes in February and
March, 2003, our total debt and financing obligations through 2008 will be as
follows:
Lease
Debt Obligations Total
---- ----------- -----
2003 10,451 344 10,795
2004 - 252 252
2005 - 18 18
2006 - 18 18
2007 - 18 18
2008 98,065 18 98,083
-------- ----- --------
Total $108,516 $ 668 $109,184
======== ===== ========
Cash flow needs of Penn Treaty primarily include interest payments on
outstanding debt and 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 we may need to rely upon the
dividend capabilities of our agency subsidiaries to meet current liquidity
needs. Our current cash on hand and these sources of funds are expected to be
sufficient to meet our liquidity needs through September 2004, but may be
insufficient to meet our interest payments on and after October 2004. We will
need to raise additional capital to satisfy any parent company liquidity needs,
including debt service payments, beyond October 2004.
Our anticipated cash needs for 2003 are as follows:
Retirement of 2003 Notes $ 9,000
Debt interest payments 5,700
Other parent expenses, net of
subsidiary reimbursement 900
--------
$ 15,600
Our anticipated cash provided for 2003 is as follows:
Proceeds from debt offering $ 16,300
Agency subsidiary dividends 2,200
--------
$ 18,500
73
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.
Our insurance subsidiaries, Penn Treaty Network America Insurance Company,
American Network Insurance Company, and American Independent Network Insurance
Company of New York (representing approximately 94%, 5% and 1% of our in-force
premium, respectively) are required to hold statutory surplus that is above a
certain required level. If the statutory surplus of either of our subsidiaries
falls below such level, the Pennsylvania or New York Insurance Department would
be required to place such subsidiary under regulatory control, leading to
rehabilitation or liquidation. At December 31, 2000, Penn Treaty 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 Pennsylvania Insurance
Department ("the Department").
On February 12, 2002, the Department approved the Plan. As a primary
component of the Plan, effective December 31, 2001, Penn Treaty Network America
Insurance Company and American Network Insurance Company entered a reinsurance
transaction to reinsure, on a quota share basis, substantially all of our
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. We are
required to perform annual comparisons of our actual to expected claims
experience. If we have reason to believe, whether from this analysis or other
available information, that at least a 5% premium rate increase is necessary, we
are obligated to file and obtain such premium rate increases in order to comply
with the requirements of the agreement. If we do not file and obtain such
premium rate increases, our aggregate limit of liability would be reduced by 50%
of the premium amount that would have otherwise been received.
As part of this agreement, annual risk charges in excess of $10,000 are
credited against our experience account by the reinsurer. The annual amount
increases if we do not commute before January 1, 2008. This agreement meets the
requirements to qualify for reinsurance treatment under statutory accounting
rules. However, this agreement does not qualify for reinsurance treatment in
accordance with FASB No. 113 because, based on our analysis, the agreement does
not result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to a number of factors related to the agreement,
including experience refund provisions, the expense and risk charges credited to
the experience account by the reinsurer and the aggregate limit of liability.
74
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.
Our current modeling and actuarial projections suggest that we are likely
to be able to commute the agreement, as planned, on December 31, 2007. In order
to commute the agreement, our statutory capital following commutation must be
sufficient to support the reacquired business in compliance with all statutory
requirements. Upon commutation, we would receive cash or other liquid assets
equaling the market value of our experience account from the reinsurer. We would
also record the necessary reserves for the business in our statutory financial
statements. Our ability to commute the agreement is highly dependent upon the
market value of the experience account exceeding the level of required reserves
to be established. In addition to the performance of the reinsured policies from
now until 2007, the experience account value is susceptible to market interest
rate changes. A market interest rate increase of 100 basis points could reduce
the market value of the current experience account by approximately $70 million
and jeopardize our ability to commute as planned. As we approach the intended
commutation date, the sensitivity of our experience account to market interest
rate movement will decline as the duration of the benchmark indices becomes
shorter, however the amount of assets susceptible to such interest sensitivity
will continue to grow as additional net cash flows are added to the experience
account balance prior to commutation. We intend to give notice to the reinsurer
of our intention to commute on December 31, 2007 at such time as we are highly
confident of our ability to support the reacquired policies. The reinsurer has
agreed to fix the market value of the experience account at that time, and to
then invest the assets in a manner that we request in order to minimize short
term volatility.
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 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 then outstanding shares of our common stock
on a fully diluted basis. 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 on a fully diluted basis. 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.
75
As a result of our intention to commute, we assessed only the expense and
risk credits anticipated prior to the commutation date in our most recent DAC
recoverability analyses and are not recording the potential of future escalating
charges in our current financial statements. In addition, we are recognizing the
up front costs of entering into the agreement, including the fair value of the
warrants granted to the reinsurer, over the period of time to the expected
commutation date.
In the event we determine that commutation of the reinsurance agreement is
unlikely on December 31, 2007, but likely at some future date, we will include
additional annual expense risk charge credits against our experience account in
our DAC recoverability analysis. As a result, we could impair the value of our
DAC asset and record the impairment in our financial statements. However, we
currently believe that we will have a sufficient amount of statutory capital and
surplus to do so by December 31, 2007 or that sufficient alternatives, such as
additional capital issuance or new reinsurance opportunities, are available to
enable us to commute the agreement as planned.
The reinsurance agreement also granted the reinsurer an option to
participate in reinsuring new business sales on a quota share basis. In August
2002, the reinsurer exercised its option to reinsure up to 50% of future sales,
subject to a limitation of the reinsurer's risk. The reinsurer may continue this
level of participation on the next $100 million in new policy premium issued
after January 1, 2002. The final agreement, which was entered into in December
2002, further provides the reinsurer the option to reinsure a portion of the
next $1 billion in newly issued long-term care annual insurance premium, subject
to maximum quota share amounts of up to 40% as additional policies are written.
This agreement does not qualify for reinsurance treatment in accordance
with Generally Accepted Accounting Principles ("GAAP") because, based on our
analysis, the agreement does not result in the reasonable possibility that the
reinsurer may realize a significant loss. This is due to an aggregate limit of
liability that reduces the likelihood of the reinsurer realizing a significant
loss on the agreement. However, this agreement meets the requirements to qualify
for reinsurance treatment under statutory accounting rules.
In February 2003, the reinsurer notified us that it may, for reasons
unrelated to us, discontinue its quota share reinsurance of new long-term care
insurance policies issued on or after September 1, 2003. The Company's separate
agreement with the reinsurer to reinsure existing policies issued prior to
December 31, 2001 will be unaffected by any determination made by the reinsurer
regarding newly issued policies.
Upon the Department's approval of the Plan in February 2002, we recommenced
new policy sales in 23 states, including Pennsylvania. We have now recommenced
new policy sales in 10 additional states, including Florida, Virginia and Texas,
which have historically represented approximately 18%, 7% and 5% of our new
policy sales, respectively. We are actively working with the remaining states to
recommence new policy sales in all jurisdictions. We have recently agreed upon
terms for the recommencement of sales in California, which has historically
represented approximately 15% of our new policy sales.
The Plan requires us to comply with certain 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 by an additional
$125,000 throughout 2002-2004 (of which $48,000 remained at
December 31, 2002), such that our subsidiaries' 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. The reinsurance
agreement has provided the capacity to accommodate this increase.
76
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.
The majority of our insurance subsidiaries' cash flow results from our
existing long-term care policies, which have been ceded to the reinsurer under
this agreement. Our subsidiaries' ability to meet additional liquidity needs and
cover fixed expenses in the future is highly dependent upon our ability to issue
new policies and to control expense growth. Our future growth and new policy
issuance 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.
Under the insurance laws of Pennsylvania and New York, where our insurance
subsidiaries are domiciled, insurance companies can pay ordinary dividends only
out of earned surplus. In addition, under Pennsylvania law, our Pennsylvania
insurance subsidiaries (including our primary insurance subsidiary) must give
the Department at least 30 days' advance notice of any proposed "extraordinary
dividend" and cannot pay such a dividend if the Department disapproves the
payment during that 30-day period. For purposes of that provision, an
extraordinary dividend is a dividend that, together with all other dividends
paid during the preceding twelve months, exceeds the greater of 10% of the
insurance company's surplus as shown on the company's last annual statement
filed with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to the immediate or
accelerated recognition of all costs associated with premium growth and benefit
reserves. Additionally, the Plan requires the Department to approve all dividend
requests made by Penn Treaty Network America, regardless of normal statutory
requirements for allowable dividends. We believe that the Department is unlikely
to consider any dividend request in the foreseeable future, as a result of Penn
Treaty Network America's current statutory surplus position. Although not
stipulated in the Plan, this requirement is likely to continue until such time
as Penn Treaty meets normal statutory allowances, including reported net income
and positive cumulative earned surplus. We do not expect that this will occur in
the foreseeable future.
77
Under New York law, our New York insurance subsidiary (American
Independent) must give the New York Insurance Department 30 days' advance notice
of any proposed dividend and cannot pay any dividend if the regulator
disapproves the payment during that 30-day period. In addition, our New York
insurance company must obtain the prior approval of the New York Insurance
Department before paying any dividend that, together with all other dividends
paid during the preceding twelve months, exceeds the lesser of 10% of the
insurance company's surplus as of the preceding December 31 or its adjusted net
investment income for the year ended the preceding December 31.
Penn Treaty Network America Insurance Company and American Network
Insurance Company have not paid any dividends to Penn Treaty for the past three
years and are unlikely in the foreseeable future to be able to make dividend
payments due to insufficient statutory surplus and anticipated earnings.
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.
Consequently, in 2002, Penn Treaty received a dividend from our New York
subsidiary of $651.
Our subsidiaries' debt currently consists primarily of a mortgage note in
the amount of $1,494 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%.
New Accounting Principles
(amounts in thousands)
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 recoverability of its 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.
78
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 value 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. At
December 31, 2002, these intangible assets have been reclassified from goodwill
to other assets on our financial statements.
In August 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement No. 144 supercedes
statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of, and provides new rules on asset impairment
and a single accounting model for long-lived assets to be disposed of. Although
retaining many of the fundamental recognition and measurement provisions of
Statement No. 121, the new rules significantly change the criteria that would
have to be met to classify an asset as held-for-sale. The new rules also
supercede the provisions of APB No. 30, "Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and infrequently Occurring Events and Transactions", with
regard to reporting the effects of a disposal of a segment of a business and
require expected future operating losses from discontinued operations to be
displayed in discontinued operations in the period(s) in which the losses are
incurred. Statement No. 144 was effective January 1, 2002. This statement did
not have a material impact on the Company's consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", which addresses the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under guarantees. This interpretation also clarifies the
requirements related to the recognition of a liability by a guarantor at the
inception of a guarantee for the obligations the guarantor has undertaken in
issuing that guarantee. The provisions related to the disclosure requirements to
be made by a guarantor are effective for financial statements of interim and
annual reporting periods ending after December 15, 2002. The provisions related
to the recognition of a liability and initial measurement shall be applied
prospectively to guarantees issued or modified after December 31, 2002,
irrespective of the guarantor s fiscal year-end. Management of the Company
anticipates that the adoption of this interpretation will not have a material
impact on the Company s financial statements.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123, "Accounting
for Stock-Based Compensation" ("SFAS No. 123"). The objective of SFAS No. 148 is
to provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. SFAS No.
148 does not change the provisions of SFAS No. 123 that permit entities to
continue to apply the intrinsic value method of Accounting Principles Board
Opinion No. 25, " Accounting for Stock Issued to Employees" ("APB No. 25"). In
addition, this Statement amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The Company continues to maintain
its accounting for stock-based compensation in accordance with APB No. 25, but
has adopted the disclosure provisions of SFAS No. 148 (See Note 11).
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities, an interpretation of Accounting Research Bulletin
No. 51" ( "FIN No. 46" ). FIN No. 46 requires existing unconsolidated variable
interest entities to be consolidated by their primary beneficiaries if the
entities do not effectively disperse risks among parties involved. FIN No. 46
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
FIN No. 46 applies to public enterprises as of the beginning of the applicable
interim or annual period. FIN No. 46 may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated. The
implementation of FIN No. 46 is not expected to have a material impact on the
Company s financial statements.
In August 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement No. 144 supercedes
statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of, and provides new rules on asset impairment
and a single accounting model for long-lived assets to be disposed of. Although
retaining many of the fundamental recognition and measurement provisions of
Statement No. 121, the new rules significantly change the criteria that would
have to be met to classify an asset as held-for-sale. The new rules also
supercede the provisions of APB No. 30, "Reporting the Results of
Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and infrequently Occurring Events and Transactions", with
regard to reporting the effects of a disposal of a segment of a business and
require expected future operating losses from discontinued operations to be
displayed in discontinued operations in the period(s) in which the losses are
incurred. Statement No. 144 was effective January 1, 2002. This statement did
not have a material impact on our consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", which addresses the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under guarantees. This interpretation also clarifies the
requirements related to the recognition of a liability by a guarantor at the
inception of a guarantee for the obligations the guarantor has undertaken in
issuing that guarantee. The provisions related to the disclosure requirements to
be made by a guarantor are effective for financial statements of interim and
annual reporting periods ending after December 15, 2002. The provisions related
to the recognition of a liability and initial measurement shall be applied
prospectively to guarantees issued or modified after December 31, 2002,
irrespective of the guarantor s fiscal year-end. Management of the Company
anticipates that the adoption of this interpretation will not have a material
impact on our financial statements.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123, "Accounting
for Stock-Based Compensation" ("SFAS No. 123"). The objective of SFAS No. 148 is
to provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. SFAS No.
148 does not change the provisions of SFAS No. 123 that permit entities to
continue to apply the intrinsic value method of Accounting Principles Board
Opinion No. 25, " Accounting for Stock Issued to Employees" ("APB No. 25"). In
addition, this Statement amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. We continues to maintain
its accounting for stock-based compensation in accordance with APB No. 25, but
has adopted the disclosure provisions of SFAS No. 148 (See Note 11).
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities, an interpretation of Accounting Research Bulletin
No. 51" ( "FIN No. 46" ). FIN No. 46 requires existing unconsolidated variable
interest entities to be consolidated by their primary beneficiaries if the
entities do not effectively disperse risks among parties involved. FIN No. 46
applies immediately to variable interest entities created after January 31,
2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
FIN No. 46 applies to public enterprises as of the beginning of the applicable
interim or annual period. FIN No. 46 may be applied prospectively with a
cumulative-effect adjustment as of the date on which it is first applied or by
restating previously issued financial statements for one or more years with a
cumulative-effect adjustment as of the beginning of the first year restated. The
implementation of FIN No. 46 is not expected to have a material impact on our
financial statements.
Item 7A. 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.
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.
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. However, our experience account balance, which represents
substantially all of our investable assets at December 31, 2002, is with one
reinsurer. Although sufficient assets to support our statutory reserve
liabilities are secured by trust accounts and irrevocable letters of credit with
major United States financial institutions, the accumulated profits of our
reinsured business are susceptible to significant credit risk of the reinsurer.
79
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 86.8% of total liabilities
and reinsurance receivables on unpaid losses and experience account due from
reinsurer represent 67.6% 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 our financial instruments (including our experience account balance,
as discussed below) as of December 31, 2002, excluding insurance liabilities and
reinsurance receivables on unpaid losses because such insurance related assets
and liabilities are not carried at fair value, would have been as follows:
If interest rates had increased by 100 basis points at December 31, 2002,
there would have been a decrease of approximately $68 million in the net fair
value of our investment portfolio less our long-term debt and the related swap
agreement. A 200 basis point increase in market rates at December 31, 2002 would
have resulted in a decrease of approximately $129 million in the net fair
value. If interest rates had decreased by 100 and 200 basis points, there would
have been a net increase of approximately $76 million and $162 million,
respectively, in the net fair value of our total investments and debt.
If interest rates had increased by 100 basis points at December 31, 2001,
there would have been a decrease of approximately $17.4 million in the net fair
value of our investment portfolio less our long-term debt and the related swap
agreement. The change in fair value 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 December 31, 2001 would have resulted in
a decrease of approximately $33.5 million in the net fair value. If interest
rates had decreased by 100 and 200 basis points, there would have been a net
increase of approximately $18.9 million and $39.4 million, respectively, in the
net fair value of our total investments and debt.
Effective December 31, 2001, we entered a reinsurance agreement to
reinsure, on a quota share basis, substantially all of our long-term care
insurance policies in-force. The transaction resulted in the transfer of debt
and equity securities of approximately $563 million to the reinsurer. The
agreements provide us the opportunity to commute and recapture after December
31, 2007. To that end, the reinsurer will maintain a notional experience account
for our benefit only in the event of commutation and recapture, which reflects
the initial premium paid, future premiums collected net of claims, expenses 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 hedges that are designed to closely match the duration of
reserve liabilities. As a result, we will likely experience significant
volatility in our future financial statements.
80
Our ability to commute the agreement is highly dependent upon the market
value of the experience account exceeding the level of required reserves to be
established. In addition to the performance of the reinsured policies from now
until 2007, the experience account value is susceptible to market interest rate
changes. A market interest rate increase of 100 basis points could reduce the
market value of the current experience account by approximately $70 million and
jeopardize our ability to commute as planned. As we approach the intended
commutation date, the sensitivity of our experience account to market interest
rate movement will decline as the duration of the benchmark indices becomes
shorter, however the amount of assets susceptible to such interest sensitivity
will continue to grow as additional net cash flows are added to the experience
account balance prior to commutation. We intend to give notice to the reinsurer
of our intention to commute on December 31, 2007 at such time as we are highly
confident of our ability to support the reacquired policies. The reinsurer has
agreed to fix the market value of the experience account at that time, and to
then invest the assets in a manner that we request in order to minimize short
term volatility.
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 the possible impact on our investment income of hypothetical effects of
changes in market rates or prices on the fair values of financial instruments as
of December 31, 2001.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Refer to Consolidated Financial Statements and notes thereto attached to this
report.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Pages
-----
Report of Independent Accountants F-2
Financial Statements:
Consolidated Balance Sheets as of December 31,
2002 and 2001 F-3
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2002, 2001 and 2000 F-4
Consolidated Statements of Shareholders' Equity
for the Years Ended December 31, 2002,
2001 and 2000 F-5
Consolidated Statements of Cash Flows for the
Years Ended December 31, 2002, 2001 and 2000 F-6
Notes to Consolidated Financial Statements F-7
Financial Pages (F) 1
Report of Independent Accountants
To the Board of Directors and Shareholders of Penn Treaty American Corporation
Allentown, Pennsylvania
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income and comprehensive income, of shareholders'
equity and of cash flows present fairly, in all material respects, the financial
position of Penn Treaty American Corporation and Subsidiaries (the "Company") at
December 31, 2002 and 2001, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2002 in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets," effective January 1, 2002.
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
March 31, 2003
Financial Pages (F) 2
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(amounts in thousands, except per share information)
December 31, December 31,
2002 2001
---- ----
ASSETS
Investments:
Bonds, available for sale at market (cost of $26,775 and $463,618, respectively) (1) $ 28,454 $ 478,608
Equity securities at market (cost of $0 and $8,760, respectively) - 9,802
Policy loans 238 181
---------- ---------
Total investments 28,692 488,591
Cash and cash equivalents (1) 29,206 114,600
Property and equipment, at cost, less accumulated depreciation of
$7,925 and $6,294, respectively 13,611 12,783
Unamortized deferred policy acquisition costs 171,357 180,052
Receivables from agents, less allowance for
uncollectable amounts of $119 and $292, respectively 1,654 2,190
Accrued investment income 414 7,907
Federal income tax recoverable - 4,406
Goodwill 20,360 25,771
Receivable from reinsurers 26,218 25,594
Corporate owned life insurance 57,773 54,478
Experience account due from reinsurer 708,982 -
Other assets 21,933 23,995
---------- ---------
Total assets $1,080,200 $ 940,367
=========== =========
LIABILITIES
Policy reserves:
Accident and health $ 464,318 $ 382,660
Life 12,553 13,386
Policy and contract claims 329,944 214,466
Accounts payable and other liabilities 18,859 19,422
Long-term debt 76,245 79,190
Deferred income taxes 23,101 38,447
----------- ---------
Total liabilities 925,020 747,571
----------- ---------
Commitments and contingencies (Note 12) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding - -
Common stock, par value $.10; 40,000 shares authorized, 20,340 and 19,750
shares issued and outstanding, respectively 2,034 1,975
Additional paid-in capital 97,058 94,802
Accumulated other comprehensive income 1,090 10,583
Retained earnings 61,703 92,141
----------- ---------
161,885 199,501
Less 915 common shares held in treasury, at cost (6,705) (6,705)
----------- ---------
155,180 192,796
----------- ---------
Total liabilities and shareholders' equity $ 1,080,200 $ 940,367
=========== =========
(1) Cash and investments of $22,022 and $15,854, respectively, are restricted as to use.
See accompanying notes to consolidated financial statements.
Financial Pages (F) 3
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2002, 2001 and 2000
(amounts inthousands, except per share information)
2002 2001 2000
---- ---- ----
Revenues:
Premium revenue $ 333,643 $ 350,391 $ 357,113
Net investment income 40,107 30,613 27,408
Net realized capital gains (losses) 15,663 (4,367) 652
Trading account losses - (3,428) -
Market gain on experience account 56,555 - -
Other income 11,585 9,208 8,096
--------- --------- ---------
457,553 382,417 393,269
--------- --------- ---------
Benefits and expenses:
Benefits to policyholders 371,998 239,155 243,571
Commissions 45,741 76,805 102,313
Net policy acquisition costs amortized (deferred) 7,595 9,860 (43,192)
Impairment of unamortized policy acquisition costs 1,100 61,800 -
General and administrative expenses 46,472 49,282 49,973
Expense and risk charges on reinsurance 14,308 - -
Excise tax expense 2,919 5,635 -
Change in reserve for claim litigation - (250) 1,000
Interest expense 5,733 4,999 5,134
--------- --------- ---------
495,866 447,286 358,799
--------- --------- ---------
(Loss) income before federal income taxes and cumulative
effect of change in accounting principle (38,313) (64,869) 34,470
(Benefit) provision for federal income taxes (13,026) (16,280) 11,720
--------- --------- ---------
Net (loss) income before cumulative effect of
change in accounting principle (25,287) (48,589) 22,750
Cumulative effect of change in accounting principle (5,151) - -
--------- --------- ---------
Net (loss) income $ (30,438) $ (48,589) $ 22,750
========== ========== =========
Other comprehensive (loss) income:
Unrealized holding gain arising during period 1,310 11,606 10,350
Income tax expense from unrealized holdings (465) (3,946) (3,519)
Reclassification of (gains) losses included in net income (15,663) 5,432 (652)
Income tax expense (benefit) from reclassification 5,325 (1,847) 222
--------- --------- ---------
Comprehensive (loss) income $ (39,931) $ (37,344) $ 29,151
========== ========= =========
Basic earnings per share from net (loss) income before
cumulative effect of change in accounting principle $ (1.31) $ (3.41) $ 3.13
========= ========= =========
Basic earnings per share from net (loss) income $ (1.58) $ (3.41) $ 3.13
========= ========= =========
Diluted earnings per share from net (loss) income before
cumulative effect of change in accounting principle $ (1.31) $ (3.41) $ 2.61
========= ========= =========
Diluted earnings per share from net (loss) income $ (1.58) $ (3.41) $ 2.61
========= ========= =========
Weighted average number of shares outstanding 19,240 14,248 7,279
Weighted average number of shares and share equivalents 19,240 14,248 9,976
See accompanying notes to consolidated financial statements.
Financial Pages (F) 4
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
for the Years Ended December 31, 2002, 2001 and 2000
(amounts in thousands)
Accumulated
Common Stock Additional Other Total
-------------------- Paid-In Comprehensive Retained Treasury Shareholders'
Shares Amount Capital Income (Loss) Earnings Stock Equity
------ ------
Balance, December 31, 1999 8,191 $ 819 $ 53,655 $ (7,064) $ 117,980 $ (6,705) $ 158,685
Net income - - - - 22,750 - 22,750
Other comprehensive income - - - 6,402 - - 6,402
Option-based compensation - - 86 - - - 86
Exercised options proceeds 11 1 138 - - - 139
-----------------------------------------------------------------------------------------
Balance, December 31, 2000 8,202 820 53,879 (662) 140,730 (6,705) 188,062
Net loss - - - - (48,589) - (48,589)
Other comprehensive income - - - 11,245 - - 11,245
Option-based compensation - - 485 - - - 485
Rights offering proceeds 11,547 1,155 24,571 - - - 25,726
Warrants issued - - 15,855 - - - 15,855
Exercised options proceeds 1 - 12 - - - 12
-----------------------------------------------------------------------------------------
Balance, December 31, 2001 19,750 1,975 94,802 10,583 92,141 (6,705) $ 192,796
Net loss - - - - (30,438) - (30,438)
Other comprehensive loss - - - (9,493) - - (9,493)
Option-based compensation - - (430) - - - (430)
Private placement proceeds 510 51 2,301 - - - 2,352
Shares issued to financial advisor 80 8 385 - - - 393
-----------------------------------------------------------------------------------------
Balance, December 31, 2002 20,340 $2,034 $ 97,058 $ 1,090 $ 61,703 $ (6,705) $ 155,180
=========================================================================================
See accompanying notes to consolidated financial statements.
Financial Pages (F) 5
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Years Ended December 31,
(amounts in thousands)
2002 2001 2000
---- ---- ----
Net cash flow from operating activities:
Net (loss) income $ (30,438) $ (48,589) $ 22,750
Adjustments to reconcile net (loss) income to cash
provided by operations:
Amortization of intangible assets 563 2,068 2,068
Cumulative effect of change in accounting principle 5,151 - -
Gain on asumption reinsurance 2,640 - -
Policy acquisition costs, net 8,695 71,660 (43,192)
Deferred income tax (benefit) provision (10,478) (12,778) 8,675
Depreciation and amortization expense 1,631 1,409 1,275
Amortization of deferred reinsurance premium 2,643 - -
Net realized capital (gains) losses (15,663) 7,795 (652)
Investment credit on corporate owned life insurance (3,295) (2,850) (1,604)
Increase (decrease) due to change in:
Receivables from agents 536 1,143 (620)
Federal income taxes recoverable 4,406 (735) (2,055)
Accrued investment income 7,493 (1,693) (296)
Receivable from reinsurers (624) (9,463) (1,061)
Experience account due from reinsurer (85,955) - -
Policy reserves 80,825 34,637 89,196
Policy and contract claims 115,478 49,901 27,031
Accounts payable and other liabilities (563) 4,716 1,819
Net proceeds from purchases and sales of trading account - 21,285 -
Other, net (3,503) 2,771 (919)
--------- --------- --------
Cash provided by operations 79,542 121,277 102,415
--------- --------- --------
Cash flow from investing activities:
Net cash from purchase of subsidiary - - (6,000)
Proceeds from sales of bonds 475,416 107,296 207,906
Proceeds from sales of equity securities 9,547 2,699 30,163
Maturities of investments 3,892 18,886 12,696
Purchases of bonds (27,621) (258,343) (205,213)
Purchases of equity securities (20) (5,045) (28,326)
Premium payments for corporate owned life insurance - (10,000) (10,000)
Deposits to experience account due from reinsurer (623,027) - -
Acquisition of property and equipment (2,530) (1,726) (3,637)
--------- --------- --------
Cash used in investing (164,343) (146,233) (2,411)
---------- --------- --------
Cash flow from financing activities:
Net proceeds from stock offering 2,352 25,726 -
Proceeds from exercise of stock options - 12 138
Repayments of long-term debt (2,945) (2,778) (893)
--------- --------- --------
Cash (used in) provided by financing (593) 22,960 (755)
--------- --------- --------
(Decrease) increase in cash and cash equivalents (85,394) (1,996) 99,249
Cash balances:
Beginning of period 114,600 116,596 17,347
--------- --------- --------
End of period $ 29,206 $ 114,600 $116,596
========= ========= ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $ 5,365 $ 4,956 $ 5,133
Cash (received) paid during the year for federal income taxes (6,950) (2,778) 5,110
See accompanying notes to consolidated financial statements.
Financial Pages (F) 6
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(amounts in thousands, except per share information)
1. Basis of Presentation:
The accompanying consolidated financial statements of Penn Treaty American
Corporation and its Subsidiaries (the "Company") have been prepared in
accordance with accounting principles generally accepted in the United
States of America ("GAAP") and include Penn Treaty Network America
Insurance Company ("PTNA"), American Network Insurance Company ("ANIC"),
American Independent Network Insurance Company of New York ("AIN"), Penn
Treaty (Bermuda), Ltd. ("PTB"), United Insurance Group Agency, Inc.
("UIG"), Network Insurance Senior Health Division ("NISHD") and Senior
Financial Consultants Company ("SFCC"). Significant intercompany
transactions and balances have been eliminated in consolidation. Certain
prior year amounts have been reclassified to conform to the current year
presentation.
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent liabilities
and the reported amounts of revenues and expenses. Actual results could
differ from those estimates.
Nature of Operations:
The Company sells accident and health, life and disability insurance
through its wholly owned subsidiaries. The Company's principal lines of
business are long-term care products and home health care products. The
Company distributes its products principally through independent agents and
managing general agents. The Company operates its home office in Allentown,
Pennsylvania, and has satellite offices in Michigan and New York, whose
principal functions include marketing and underwriting new business.
The Company is licensed in all states and receives renewal premiums from
policyholders, but is currently restricted from issuing new policies in 16
states. The Company recently agreed upon terms for the recommencement of
sales in California, subject to certain conditions. California has
historically represented approximately 15% of the Company's premium. The
Company is approved for sales in Florida and Pennsylvania (subject to
Corrective Action Plans), which accounted for 18% and 12%, respectively, of
the Company's premiums for the year ended December 31, 2002. No other
state's sales accounted for more than 10% of the Company's premiums for the
year ended December 31, 2002.
2. Summary of Significant Accounting Policies:
Investments:
Management categorizes its investment securities as available for sale
since they may be sold in response to changes in interest rates,
prepayments and similar factors. Investments in this classification are
reported at the current market value with net unrealized gains or 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.
Effective January 1, 2001, in accordance with Statement of Financial
Accounting Standard No. 133 "Accounting for Derivative Instruments and
Hedging Activities" ("SFAS No. 133"), the Company transferred its
convertible bond portfolio, which contained embedded derivatives, from the
available for sale category of investments to the trading category.
Realized gains and losses and changes in unrealized gains and losses for
the trading portfolio were recorded in current operations. The unrealized
loss at the time of the transfer was $1,064. During 2001, the Company sold
its entire convertible bond portfolio.
Realized investment gains and losses, including provisions for market
declines considered to be other than temporary, are included in income.
Gains and losses on sales of investment securities are computed on the
specific identification method.
Financial Pages (F) 7
Debt and equity securities are regularly evaluated to determine if market
values below amortized cost are as a result of credit quality, performance
or general market decline. If market value declines are determined to be
other than temporary, the amortized cost is adjusted to the market value of
the security, with the loss recognized in the current period. Purchases and
sales of securities are recorded on the trade-date basis. Interest income
is recorded on the accrual basis. Dividends are recorded on the ex-dividend
date.
The Company is subject to interest rate risk to the extent that its
investment portfolio cash flows are not matched to its insurance
liabilities. Management believes it manages this risk through monitoring
cash flows and actuarial assumptions regarding the timing of future
insurance liabilities. Management further believes that, while not
currently under its direction, the benchmark indices supporting the total
return of its experience account asset are appropriately matched to the
duration of its ceded reserve liabilities.
Policy loans are stated at the aggregate unpaid principal balance.
Unamortized Deferred Policy Acquisition Costs ("DAC"):
The costs primarily related to and varying with the acquisition of new
business, principally commissions, underwriting and policy issue expenses,
have been deferred. These deferred costs are amortized over the related
premium-paying periods utilizing the same projected premium assumptions
used in computing reserves for future policy benefits.
The Company regularly assesses the recoverability of deferred acquisition
costs through actuarial analysis. To determine recoverability, the present
value of future premiums less future costs and claims are added to current
reserve balances. If this amount is greater than current unamortized
deferred acquisition costs, the unamortized amount is deemed recoverable.
In the event recoverability is not demonstrated, the Company reassesses the
calculation using justifiable premium rate increases. If rate increases are
not received or are deemed unjustified, the Company will expense, as
impaired, the attributed portion of the deferred acquisition cost asset in
the current period. If the Company concludes that the deferred acquisition
costs are impaired, the Company will record an impairment loss and a
reduction in the deferred acquisition cost asset. In the event of an
impairment, the Company will also evaluate its historical assumptions
utilized in establishing the policy reserves and deferred acquisition costs
and may update those assumptions to reflect current experience (referred to
as "unlocking"). The primary assumptions include persistency, morbidity
(claims expectations), investment yields and premium rate increases.
Recoverability of deferred acquisition costs is highly dependent upon the
Company's ability to obtain future premium rate increases. While the
Company has been successful in obtaining premium rate increases on existing
policies in the past, the ability to obtain these increases is subject to
regulatory approval, and is not guaranteed.
During 2001, the Company recognized an impairment of its deferred
acquisition costs of approximately $61,800. Effective December 31, 2001,
the Company entered into a reinsurance agreement covering substantially all
of its long-term care policies (see Note 13). The reinsurance agreement
requires the Company to credit an annual expense and risk charge to the
experience account maintained as part of the contract. The expense and risk
charge will only be paid to the reinsurer in the event the Company commutes
the contract. Since the Company plans to commute the contract and also
believes it is probable that the contract will be commuted, expense and
risk charges have been included as a reduction to the anticipated future
profits for purposes of evaluating DAC impairment. This was the primary
factor causing the 2001 DAC impairment.
During 2002, the Company recognized an impairment of its deferred
acquisition costs of approximately $1,100 due to its anticipation of
reduced future investment earnings rates and accelerated claims costs,
substantially offset by increased premium rate expectations.
Management believes the current assumptions and other considerations used
to estimate, and evaluate the recoverability of, DAC are appropriate.
However, in the event actual experience, including planned rate increases,
differ from the assumptions, the Company could recognize an additional
impairment of its deferred acquisition costs in the future, which could
have a material adverse affect upon its results of operations and financial
condition.
Financial Pages (F) 8
Property and Equipment:
Property and equipment are stated at cost, less accumulated depreciation
and amortization. Expenditures for improvements, which materially increase
the estimated useful life of the asset, are capitalized. Expenditures for
repairs and maintenance are charged to operations as incurred. Depreciation
is provided principally on a straight-line basis over the related asset's
estimated life. Upon sale or retirement, the cost of the asset and the
related accumulated depreciation are removed from the accounts and the
resulting gain or loss, if any, is included in operations.
The following table lists the range of lives, cost and accumulated
depreciation for various asset classes:
December 31, 2002
------------------------------------------------------
Accumulated Carrying
Class Years Cost Depreciation Value
----- ----- ---- ------------ -----
Automobiles 5 $ 313 $ 219 $ 94
Equipment 3 - 12 4,358 3,540 818
Software 5 - 10 8,383 1,222 7,161
Furniture 7 - 12 2,274 1,509 765
Buildings 10 - 40 6,208 1,435 4,773
-------- -------- --------
$ 21,536 $ 7,925 $ 13,611
======== ======== ========
December 31, 2001
------------------------------------------------------
Accumulated Carrying
Class Years Cost Depreciation Value
----- ----- ---- ------------ -----
Automobiles 5 $ 313 $ 190 $ 123
Equipment 3 - 12 4,195 2,837 1,358
Software 5 - 10 6,112 615 5,497
Furniture 7 - 12 2,256 1,350 906
Buildings 10 - 40 6,201 1,302 4,899
-------- -------- ---------
$ 19,077 $ 6,294 $ 12,783
======== ======== =========
The Company amortized $607, $399 and $166 of its cost related to software
in 2002, 2001 and 2000, respectively. Depreciation expense on other
property and equipment was $1,024, $1,010 and $1,109 for the years ended
December 31, 2002, 2001 and 2000, respectively.
Cash and Cash Equivalents:
Cash and cash equivalents include highly liquid debt instruments with an
original maturity of three months or less.
Present Value of Future Profits Acquired:
The present value of future profits of ANIC's acquired business is being
amortized over the life of the insurance business acquired. During each of
the years ended 2001 and 2000, $415 was amortized to expense. Total
amortization during 2002 was $1,145 due to approximately 50% of the
policies under an assumption reinsurance contract legally transferring
title.
At the time of purchase, the acquired ANIC premium in-force was deemed to
have a remaining average life of approximately ten years. Although
amortization of future profits will normally occur in accordance with
actuarial assumptions over the life of the policies, the Company determined
to amortize this on a straight-line basis over ten years and regularly
monitors the emerging profitability of the acquired business. The Company
believes that this approach is not materially different than if an
actuarial methodology had been employed. The remaining unamortized carrying
amount of future profits at December 31, 2002 and 2001, was $791 and
$1,937, respectively.
Financial Pages (F) 9
Impairment of Long-Lived Assets:
Long-lived assets and certain identifiable intangible assets held and used
by the Company are reviewed for impairment whenever events or circumstances
indicate that the carrying amount may not be recoverable. No impairment
losses were recorded in 2002, 2001 or 2000.
Other Assets:
Other assets consist primarily of estimates of premiums due but not yet
collected and deferred reinsurance premiums.
Corporate Owned Life Insurance:
The Company has historically purchased corporate owned life insurance
("COLI") to fund the future payment of employee benefit expenses. The
Company has purchased $50,000 of COLI, of which it purchased $10,000 in
each of 2001 and 2000. No additional purchases were made in 2002. The
Company includes the cash value of these policies, which is invested in
investment grade corporate bonds, as a separate financial statement
caption. Increases in the cash surrender value are recorded as other
income.
Income Taxes:
Income taxes consist of amounts currently due plus deferred tax expense or
benefits. Deferred income tax liabilities, net of assets, have been
recorded for temporary differences between the reported amounts of assets
and liabilities in the accompanying financial statements and those in the
Company's income tax return.
Excise Taxes:
The Company pays excise taxes related to reinsurance agreements with a
foreign reinsurer. The amount recorded each year is equal to one percent of
the premiums ceded to the reinsurer. The Company recorded an expense of
$2,919 and $5,635 for the years ended Demcmber 31, 2002 and 2001,
respectively. No expense was recorded during 2000 because the agreements
did not yet exist.
Revenue Recognition:
Premiums on long duration accident and health insurance, the majority of
which is guaranteed renewable, and life insurance are recognized when due.
Estimates of premiums due but not yet collected are accrued.
Commission override revenue from unaffiliated insurers is included in other
income when the underlying premium is due, net of an allowance for unissued
or cancelled policies.
Policy Reserves and Policy and Contract Claims:
There are two components to the Company's policyholder liabilities. The
first is a policy reserve for future policy benefits and the second is a
policy and contract claim reserve for incurred claims, either reported or
unreported.
The policy reserve liability is determined using the present value of
estimated future policy benefits to be paid to, or on behalf of
policyholders, less the present value of estimated future premiums to be
collected from policyholders, including anticipated premium rate increases.
This liability is accrued as policy reserves and is recognized concurrent
with premium revenue. Those estimates are based on assumptions, including
estimates of expected investment yield, mortality, morbidity (claims
expectations), withdrawals and expenses, applicable at the time insurance
contracts are effective. These reserves differ from policy and contract
claims, which are recognized when insured events occur. The assumptions
utilized to determine the policy reserves are established at year of policy
issuance and are "locked in" for the future development of reserves (See
"Unamortized Deferred Policy Acquisition Costs").
Policy and contract claims include amounts comprising:
o an estimate, based upon prior experience, for accident and health
claims reported, and incurred but unreported claims;
o the actual in-force amounts for reported life claims and an
estimate of incurred but unreported claims; and
Financial Pages (F) 10
o an estimate of future administrative expenses, which would be
incurred to adjudicate existing claims.
The methods for making such estimates and establishing the resulting
liabilities are periodically reviewed and updated and any resulting
adjustments are reflected in earnings currently.
The establishment of appropriate reserves is an inherently uncertain
process that requires management to make critical accounting estimates.
Management believes the current assumptions and other considerations used
to estimate policy reserves and policy and contract claim liabilities are
appropriate. However, if the actual experience differs from the assumptions
and other considerations (including mortality, morbidity (claims
experience), withdrawals, expenses, premium rate increases and investment
yields) used in estimating the Company's policy reserves and policy and
contract claims, the resulting change could have a material adverse effect
on the Company's results of operations and financial condition. Due to the
inherent uncertainty of estimating reserves, it has been necessary, and may
over time continue to be necessary, to revise estimated future liabilities
as reflected in the Company's policy reserves and policy and contract
claims.
The Company reviews the recoverability of its deferred acquisition costs on
an annual basis, utilizing assumptions for future expected claims, premium
rate increases and interest rates. If the Company determines that the
future gross profits of its in-force policies are not sufficient to recover
its deferred acquisition costs, the Company recognizes a premium deficiency
and "unlocks" (or changes) historical assumptions to match current
expectations. In 2001, the Company recognized a premium deficiency and
unlocked its prior reserve assumptions. These assumptions include interest
rates, premium rate increases, shock lapses and anti-selection of
policyholder persistence. In 2002, the Company again recognized a premium
deficiency due to anticipated investment earnings rate reductions and
expected acceleration of, and increase in, the ultimate amount of claim
payments, substantially offset by higher premium rate increase assumptions.
As a result, the Company unlocked its prior reserve assumptions and
employed its new expectations in the establishment of future reserves.
The Company discounts all policy and contract claims, which involve fixed
periodic payments extending beyond one year. This is consistent with the
method allowed for statutory reporting, the long duration of claims, and
industry practice for long-term care policies. Benefits are payable over
periods ranging from six months to five years, and are also available for
lifetime coverage.
Reinsurance:
The Company reports all reserve amounts gross of reinsurance. The amounts
receivable from unaffiliated reinsurers are reported as receivables from
reinsurers.
The Company applies deposit accounting for reinsurance agreements that do
not meet the risk transfer criteria in SFAS No. 113.
Accounts Payable and Other Liabilities:
Accounts payable and other liabilities consist primarily of amounts payable
to agents, reinsurers and vendors, as well as deferred income items. During
2001, the Company reinsured its disability policies with an unaffiliated
insurer, for which it received a ceding commission of approximately $5,000.
This deferred ceding commission will be recognized as income over the
remaining life of the policies, or when the Company's policy liability is
novated through policyholder or state approval, as may be required. The
Company recognized income of $2,346 in 2002 and $319 in 2001.
Earnings Per Share:
A reconciliation of the numerator and denominator of the basic earnings per
share computation to the numerator and denominator of the diluted earnings
per share computation follows. Basic earnings per share excludes dilution
and is computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period.
Diluted earnings per share 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. As
such, the Company has not included securities of 7,192 and 2,727, for 2002
and 2001, respectively that could potentially dilute basic earnings per
share in the future.
Financial Pages (F) 11
For the Periods Ended December 31,
-----------------------------------
2002 2001 2000
---- ---- ----
Net (loss) income before cumulative effect of
change in accounting principles $ (25,287) $ (48,589) $ 22,750
Weighted average common shares outstanding 19,240 14,248 7,279
-------- --------- ---------
Basic earnings per share from net (loss) income before
cumulative effect of change in accounting principles $ (1.31) $ (3.41) $ 3.13
========= ========= =========
Net (loss) income before cumulative effect of
accounting change $ (25,287) $ (48,589) $ 22,750
Cumulative effect of change in accounting principles (5,151) - -
--------- --------- ---------
Net (loss) income $ (30,438) $ (48,589) $ 22,750
========= ========= =========
Basic earnings per share from net (loss) income $ (1.58) $ (3.41) $ 3.13
========= ========= =========
Adjustments, net of tax:
Interest expense on convertible debt $ - $ - $ 3,084
Amortization of debt offering costs - - 240
--------- --------- ---------
Diluted net (loss) income before cumulative effect of
change in accounting principles $ (25,287) $ (48,589) $ 26,074
========= ========= =========
Diluted net (loss) income $ (30,438) $ (48,589) $ 26,074
========= ========= =========
Weighted average common shares outstanding 19,240 14,248 7,279
Common stock equivalents due to dilutive
effect of stock options - - 69
Shares converted from convertible debt - - 2,628
--------- -------- ---------
Total outstanding shares for fully diluted earnings
per share computation 19,240 14,248 9,976
--------- --------- ---------
Diluted earnings per share from net (loss) income before
cumulative effect of accounting change $ (1.31) $ (3.41) $ 2.61
========= ========= =========
Diluted earnings per share $ (1.58) $ (3.41) $ 2.61
========= ========= =========
Recent Accounting Principles:
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
SFAS 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
recoverability 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 attributed 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. At December 31, 2002, the
Company reclassified its intangible asset for the purchase of an agent's
renewal commission stream of $260 from goodwill to other assets on the
Company's financial statements.
Financial Pages (F) 12
No goodwill was amortized in 2002. In 2001 and 2000, the Company amortized
$1,293 of goodwill. For comparative purposes, the following table adjusts
net (loss) income and basic and diluted earnings per share for 2001 and
2000, as if goodwill amortization had ceased at the beginning of 2000 and
no cumulative effect of accounting change had been recorded.
Twelve Months Ended December 31,
-------------------------------------
2002 2001 2000
---- ---- ----
Reported net (loss) income $ (30,438) $ (48,589) $ 22,750
Cumulative effect of change in accounting principle 5,151 - -
Adjustment for goodwill amortization, net of tax - 853 853
--------- --------- ---------
Adjusted net (loss) income $ (25,287) $ (47,736) $ 23,603
========= ========= =========
Reported basic earnings per share before
effect of change in accounting principle $ (1.31) $ (3.41) $ 3.13
Adjustment for goodwill amortization, net of tax - 0.06 0.12
--------- --------- ---------
Adjusted basic earnings per share $ (1.31) $ (3.35) $ 3.25
========= ========= =========
Reported diluted earnings per share $ (1.31) $ (3.41) $ 2.61
Adjustment for goodwill amortization, net of tax - 0.06 0.09
--------- --------- ---------
Adjusted diluted earnings per share $ (1.31) $ (3.35) $ 2.70
========= ========= =========
In August 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Statement No. 144 supercedes
statement No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed of, and provides new rules on asset
impairment and a single accounting model for long-lived assets to be
disposed of. Although retaining many of the fundamental recognition and
measurement provisions of Statement No. 121, the new rules significantly
change the criteria that would have to be met to classify an asset as
held-for-sale. The new rules also supercede the provisions of APB No. 30,
"Reporting the Results of Operations-Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and infrequently
Occurring Events and Transactions", with regard to reporting the effects of
a disposal of a segment of a business and require expected future operating
losses from discontinued operations to be displayed in discontinued
operations in the period(s) in which the losses are incurred. Statement No.
144 was effective January 1, 2002. This statement did not have a material
impact on the Company's consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", which addresses the disclosures to
be made by a guarantor in its interim and annual financial statements about
its obligations under guarantees. This interpretation also clarifies the
requirements related to the recognition of a liability by a guarantor at
the inception of a guarantee for the obligations the guarantor has
undertaken in issuing that guarantee. The provisions related to the
disclosure requirements to be made by a guarantor are effective for
financial statements of interim and annual reporting periods ending after
December 15, 2002. The provisions related to the recognition of a liability
and initial measurement shall be applied prospectively to guarantees issued
or modified after December 31, 2002, irrespective of the guarantor s fiscal
year-end. Management of the Company anticipates that the adoption of this
interpretation will not have a material impact on the Company s financial
statements.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123,
"Accounting for Stock-Based Compensation" ("SFAS No. 123"). The objective
of SFAS No. 148 is to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for
stock-based employee compensation. SFAS No. 148 does not change the
provisions of SFAS No. 123 that permit entities to continue to apply the
intrinsic value method of Accounting Principles Board Opinion No. 25, "
Accounting for Stock Issued to Employees" ("APB No. 25"). In addition, this
Statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about
the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The Company continues to
maintain its accounting for stock-based compensation in accordance with APB
No. 25, but has adopted the disclosure provisions of SFAS No. 148 (See Note
11).
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities, an interpretation of Accounting Research
Bulletin No. 51" ( "FIN No. 46" ). FIN No. 46 requires existing
unconsolidated variable interest entities to be consolidated by their
primary beneficiaries if the entities do not effectively disperse risks
among parties involved. FIN No. 46 applies immediately to variable interest
entities created after January 31, 2003, and to variable interest entities
in which an enterprise obtains an interest after that date. It applies in
the first fiscal year or interim period beginning after June 15, 2003, to
variable interest entities in which an enterprise holds a variable interest
that it acquired before February 1, 2003. FIN No. 46 applies to public
enterprises as of the beginning of the applicable interim or annual period.
FIN No. 46 may be applied prospectively with a cumulative-effect adjustment
as of the date on which it is first applied or by restating previously
issued financial statements for one or more years with a cumulative-effect
adjustment as of the beginning of the first year restated. The
implementation of FIN No. 46 is not expected to have a material impact on
the Company's financial statements.
Financial Pages (F) 13
3. Acquisition of Business:
On January 10, 2000, PTNA entered a purchase agreement to acquire all of
the common stock of NISHD, a Florida brokerage insurance agency for cash of
$6,000. The acquisition was effective January 1, 2000. The Company
accounted for the acquisition as a purchase and recorded $6,000 of
goodwill, which, until January 1, 2002, was being amortized over 20 years.
4. Investments and Financial Instruments
December 31, 2002
--------------------------------------------------------------
Amortized Gross Unrealized Gross Unrealized Estimated
Cost Gains Losses Market Value
U.S. Treasury securities
and obligations of U.S
Government authorities
and agencies $ 15,689 $ 1,172 $ - $ 16,861
Mortgage backed securities 1,603 78 - 1,681
Obligations of states and
political sub-divisions - - - -
Debt securities issued by
foreign governments 205 11 - 216
Corporate securities 9,278 419 (1) 9,696
--------------------------------------------------------------
$ 26,775 $ 1,680 $ (1) $ 28,454
==============================================================
December 31, 2001
--------------------------------------------------------------
Amortized Gross Unrealized Gross Unrealized Estimated
Cost Gains Losses Market Value
U.S. Treasury securities
and obligations of U.S
Government authorities
and agencies $ 164,712 $ 7,351 $ - $ 172,063
Mortgage backed securities 42,587 744 - 43,331
Obligations of states and
political sub-divisions 572 40 - 612
Debt securities issued by
foreign governments 11,954 135 - 12,089
Corporate securities 243,793 6,720 - 250,513
--------------------------------------------------------------
$ 463,618 $14,990 $ - $ 478,608
==============================================================
Financial Pages (F) 14
The amortized cost and estimated market values of debt securities at
December 31, 2002, by contractual maturity, are shown below. Expected
maturities may differ from contractual maturities because borrowers may
have the right to call or prepay obligations with or without call or
prepayment penalties.
Amortized Estimated
Cost Market Value
---- ------------
Due in one year or less $ 3,616 $ 3,723
Due after one year through five years 14,890 15,977
Due after five years through ten years 6,417 6,821
Due after ten years 249 252
Collateralized Mortgage Obligations 1,603 1,681
------- -------
$26,775 $28,454
======= =======
Gross proceeds and realized gains and losses on debt securities, including
impairment losses for declines deemed other than temporary and excluding
calls, were as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- ----- ------
2002 $ 478,808 $ 18,728 $ 3,822
2001 $ 158,182 $ 4,970 $ 7,697
2000 $ 209,229 $ 8,613 $ 9,114
Gross proceeds and realized gains and losses on equity securities,
including impairment losses for declines deemed other than temporary, were
as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- ----- ------
2002 $ 9,547 $ 1,861 $ 1,094
2001 $ 20,026 $ 1,055 $ 6,123
2000 $ 30,163 $ 4,241 $ 3,088
The Company assesses whether declines in market value are other than
temporary. Upon such determination, the Company will impair the security's
amortized cost and record an impairment charge in its results of
operations. At December 31, 2000, the Company reduced its cost basis on a
bond, whose issuer had declared bankruptcy, to its market value, realizing
an impairment charge of approximately $3,200. In 2001, the Company reduced
its cost basis of equity securities by $5,767 as a result of differences
deemed other than temporary. The Company reduced its cost basis on bonds in
2002 by $12 due to differences deemed other than temporary.
At December 31, 2001, the Company entered a reinsurance agreement for which
substantially all of its investment portfolio was later ceded as the
initial premium for this agreement. As a result of this intended transfer
or sale of assets, the Company determined that all gross unrealized losses
on its debt and equity securities likely would not be recovered and were
therefore deemed to be other than temporary impairments. The Company
recognized a loss of $3,867 from this determination. The Company recognized
other impairment charges in 2001 of approximately $1,900 due to other than
temporary declines. As a result of the transfer of assets to the reinsurer
and from other normal investment operations in 2002, the Company recognized
net gains of $14,701 from the sale of securities.
Financial Pages (F) 15
Gross unrealized gains and losses pertaining to equity securities were as
follows:
Gross Gross
Original Unrealized Unrealized Estimated
Cost Gains Losses Market Value
---- ----- ------ ------------
2002 $ - $ - $ - $ -
2001 $ 8,760 $ 1,042 $ - $ 9,802
2000 $ 17,112 $ 1,758 $ (2,374) $ 16,496
Net investment income is applicable to the following types of investments:
2002 2001 2000
---- ---- ----
Bonds $ 2,289 $ 28,157 $ 25,777
Equity securities - 519 665
Experience account due from reinsurer 38,375 - -
Cash and short-term investments 647 3,167 1,751
--------------------------------
Investment income 41,311 31,843 28,193
Investment expense (242) (1,230) (785)
--------------------------------
Net investment income $ 41,069 $ 30,613 $ 27,408
================================
Pursuant to certain statutory licensing requirements, as of December 31,
2002, the Company had on deposit investments aggregating $10,848 (fair
value) in insurance department safekeeping accounts. The Company is not
permitted to remove the bonds from these accounts without approval of the
regulatory authority.
The Company maintains assets in a trust account under a reinsurance
agreement with an unaffiliated insurer. The Company is required to hold
assets equal to 102% of the reserves, or approximately $11,174 and $7,401
at December 31, 2002 and 2001, respectively, for policies assumed under
this agreement. At both December 31, 2002 and 2001, the market value of the
assets in trust exceeded the required amount.
5. Experience Account Due From Reinsurer:
The reinsurance agreement with Centre Solutions (Bermuda) Limited
("Centre") includes a provision for the maintenance of an experience
account for the Company's benefit in the event of future commutation of the
agreement.
The initial premium and future cash flows from the reinsured policies, less
claims payments, ceding commissions, risk charges and certain other
charges, is credited to a notional experience account, which is held by the
reinsurer for the Company's benefit in the event of commutation and
recapture on or after December 31, 2007 (See Note 13). 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 the reserve liability.
The notional experience account represents a hybrid instrument, containing
both a fixed debt host contract and an embedded derivative. The economic
characteristics and risks of the embedded derivative instrument are not
clearly and closely related to the economic characteristics and risks of
the fixed debt host contract. In accordance with SFAS No. 133, the Company
is accounting for the investment credit received on the experience account
as follows:
Financial Pages (F) 16
o The fixed debt host yields a fixed return based on the yield to
maturity of the underlying benchmark indices. The return on the fixed
debt host is reported as investment income in the statement of income
and comprehensive income.
o The change in fair value of the embedded derivative represents the
percentage change in the underlying indices applied to the notional
experience account, similar to that of an unrealized gain/loss on a
bond. The change in the fair value of the embedded derivative is
reported as market gain on experience account in the statement of
income and comprehensive income.
The benchmark indices are comprised of US treasury strips, agencies and
investment grade corporate bonds, with weightings of approximately 25%, 15%
and 60%, respectively, and have a duration of approximately 11 years. The
hybrid instrument subjects the Company to significant volatility as the
estimated value of the embedded derivative is highly sensitive to changes
in interest rates. A 100 basis point increase in interest rates would
reduce the current experience account balance by approximately $70,000.
During 2002, the experience account activity was as follows:
Beginning balance $ -
Initial premium transfer 560,887
Premiums, net of claims and
ceding allowance 67,668
Investment credit:
Investment income 38,375
Market gain 56,555
Expense and risk charges (14,308)
Broker and custodian fees (195)
----------
Ending balance $ 708,982
==========
6. Policy Reserves and Claims:
Policy reserves have been computed principally by the net premium method
based upon estimated future investment yield, mortality, morbidity (claims
experience), withdrawals and other benefits. Since 2001, the Company has
employed a prospective net premium methodology, which incorporates premium
rate increases expected to be implemented in the near term in the net
premium used to establish policy reserves. The composition of the policy
reserves at December 31, 2002 and 2001, and the assumptions pertinent
thereto are presented below:
Financial Pages (F) 17
Amount of Policy Reserves
as of December 31,
2002 2001
---- ----
Accident and health $ 464,318 $ 382,660
Annuities and other 137 131
Ordinary life, individual 12,416 13,255
Years of Issue Discount Rate Discount Rate
Accident and health 1976 to 1986 5.7% 6.5%
1987 5.7% 6.5%
1988 to 1991 5.7% 6.5%
1992 to 1995 5.7% 6.5%
1996 5.7% 6.5%
1997 to 2000 5.7% 6.5%
2001 5.7% 6.5%
2002 5.3%
Annuities and other 1977 to 1983 6.5% & 7.0% 6.5% & 7.0%
Ordinary life, individual 1962 to 2002 3.0% to 5.5% 3.0% to 5.5%
Basis of Assumption
Accident and health: Morbidity and withdrawals based on actual and
projected experience. Morbidity represents the claim costs we expect
to incur in the future. The assumption for these future claim costs is
based on past company experience modified for both industry experience
and recent trends, withdrawals represent the lapsation of policies due
to either death or cancellation.
Annuities and other Primarily funds on deposit inclusive of accrued
interest.
Ordinary life, individual: Mortality based on 1975-80 SOA Mortality Table
(Age Last Birthday).
Activity in policy and contract claims is summarized as follows:
2002 2001 2000
---- ---- ----
Balance at January 1 $ 214,466 $ 164,565 $ 137,534
less reinsurance recoverable (8,888) (5,454) (3,917)
--------- --------- ---------
Net balance at January 1 205,578 159,111 133,617
--------- --------- ---------
Incurred related to:
Current year claims 200,006 193,552 135,084
Prior years claims 80,948 8,845 6,564
Imputed prior year interest 10,225 8,632 6,863
--------- --------- ---------
Total incurred 291,179 211,029 148,511
--------- --------- ---------
Paid related to:
Current year claims 48,627 73,726 37,864
Prior years claims 127,245 90,836 85,153
--------- --------- ---------
Total paid 175,872 164,562 123,017
--------- --------- ---------
Net balance at December 31 320,885 205,578 159,111
plus reinsurance recoverable 9,059 8,888 5,454
--------- --------- ---------
Balance at December 31 $ 329,944 $ 214,466 $ 164,565
========== ========== =========
Financial Pages (F) 18
The Company establishes reserves for the future payment of all currently
incurred claims. 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. Claim reserves include current assumptions as
to type and duration of care, remaining policy benefits, and interest
rates. The Company compares actual experience with estimates and adjusts
its reserves on the basis of such comparisons.
The Company evaluates its prior year assumptions by reviewing the
development of reserves for the prior period (i.e. incurred from prior
years). This amount includes imputed interest from prior year-end reserve
balances plus adjustments to reflect actual versus estimated claims
experience. These adjustments (particularly when calculated as a percentage
of the prior year-end reserve balance) provide a relative measure of
deviation in actual performance as compared to its initial assumptions.
In 2002, the Company added approximately $80,948 to its claim reserves for
2001 and prior period incurred claims. During 2002, the Company completed
an analysis of the adverse deviation recognized in the past development of
its reserves for current claims. The analysis included a comparison of
actual to expected experience.
As a result of this analysis, the Company refined its process and
assumptions for developing claims reserves. The most significant changes
were as follows:
a) Redefinition of Claims:
In the past 10 years, more policies have been sold offering benefits for
both nursing facility and in-home health care coverage. Increasing numbers
of claims have been reported on these policies over the past few years. The
Company has historically recorded claims that begin in one type of care and
later move to another type of care as two separate claims. Defining claims
in this manner has projected a greater number of expected claims from
certain types of policies, while projecting a shorter expected length of
claims. The Company has now determined to define this as one claim, using
the earliest date of service as the incurral date. This redefinition of
claims results in fewer expected future claims, but anticipates that each
claim will last longer.
b) Continuance Assumptions:
Once a claim occurs, the Company develops claim reserves by using
continuance tables, which measure the likelihood of a claim continuing in
the future. Historically, the Company has applied every claim to a set of
uniform continuance tables. The Company's actuarial modeling suggests that
this uniform continuance assumption no longer reflects the increasing
number of claims from policies with longer benefit periods or increased
benefit amounts. The Company has developed an improved methodology by
creating separate continuance tables for facility, home health and
comprehensive care, as well as for tax qualified and non-qualified plans.
In addition, the Company has established separate continuance tables for
claims caused by cognitive impairment. The Company's 2002 analysis
indicates that the duration of its existing claims has been increasing in
recent years and will be longer than was previously expected. The Company
revised its continuance assumption to reflect this trend.
As a result of its redefinition of claims and employment of new continuance
tables for separate types of claims with longer claim durations, the
Company strengthened its policy and contract reserves by approximately
$78,000 in 2002 for claims incurred prior to January 1, 2002.
In addition, the Company reduced its assumed discount rate from 6.5% to
5.7% based upon recent investment yields. This change resulted in an
increase to reserves of approximately $5,000.
In 2001, excluding the impact of imputed interest of $8,632, the Company
added $8,845 to its claim reserves for 2000 and prior claim incurrals. Two
factors affected the reserves the Company held for claims incurred in prior
years. (1) In 2001, the Company engaged a new consulting actuary that
provided the Company with additional industry data to incorporate in its
continuance expectations (the probability that a claim in one duration will
continue to another). The Company's analysis of this supplemental data
suggested that it would recognize higher future payments on currently
incurred claims than was previously anticipated. As a result, the Company
lengthened its continuance tables for claim durations beyond the third
year, and increased its reserves held for claims incurred to record this
liability. This resulted in an increase of reserves incurred in prior years
of $7,262; and (2) In 2001, the Company reduced the discount rate used in
the establishment of reserves to appropriately reflect the current
investment rate earned on assets supporting this liability. As a result,
reserves for claims incurred in prior years were increased $1,582.
Financial Pages (F) 19
In 2000, the Company added $6,564 for claims incurred in prior years. The
Company believes that this increase in reserves for prior year incurred
claims of 4.8% did not reflect a material variance from its expectations.
However, the Company attributes the variance to the method it employed for
determining incurred but not reported claims ("IBNR"). This method sought
to project a ratio of incurred claims to earned premium based upon historic
experience and current trends. The actual number and type of claims that
were ultimately reported to the Company exceeded the amount of IBNR that it
had recorded at the original estimated date.
Over time, it may continue to be necessary for the Company to increase or
decrease its reserves further as additional experience develops.
7. Long-Term Debt:
Long-term debt at December 31, 2002 and 2001 is as follows:
2002 2001
---- ----
Convertible, subordinated debt issued in November 1996, with a semi-annual
coupon of 6.25% annual percentage rate. Debt is callable after December 2, 1999
at declining redemption values and matures in December 2003. Prior to maturity,
the debt is convertible to shares of the Company's common stock at $28.44 per
share. $11,408 $74,750
Convertible, subordinated debt issued in October 2002, annual coupon of 6.25%
annual percentage rate. Debt is callable after October 15, 2005 at declining
redemption values and matures in October 2008. Prior to maturity, the debt is
convertible to shares of the Company's common stock at $1.75 per share. 63,343 -
Mortgage loan with interest rate fixed for five years at 6.85% effective
September 1998, which was repriced from 7.3% in 1997. Although carrying a
variable rate of LIBOR + 90 basis points, the loan has an effective fixed rate
due to an offsetting swap with the same institution. Current monthly payment of
$16 based on a fifteen year amortization schedule with a balloon payment due
September 2003; collateralized by property with depreciated cost of $2,673 and
$2,361 as of December 31, 2002 and 2001, respectively. 1,494 1,582
Installment note for purchase of UIG, due January 2002, payable in annual
installments at 0% interest. (imputed at 6%) - 2,858
------- -------
$76,245 $79,190
======= =======
Financial Pages (F) 20
Principal repayment of mortgage and other debt obligations are due as
follows:
Lease
Debt Obligations Total
---- ----------- -----
2003 $ 12,902 $ 344 $ 13,246
2004 - 252 252
2005 - 18 18
2006 - 18 18
2007 - 18 18
2008 63,343 18 63,361
-------- ----- --------
Total $ 76,245 $ 668 $ 76,913
======== ===== ========
In the fourth quarter of 2002, the Company exchanged $63,343 of its 6.25%
Subordinated Convertible Notes due 2003 for a like amount of newly issued
6.25% Subordinated Convertible Notes due 2008. Subsequent to December 31,
2002, the Company modified the terms of the Notes. The primary differences
between the 2003 Notes and the exchanged 2008 Notes, as modified, are as
follows:
1) Conversion Price - lowered from $28.44 per share to $5.31. The
conversion price was subsequently reduced to $4.50 and then $2.50 prior to
December 31, 2002. In the first quarter of 2003, the Company reduced the
conversion price further to $1.75.
2) Call Protection - the new notes cannot be called or caused by the
Company to convert until October 2005.
3) Mandatory Conversion - the new notes will mandatorily convert after
October 15, 2005 in the event that the Company's average stock price for 15
trading days exceeds $1.75.
4) Interest Payment - holders of the new notes are entitled to convert
bonds into shares of Company common stock before October 15, 2005, and, in
doing so, may elect to receive a discounted amount of interest that they
would have otherwise received until that date. The Company may elect to pay
this interest in cash or in newly issued shares of common stock. If issued,
the stock would be priced at a 10% discount to the then fair market value
of traded shares.
8. Federal Income Taxes:
The (benefit) provision for federal income taxes for the years ended
December 31 consisted of:
2002 2001 2000
---- ---- ----
Current $ (2,548) $ (3,503) $ 3,045
Deferred (10,478) (12,777) 8,675
-------- -------- --------
$(13,026) $(16,280) $ 11,720
======== ======== ========
Financial Pages (F) 21
Deferred income tax assets and liabilities have been recorded for temporary
differences between the reported amounts of assets and liabilities in the
accompanying financial statements and those in the Company's income tax
return. Management believes the existing net deductible temporary
differences are realizable on a more likely than not basis. The sources of
these differences and the approximate tax effect are as follows for the
years ended December 31:
2002 2001
---- ----
Net operating loss carryforward $ 20,189 $ 26,547
Other than temporary decline
in market value - 3,187
Other 369 691
Valuation allowance (5,775) (5,775)
-------- --------
Total deferred tax assets $ 14,783 $ 24,650
======== ========
Deferred policy acquisition costs $ (25,183) $(36,822)
Present value of future profits acquired (346) (678)
Premiums due and unpaid (1,267) (767)
Unrealized gains on investments (583) (5,451)
Policy reserves (4,124) (13,830)
Deferred reinsurance premium (4,625) (5,549)
Other (1,756) -
--------- --------
Total deferred income liabilities $ (37,884) $(63,097)
========= ========
Net deferred income tax $ (23,101) $(38,447)
========= ========
The Company has net operating loss carryforwards of approximately $7,300 on
a tax effected basis, which have been generated by taxable losses at the parent
company, and if unused will expire between 2012 and 2022. The parent company's
net operating loss carryforwards can be utilized by the Company's insurance
subsidiaries subject to the lesser of 35% of the insurance subsidiary taxable
income or 33% of the current aggregate carryforward amount. During 2001, the
Company established a valuation allowance of $5,775 against these parent company
net operating loss carryforwards. In addition, the Company has net operating
loss carryforwards of approximately $12,900 on a tax effected basis, which have
been generated by taxable losses at the Company's life subsidiaries, and if
unused, will expire in 2016.
A reconciliation of the income tax (benefit) provision computed using the
federal income tax rate to the (benefit) provision for federal income taxes is
as follows:
2002 2001 2000
---- ---- ----
Computed federal income tax (benefit)
provision at statutory rate $(15,212)(1) $ (22,704) $ 12,065
Valuation allowance - 5,775 -
Impairment of goodwill 1,803 - -
Small life insurance company
deduction - (363) -
Tax-exempt income (1,225) (1,147) (585)
Other 1,608 2,159 240
-------- --------- --------
$(13,026) $ (16,280) $ 11,720
======== ========= ========
At December 31, 2002, the accumulated earnings of the Company for Federal income
tax purposes included $1,451 of "Policyholders' Surplus", a special memorandum
tax account. This memorandum account balance has not been currently taxed, but
income taxes computed at then-current rates will become payable if surplus is
distributed. Provisions of the Deficit Reduction Act of 1984 do not permit
further additions to the "Policyholders' Surplus" account.
(1) The computed federal income tax (benefit) for the year ended December 31,
2002 is calculated by multiplying the statutory rate of 35% by ($43,464),
which represents the loss before federal income taxes of $(38,313) plus the
cumulative effect of the change in accounting principle of ($5,151).
Financial Pages (F) 22
9. Statutory Information:
Statutory Financial Results --
The insurance subsidiaries prepare their statutory financial statements in
accordance with accounting practices prescribed or permitted by the
insurance department of the state of domicile. Net income and capital and
surplus as reported in accordance with statutory accounting principles for
the Company's insurance subsidiaries are as follows:
2002 2001 2000
---- ---- ----
Net income (loss) $ 7,963 ($32,222) ($28,984)
Capital and surplus $34,909 $17,807 $29,137
Total reserves, including policy and contract claims, reported to
regulatory authorities were approximately $761,042 and $584,949 less than
those recorded for GAAP as of December 31, 2002 and 2001, respectively.
This difference is primarily attributable to reinsurance agreements in
force as of December 31, 2002 and 2001. For further discussion see Note 13,
"Reinsurance".
The differences in statutory net income (loss) compared to GAAP net (loss)
income are primarily due to the immediate expensing of acquisition costs,
as well as differing reserving methodologies and treatment of reinsurance
and deferred income taxes. Due to the differences in expensing of
acquisition costs and reserving methodologies, under statutory accounting
there is generally a net loss and a corresponding decrease in surplus,
referred to as surplus strain, during periods of growth.
Effective December 31, 2001, the Company entered a reinsurance transaction
that, according to Pennsylvania insurance regulation, required the
reinsurer to provide it with letters of credit in order for the Company to
receive statutory reserve and surplus credit from the reinsurance. The
letters of credit were dated subsequent to December 31, 2001, as a result
of the final closing of the agreement. In addition, the initial premium
paid for the reinsurance included investment securities carried at
amortized cost on the statutory financial statements, but valued at market
value for purposes of the premium transfer. The Pennsylvania Insurance
Department permitted the Company to receive credit of $29,000 for the
letters of credit, and to accrue the anticipated, yet unknown, gain of
$18,000 from the sale of securities at market value, in its statutory
financial results for December 31, 2001. The impact of this permitted
practice served to increase the statutory surplus of the Company's
insurance subsidiaries by approximately $47,000 at December 31, 2001. Had
the Company not been granted a permitted practice, its statutory surplus
would have been negative. Upon finalization of the reinsurance agreement,
transfer of funds and establishment of appropriate Letters of Credit,
during 2002, the permitted practices were no longer required.
Pennsylvania Corrective Action Plan --
The Company's insurance 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
insurance subsidiaries 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, Penn Treaty, 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.
Financial Pages (F) 23
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 by an additional
$125,000 over a three year period, of which $48,000 remains to be
increased throughout 2003-2004.
The reinsurance agreement entered into as part of the Corrective Action
Plan is accounted for as reinsurance for statutory accounting purposes, but
does not qualify for reinsurance for GAAP accounting purposes (See Note
13). As the agreement is treated as reinsurance for statutory accounting
purposes, it results in the ceding (or removal) of substantially all of the
insurance subsidiaries' policy reserve and policy and contract claim
liabilities for statutory accounting purposes. Furthermore, any adverse
development of the 2001 and prior policy reserve and contract claim
liabilities, including the $125,000 of reserve increases mentioned above,
is ceded to the reinsurer and not reflected on the insurance subsidiaries'
statutory financial statements.
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 Company is required to perform
annual comparisons of its actual to expected claims experience. If the
Company has reason to believe, whether from this analysis or other
available information, that at least a 5% premium rate increase is
necessary, the Company is obligated to file and obtain such premium rate
increases in order to comply with the requirements of the agreement. If the
Company does not file and obtain such premium rate increases, the aggregate
limit of liability would be reduced by 50% of the premium amount that would
have otherwise been received.
In the event the statutory policy and contract claim reserves ultimately
exceed the limit of liability established in the reinsurance agreement,
either as a result of claim reserve development or reductions in the amount
of the reinsurer's limit of liability, the insurance subsidiaries would
have to retain any reserve liabilities in excess of the limit of liability,
which could have a materially adverse impact upon the insurance
subsidiaries' statutory surplus.
The estimation of policy reserves for statutory accounting purposes differs
from that utilized in GAAP. For statutory accounting purposes, the
assumptions utilized and the methodology applied may be at the discretion
of the Department's interpretation of its regulations. As noted above, as
part of the Corrective Action Plan, the Pennsylvania Insurance Department
has provided the Company with guidelines for establishing its statutory
policy reserves. Because the Pennsylvania insurance subsidiaries have
limited statutory capital and the 2001 Centre Agreement has a limit of
liability, any changes in the Department's interpretation or view of how
the Company's insurance subsidiaries determine their statutory policy
reserves could have a material adverse impact on the insurance
subsidiaries, possibly resulting in regulatory control or liquidation.
Failure to comply with the Corrective Action Plan could result in the
Department taking control of the Company's insurance subsidiaries.
Financial Pages (F) 24
Statutory Dividend Restrictions --
States restrict the dividends the Company's insurance subsidiaries are
permitted to pay. Dividend payments will depend on profits arising from the
business of its insurance company subsidiaries, computed according to
statutory formulae. Under the insurance laws of Pennsylvania and New York,
where the Company's insurance subsidiaries are domiciled, insurance
companies can pay ordinary dividends only out of earned surplus. In
addition, under Pennsylvania law, PTNA and ANIC must give the Department at
least 30 days' advance notice of any proposed "extraordinary dividend" and
cannot pay such a dividend if the Department disapproves the payment during
that 30-day period. For purposes of that provision, an extraordinary
dividend is a dividend that, together with all other dividends paid during
the preceding twelve months, exceeds the greater of 10% of the insurance
company's surplus as shown on the company's last annual statement filed
with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to the
immediate or accelerated recognition of all costs associated with premium
growth and benefit reserves. Additionally, the Plan requires the Department
to approve all dividend requests made by Penn Treaty, regardless of normal
statutory requirement for allowable dividends. The Company believes that
the Department is unlikely to consider any dividend request in the
foreseeable future, as a result of PTNA's statutory surplus position.
Although not stipulated in the Plan, this requirement is likely to continue
until such time as PTNA meets normal statutory requirements, including
reported net income and positive cumulative earned surplus.
Under New York law, AINIC must give the New York Insurance Department 30
days' advance notice of any proposed dividend and cannot pay any dividend
if the regulator disapproves the payment during that 30-day period. In
addition, AINIC must obtain the prior approval of the New York Insurance
Department before paying any dividend that, together with all other
dividends paid during the preceding twelve months, exceeds the lesser of
10% of the insurance company's surplus as of the preceding December 31 or
its adjusted net investment income for the year ended the preceding
December 31.
PTNA and ANIC have not paid any dividends to the parent company for the
past three years and are unlikely in the foreseeable future to be able to
make dividend payments due to insufficient statutory surplus and
anticipated earnings. However, AINIC is not subject to the Plan and was
permitted by New York statute to make a dividend payment in 2002 of $651.
AINIC will not be able to make a dividend payment in 2003.
Codification --
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles ("Codification") guidance, which replaced the current Accounting
Practices and Procedures manual as the NAIC's primary guidance on statutory
accounting as of January 1, 2001. The Codification provides guidance for
areas where statutory accounting has been silent and changes current
statutory accounting in some areas, including the recognition of deferred
income taxes.
The Pennsylvania and New York Insurance Departments have adopted the
Codification guidance, effective January 1, 2001. The Codification guidance
serves to reduce the insurance subsidiaries' surplus, primarily due to
certain limitations on the recognition of goodwill and EDP equipment and
the recognition of other than temporary declines in investments. These
reductions are partially offset by certain other items, including the
recognition of deferred tax assets subject to certain limitations. In 2001,
the Company's statutory surplus was reduced by approximately $2,000 as a
result of the Codification guidance.
10. 401(k) Retirement Plan:
The Company has a 401(k) retirement plan, covering substantially all
employees with at least one year of service. Under the plan, participating
employees may contribute up to 15% of their annual salary on a pre-tax
basis. The Company, under the plan, equally matches employee contributions
up to the first 3% of the employee's salary. The Company and employee
portion of the plan is vested immediately. The Company's expense related to
this 401(k) plan was $239, $167 and $147 for the years ended December 31,
2002, 2001 and 2000, respectively. The Company may elect to make a
discretionary contribution to the plan, which will be contributed
proportionately to each eligible employee. The Company did not make a
discretionary contribution in 2002, 2001 or 2000.
11. Stock Option Plans:
At December 31, 2002, the Company had three stock-based compensation plans,
which are described below. For 2000, and for certain options granted in
2001 and 2002, the Company has adopted the disclosure-only provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation" ("SFAS No. 123"), and applies APB Opinion No. 25
"Accounting for Stock Issued to Employees," ("APB Opinion No. 25") and
related Interpretations in accounting for its plans. While the Company
continues to maintain its accounting for stock-based compensation in
accordance with APB Opinion No. 25, it has adopted the disclosure
provisions of SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure ( "SFAS No. 148" ), which amends
SFAS No. 123. Accordingly, the Company is not required to recognize
compensation expense when the exercise price is equal to, or greater than,
the fair market value at the date of grant.
Financial Pages (F) 25
The Company's 1987 Employee Incentive Stock Option Plan provided for the
granting of options to purchase up to 1,200 shares of common stock. This
plan expired in 1997 and was subsequently replaced by the 1998 Employee
Non-Qualified Incentive Stock Option Plan ("1998 Plan"). The 1998 Plan
allows for the grant of options to purchase up to 600 shares of common
stock. No new options may be granted under the 1987 Plan. The term of each
option granted in 2001 and 2002 is ten years.
Effective May 1995, the Company adopted a Participating Agent Stock Option
Plan which provides for the granting of options to purchase up to 300
shares of common stock. The exercise price of all options granted under the
plan may not be less than the fair market value of the shares on the date
of grant. The term of each option is ten years, and the options become
exercisable in four equal, annual installments commencing one year from the
option grant date. SFAS No. 123 requires that the fair value of options
granted to non-employees (agents) be recognized as compensation expense
over the estimated life of the option. Options were granted to agents in
1997, 1996 and 1995. No agent options have been granted since 1997. The
Company recognized $0, $51 and $86 of compensation expense in 2002, 2001
and 2000, respectively as a result of these grants.
During 2001, the Company granted 566 replacement options to its employees
for all existing options granted under its existing fixed option plans. As
a result, these options are now subject to the variable accounting
provisions of APB Opinion No. 25 until exercised, forfeited or cancelled.
The Company recorded a compensation contra-expense and expense of $430 in
2002 and 2001, respectively, related to these variable options,
representing the intrinsic value of the stock options at the reporting date
to the extent the fair value exceeded the exercise price of the employee
options at the grant date. In addition, 30 options were granted to a new
senior executive in 2001 and 4 were granted to another new executive in
2002.
Had compensation cost for the Company's employee stock-based compensation
plans been determined based on the fair value at the grant dates for awards
under those plans consistent with the method of SFAS No. 123, the Company's
net (loss) income and earnings per share would have been reduced to the pro
forma amounts indicated below.
Compensation cost is estimated using an option-pricing model with the
following assumptions for new options granted to employees in 2002, 2001
and 2000. In 2002, options were valued with an expected life of 5.3 years,
volatility of 70.9% and a risk free rate of 4.4%. The weighted average
fair value of options granted in 2002 was $2.37. In 2001, options were
valued with an expected life of 5.3 years, volatility of 70.9% and a risk
free rate of 4.9%. The weighted average fair value of options granted in
2001 was $1.71. In 2000, options were valued with an expected life of 5.3
years, volatility of 28.3% and a risk free rate of 4.8%. The weighted
average fair value of options granted in 2000 was $6.80.
The Company's net income and earnings per share results would have been
reduced to the pro forma amounts indicated below for the years ended
December 31, 2002, 2001 and 2000, respectively.
2002 2001 2000
---- ---- ----
Net Income As reported $ (30,438) $(48,589) $ 22,750
Pro forma $ (30,982) $(49,133) $ 22,325
Basic Earnings Per Share As reported $ (1.58) $ (3.41) $ 3.13
Pro forma $ (1.58) $ (3.41) $ 3.07
Diluted Earnings Per Share As reported $ (1.58) $ (3.41) $ 2.61
Pro forma $ (1.58) $ (3.41) $ 2.57
Financial Pages (F) 26
The following is a summary of the Company's option activity, including
grants, exercises, forfeitures and weighted average price information:
2002 2001 2000
------------------------------- ------------------------------ ----------------------------
Exercise Exercise Exercise
Price Price Price
Options Per Option Options Per Option Options Per Option
------------------------------- ------------------------------ ----------------------------
Outstanding at beginning of year 648 $ 8.48 685 $ 19.59 552 $ 19.64
Granted 4 $ 4.40 596 $ 6.96 155 $ 19.25
Exercised - $ - 1 $ 12.45 11 $ 12.56
Forfeitures - $ - 632 $ 18.79 11 $ 24.44
---------------- ---------------- ---------------
Outstanding at end of year 652 $ 8.45 648 $ 8.48 685 $ 19.59
================ ================ ===============
Exercisable at end of year 648 $ 8.48 88 $ 17.99 457 $ 18.15
================ ================ ===============
Outstanding Remaining Exercisable
at December Contractual at December
Range of Exercise Prices 31, 2002 Life (Yrs) 31, 2001
-----------------------------------------------
3.40 -- 4.72 210 9 206
5.19 -- 7.82 258 9 258
8.60 -- 12.38 103 9 103
12.63 -- 32.25 81 6 81
-----------------------------------------------
652 9 648
===============================================
12. Commitments and Contingencies:
Operating Lease Commitments:
The total net rental expenses under all leases amounted to approximately
$928, $1,059 and $1,003 for the years ended December 31, 2002, 2001 and
2000 respectively.
The Company's required payments due under non-cancelable leases in each of
the next five years are as follows:
Years Amounts
----- -------
2003 $ 344
2004 252
2005 18
2006 18
2007 and
thereafter 36
-----
$ 668
=====
During May 1987, the Company assigned its rights and interests in a land
lease to a third party for $175. The agreement indemnifies the Company
against any further liability with respect to future lease payments. The
Company remains contingently liable to the lessor under the original deed
of lease for rental payments of $16 per year, the amount being adjustable
based upon changes in the consumer price index since 1987, through the year
2063.
Letters of Credit:
At December 31, 2002 and 2001, the Company received letters of credit of
$149,339 and $29,000, respectively, which allowed its subsidiaries to
receive statutory reserve credit and statutory surplus credit for its 2001
quota share reinsurance agreement with Centre. As part of the Company's
financial reinsurance agreements in effect at December 31, 2000, it
received a letter of credit from a bank for $5,000, which served to allow
the Company to receive statutory reserve credit for its financial
reinsurance with state insurance departments.
Reinsurance:
PTNA is a party to a reinsurance agreement to cede certain home health care
claims beyond 36 months. Reinsurance recoverables related to this treaty
were $10,175 and $7,726 at December 31, 2002 and 2001, respectively. The
reinsurer has notified PTNA that they believe the Company is in breach of
its current agreement as a result of entering the 2001 Centre Agreement
without the prior written approval of the reinsurer. PTNA has contested
this assertion of breach and is continuing discussions with the reinsurer
to reach an equitable resolution, including, but not limited to, the
recapture of the excess home health care coverage and reserves, premium
rate increases, or additional reinsurance business in the future. The
ultimate resolution of this dispute cannot be determined at this time.
Financial Pages (F) 27
Litigation:
The Company's subsidiaries are parties to various lawsuits generally
arising in the normal course of their business. The Company does not
believe that the eventual outcome of any of the suits to which it is party
will have a material adverse effect on its 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.
Our 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 our common stock
between 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 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 July 1, 2002,
the defendants filed an answer to the complaint, denying all liability.
Plaintiffs filed a motion for class certification on August 15, 2002, which
is currently pending. On February 26, 2003, the parties reached an
agreement in principle to settle the litigation for $2.3 million, to be
paid entirely by our directors and officers liability insurance carrier.
The settlement remains subject to documentation and court approval.
The Company and its subsidiary, PTNA, are defendants in an action in the
United States District Court, Middle District of Florida, Ocala Division.
Plaintiffs filed this matter on January 10, 2003 in the Fifth Judicial
Circuit of the State of Florida in and for Marion County, Civil Division,
on behalf of themselves and a class of similarly situated Florida long term
care policyholders. The Company removed this case from the Florida state
court to Federal Court on February 6, 2003. Plaintiffs claim wrongdoing in
connection with the sale of long term care insurance policies to the
Plaintiffs and the Class. Plaintiffs allege claims for reformation, breach
of fiduciary duty, breach of the implied duty of good faith and fair
dealing, negligent misrepresentation, fraudulent misrepresentation, and
restitution. The Company has filed motions to dismiss for failure to state
a claim, lack of personal jurisdiction against the Company, and a motion to
strike certain allegations of the Complaint as irrelevant and improper.
Plaintiffs filed a motion to remand on March 7, 2003. Briefing is
continuing on all of these motions. While the Company cannot predict the
outcome of this case, the results could have a material adverse impact upon
its financial condition and results of operations. However, the Company
believes that the Complaint is without merit and intends to continue to
defend the matter vigorously.
The Company and two of its subsidiaries, PTNA and Senior Financial
Consultants Company, are defendants in an action instituted on June 5, 2002
in the United States District Court for the Eastern District of
Pennsylvania by National Healthcare Services, Inc. The complaint seeks
compensatory damages in excess of $150 and punitive damages in excess of
$5,000 for an alleged breach of contract and misappropriation. The claims
arise out of a joint venture related to the AllRisk Healthcare program,
which was marketed first by PTNA and then later by Senior Financial
Consultants Company. The defendants have denied the allegations of the
complaint and will continue to defend the matter vigorously. While the
Company cannot predict the outcome of this case, the Company believes that
any resolution of this action will not have a material impact on its
financial condition or results of operations.
Financial Pages (F) 28
13. Reinsurance:
Centre Solutions (Bermuda), Limited -
2001 Centre Agreement
Effective December 31, 2001, PTNA and ANIC entered a reinsurance
transaction to reinsure, on a quota share basis, substantially all of the
Company's long-term care insurance policies then in-force ("the 2001
Agreement").
This agreement meets the requirements to qualify for reinsurance treatment
under statutory accounting rules. However, this agreement does not qualify
for reinsurance treatment in accordance with SFAS No. 113 because, based on
our analysis, the agreement does not result in the reasonable possibility
that the reinsurer may realize a significant loss. This is due to a number
of factors related to the agreement, including experience refund
provisions, expense and risk charges credited to the experience account and
the aggregate limit of liability. Accordingly, the contract is being
accounted for in accordance with deposit accounting for reinsurance
contracts.
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 (See Note 5).
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, but is not required, to commute the
agreement on December 31, 2007. In the event the Company does not commute
the agreement on December 31, 2007, the expense and risk charges applied to
the experience account will increase significantly. 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.
The Company's current modeling and actuarial projections suggest that it is
likely to be able to commute the agreement, as planned, on December 31,
2007. In order to commute the agreement, PTNA's and ANIC's statutory
surplus following commutation must be sufficient to support the reacquired
business in compliance with all statutory requirements. Upon commutation,
the Company will receive cash or other liquid assets equaling the value of
our experience account from the reinsurer. The Company would also record
the necessary reserves for the business in its statutory financial
statements. Accordingly, the Company's ability to commute the agreement is
highly dependent upon the value of the experience account exceeding the
level of required statutory reserves to be established. As of December 31,
2002, the statutory basis reserve liabilities of $905,330 exceed the
experience account value of $708,982. Management expects the growth in the
experience account will exceed the growth in the reserve liabilities such
that the experience account value will exceed the reserve liabilities at
December 31, 2007. In addition to the performance of the reinsured policies
from now through 2007, the experience account value is susceptible to
market interest rate changes. A market interest rate increase of 100 basis
points could reduce the value of the current experience account by
approximately $70,000 and jeopardize the Company's ability to commute as
planned. As the intended commutation date approaches, the sensitivity of
the experience account to market interest rate movement will decline as the
duration of the benchmark indices becomes shorter, however the amount of
assets susceptible to such interest sensitivity will continue to grow as
additional net cash flows are added to the experience account balance prior
to commutation.
As part of the reinsurance agreement, the reinsurer was granted four
tranches of warrants to purchase shares of non-voting convertible preferred
stock. The first three tranches of warrants 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 then outstanding shares of our common stock on a
fully diluted basis. 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, representing an additional 20% of the then outstanding
common stock on a fully diluted basis.
Financial Pages (F) 29
The warrants are part of the consideration for the reinsurance contract and
are recognized as reinsurance premiums over the anticipated life of the
contract, which is six years. 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. Of the original $15,855 value, $2,643 of deferred
premium was amortized during 2002.
As a result of the Company's intention to commute, it considered only the
expense and risk charges anticipated prior to the commutation date in its
most recent DAC recoverability analyses and has not recorded the potential
of future escalating charges in its current financial statements. In
addition, the Company is recognizing the additional condiseration of
entering into the agreement, represented by the fair value of the warrants
granted to the reinsurer, over the period of time to the expected
commutation date.
In the event the Company determines that commutation of the reinsurance
agreement on December 31, 2007 is unlikely, but likely at some future date,
it will include additional annual reinsurer expense and risk charges in its
DAC recoverability analysis. As a result, it could impair the value of its
DAC asset and record the impairment in its financial statements at that
time. However, the Company currently believes that it will have a
sufficient amount of statutory capital and surplus to commute the agreement
by December 31, 2007 or that sufficient alternatives, such as additional
capital issuance or new reinsurance opportunities, will be available to
enable it to commute the agreement by December 31, 2007.
2002 Centre Agreement
The 2001 Centre Agreement granted the reinsurer an option to participate in
reinsuring new business sales on a quota share basis. In August 2002, the
reinsurer exercised its option to reinsure up to 50% of future sales,
subject to a limitation of the reinsurer's risk. The reinsurer may continue
this level of participation on the first $100 million in new policy premium
issued after January 1, 2002. The final agreement, which was entered into
in December 2002, further provides the reinsurer the option to reinsure a
portion of the next $1 billion in newly issued long-term care annual
insurance premium, subject to maximum quota share amounts of up to 40% as
additional policies are written.
This agreement does not qualify for reinsurance treatment in accordance
with GAAP because, based on the Company's analysis, the agreement does not
result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to an aggregate limit of liability that
reduces the likelihood of the reinsurer realizing a significant loss on the
agreement.
Other Reinsurance Agreements -
The Company currently reinsures with unaffiliated companies any life
insurance policy to the extent the risk on that policy exceeds $50.
Effective January 1994, PTNA entered into a reinsurance agreement to cede
100% of certain life, accident and health and Medicare supplement insurance
to a third party insurer. Total reserve credits taken related to this
agreement as of December 31, 2002, 2001 and were approximately $401, $388
and $409 respectively.
PTNA is party to a reinsurance agreement to cede 100% of certain whole life
and deferred annuity policies issued by PTNA to a third party insurer.
These policies are intended for the funeral arrangement or "pre-need"
market. Total reinsurance recoverables taken related to this agreement as
of December 31, 2002 and 2001 were approximately $3,099 and $4,362,
respectively. The third party reinsurer is required to maintain securities
at least equal to the statutory reserve credit in escrow with a bank.
Effective January 1, 1996, this agreement was modified, and as a result, no
new business is reinsured under this facility. Effective December 31, 2002,
the Company entered into an assumption agreement with another insurer that
desired to acquire this business. Upon approval of certain required state
insurance departments and policyholders, the acquiring company will assume
all future liability for the business reinsured.
PTNA is a party to a reinsurance agreement to cede certain home health care
claims beyond 36 months. Reinsurance recoverables related to this treaty
were $10,175 and $7,726 at December 31, 2002 and 2001, respectively. The
reinsurer has notified PTNA that they believe the Company is in breach of
its current agreement as a result of entering the 2001 Centre Agreement
without the prior written approval of the reinsurer. PTNA has contested
this assertion of breach and is continuing discussions with the reinsurer
to reach an equitable resolution, including, but not limited to, the
recapture of the excess home health care coverage and reserves, premium
rate increases, or additional reinsurance business in the future. The
ultimate resolution of this dispute cannot be determined at this time.
Financial Pages (F) 30
In addition to the reinsurance agreement to cede certain home health care
claims beyond 36 months, PTNA is also party to a coinsurance agreement with
the same reinsurer on a previously acquired block of long-term care
business whereby 66% is ceded to a third party. At December 31, 2002 and
2001 reinsurance recoverables taken related to this treaty were
approximately $6,020 and $2,639, respectively.
Effective December 31, 2000 and 1999, PTNA entered separate funds withheld
financial reinsurance agreements with unaffiliated reinsurers. Under the
agreements, PTNA ceded the claims risk of a material portion of its
long-term care policies. The agreements did not qualify for reinsurance
treatment in accordance with SFAS No. 113 because, based on the Company's
analysis, the agreements did not result in the reasonable possibility that
the reinsurer could realize a significant loss in the event of adverse
development. As a result, the Company was applying deposit accounting for
these agreements and results of operations reflected only the
non-refundable annual fee owed to the reinsurer. Since the contracts were
executed as funds withheld, there was no reinsurance recoverable or payable
on a GAAP basis on the balance sheet. The agreements met the requirements
to qualify for reinsurance treatment under statutory accounting rules. As a
result of these agreements, 2000 statutory surplus was increased by
$19,841. During 2001, both agreements were commuted, resulting in a
reduction of statutory surplus of approximately $20,000.
In 2001, ANIC ceded substantially all of its disability policies to an
unaffiliated insurer on a quota share basis. The insurer may assume
ownership of the policies as a sale upon various state and policyholder
approvals. At December 31, 2002 and 2001, reinsurance recoverables related
to this treaty were $5,828 and $10,338, respectively.
The Company remains liable in the event that the reinsuring companies are
unable to meet their obligations.
Financial Pages (F) 31
The Company has assumed and ceded reinsurance on certain life and accident
and health contracts under various agreements. The tables below highlight
the amounts shown in the accompanying consolidated statements of income and
comprehensive income, which are net of reinsurance activity:
Ceded to Assumed
Gross Other from Other Net
Amount Companies Companies Amount
December 31, 2002 ------ --------- --------- ------
-----------------
Ordinary life insurance
In-force $ 42,767 $ 3,583 $ - $ 39,184
Premiums:
Accident and health 331,356 5,394 5,347 331,309
Life 2,480 147 1 2,334
Benefits to policyholders:
Accident and health 290,965 3,316 1,526 289,175
Life 2,167 163 - 2,004
Inc in policy reserves:
Accident and health 74,277 2,417 8,447 80,307
Life (827) (1,339) - 512
Commissions $ 46,369 $ 1,183 $ 585 $ 45,741
December 31, 2001
-----------------
Ordinary life insurance
In-force $ 52,322 $ 10,543 $ 5,437 $ 47,216
Premiums:
Accident and health 355,574 13,760 5,749 347,563
Life 3,586 759 1 2,828
Benefits to policyholders:
Accident and health 211,849 3,935 1,153 209,067
Life 2,356 394 - 1,962
Inc in policy reserves:
Accident and health 32,019 7,244 2,656 27,431
Life 1,515 820 - 695
Commissions $ 76,095 $ 1,178 $ 1,888 $ 76,805
December 31, 2000
-----------------
Ordinary life insurance
In-force $ 58,907 $ 12,675 $ - $ 46,232
Premiums:
Accident and health 352,534 3,010 4,512 354,036
Life 3,304 228 1 3,077
Benefits to policyholders:
Accident and health 164,728 2,346 713 163,095
Life 2,469 441 - 2,028
Inc (dec) in policy reserves:
Accident and health 76,514 77 1,053 77,490
Life 931 (27) - 958
Commissions $ 100,681 $ 255 $ 1,887 $102,313
14. Transactions with Related Parties:
Irv Levit Insurance Management Corporation, an insurance agency which is
owned by our Chairman and Chief Executive Officer, produced approximately
$11, $10 and $43 of renewal premiums for some of our subsidiaries for the
years ended December 31, 2002, 2001 and 2000, respectively, for which it
received commissions of approximately $2, $2 and $10, respectively. Irv
Levit Insurance Management Corporation also received commission overrides
on business written for some of our subsidiaries by certain agents,
principally general agents who were its agents prior to January 1979 and
any of their sub-agents hired prior and subsequent to January 1979. These
commission overrides totaled approximately $510, $544 and $551 for the
years ended December 31, 2002, 2001 and 2000, respectively.
Financial Pages (F) 32
As of December 31, 2001, Palisade Capital Management owned less than 1% of
our common stock. Until January, 2002, Palisade Capital Management also
managed a portion of our investment portfolio for which it received fees of
$0, $224 and $231 for the years ended December 31, 2002, 2001 and 2000,
respectively.
A member of the Company's board of directors is a principal in Davidson
Capital Management, which provides investment management services to the
Company. The Company paid this firm $99, $462 and $300 during the years
ended December 31, 2002, 2001 and 2000, respectively.
A member of the Company's board of directors and the chairman of its audit
committee is a senior executive with Advest, Inc., an investment banking
firm, which has provided investment banking services in the past and that
the Company has engaged as a financial advisor in the offering of its 2008
Subordinated Convertible Notes. This firm received $2 and $475 in fees
during 2002 and 2001, respectively. No fees were paid to this firm in 2000.
A member of the Company's board of directors is a principal in U.S. Care,
Inc., a marketing organization to which the Company paid $128, $159 and $23
in 2002, 2001 and 2000, respectively. The Company also made a loan of $100,
with interest applied at 9%, to U.S. Care, Inc. in 2001, which is
guaranteed by renewal commissions payable to the Company in future periods.
15. Concentrations of Credit Risk:
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and investments. The Company places its cash and cash
equivalents and investments with high quality financial institutions, and
attempts to limit the amount of credit exposure to any one institution.
However, at December 31, 2002, and at other times during the year, amounts
in any one institution exceeded the Federal Deposit Insurance Corporation
limits. The Company is also party to certain reinsurance transactions
whereby the Company remains ultimately liable for claims exposure under
ceded policies in the event the assuming reinsurer is unable to meet its
commitments due to default or insolvency.
16. Fair Value of Financial Instruments:
Fair values are based on estimates using present value or other valuation
techniques where quoted market prices are not available. Those techniques
are significantly affected by the assumptions used, including the discount
rate and estimates of future cash flows. The fair value amounts presented
do not purport to represent and should not be considered representative of
the underlying value of the Company.
The methods and assumptions used to estimate the fair values of each class
of the financial instruments described below are as follows:
Investments -- The fair value of fixed maturities and equity securities are
based on quoted market prices. It is not practicable to determine the fair
value of policy loans since such loans are not separately transferable and
are often repaid by reductions to benefits and surrenders.
Cash and cash equivalents -- The statement value approximates fair value.
Long-term debt -- The statement value approximates the fair value of
mortgage debt and capitalized leases, since the instruments carry interest
rates, which approximate market value. The convertible, subordinated debt,
as a publicly traded instrument, has a readily accessible fair market
value, and, as such is reported at that value.
Financial Pages (F) 33
December 31, 2002 December 31, 2001
--------------------- ----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------ ----- ------ -----
Financial assets:
Investments
Bonds, available for sale $ 28,454 $ 28,454 $478,608 $478,608
Equity securities - - 9,802 9,802
Policy loans 238 238 181 181
Cash and cash equivalents 29,206 29,206 114,600 114,600
Experience account due from reinsurer 708,982 708,982 - -
Financial liabilities:
Convertible debt $ 74,750 $ 67,275 $ 74,750 $ 52,325
Mortgage and other debt 1,495 1,495 4,440 4,440
17. Equity Issuance:
In March 2002, the Company completed a private placement of 510 shares of
common stock for net proceeds of $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. Pursuant to
registration rights granted in the private placement, the Company filed a
registration statement registering the shares granted in the private
placement for resale. 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 debt service obligations.
In June 2002, the Company completed a private placement of 60 shares of
common stock as compensation to its financial advisor in conjunction with
the private placement of 510 shares and as consideration for future
services. Thirty of these shares were included in the resale registration
statement, which was declared effective by the Securities and Exchange
Commission on June 20, 2002. The Company recorded $325 as an expense in
2002 related to this item. In November, 2002, the Company completed a
private placement of an additional 20 shares of common stock to its
financial advisor in conjunction with the exchange of its 2003 convertible
subordinated notes. The Company recorded $68 as an expense related to this
item.
18. Subsequent Events:
Subsequent to December 31, 2002, the Company exchanged $2,450 of its 6.25%
Convertible Subordinated Notes due 2008 ("the Exchange Notes") for a like
amount of its Convertible Subordinated Notes due 2003.
In December 2002, the Company commenced the sale of up to $45,000 in 6.25%
Convertible Subordinated notes due 2008 ("the 2008 Notes"). The 2008 Notes
were offered, with identical terms to the Exchange Notes. In February 2003,
the Company completed the sale of 2008 Notes and received proceeds of
$28,722. It contributed $16,000 of the proceeds to PTNA in order to satisfy
the premium to surplus requirements of its voluntary consent order with the
Florida Insurance Department. In March 2003, the Company issued an
additional $3,550 of 2008 Notes under a new prospectus supplement.
Financial Pages (F) 34
After adjusting for the further exchange of 2003 Notes for Exchange Notes
in March 2003, and the issuance of 2008 Notes in February and March, 2003,
the Company's total debt and financing obligations through 2008 will be as
follows:
Lease
Debt Obligations Total
---- ----------- -----
2003 10,451 344 10,795
2004 - 252 252
2005 - 18 18
2006 - 18 18
2007 - 18 18
2008 98,065 18 98,083
-------- ----- --------
Total $108,516 $ 668 $109,184
======== ===== ========
19. Condensed Financial Statements:
The following lists the condensed financial information for the parent
company as of December 31, 2002 and 2001 and for the years ended December
31, 2002, 2001 and 2000.
Financial Pages (F) 35
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Balance Sheets
(amounts in thousands, except per share information)
ASSETS 2002 2001
----- ----
Bonds, available for sale at market (amortized cost $0) $ - $ -
Equity securities at market (cost $0) - -
Cash and cash equivalents 59 3,126
Investment in subsidiaries* 223,895 257,515
Other assets 14,211 17,100
--------- ---------
Total assets $ 238,165 $ 277,741
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Long-term debt $ 74,750 $ 77,608
Accrued interest payable 892 651
Accounts payable 364 58
Due to subsidiaries* 6,978 6,628
-------- --------
Total liabilities 82,984 84,945
-------- --------
Shareholders' equity
Preferred stock, par value $1.00; 5,000 shares
authorized, none outstanding - -
Common stock, par value $.10; 40,000 shares
authorized, 20,340 and 19,750 shares
issued, respectively 2,034 1,975
Additional paid-in capital 97,058 94,802
Accumulated other comprehensive income (loss) 1,090 10,583
Retained earnings 61,704 92,141
-------- --------
161,886 199,501
Less 915 of common shares held in treasury, at cost (6,705) (6,705)
-------- ---------
Total shareholders' equity 155,181 192,796
-------- ---------
Total liabilities and shareholders' equity $ 238,165 $ 277,741
========= =========
* Eliminated in consolidation.
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto.
Financial Pages (F) 36
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Statements of Operations
for the Years Ended December 31, 2002, 2001 and 2000
(amounts in thousands)
2002 2001 2000
---- ---- ----
Investment and other income $ 16 $ 209 $ 771
General and administrative expense 4,199 1,165 1,159
Interest expense 4,711 4,888 4,717
------- -------- --------
Loss before equity in undistributed net
earnings of subsidiaries* (8,894) (5,844) (5,105)
Equity in undistributed net (losses)
earnings of subsidiaries* (21,544) (42,745) 27,855
-------- -------- --------
Net (loss) income (30,438) (48,589) 22,750
Retained earnings, beginning of year 92,141 140,730 117,980
-------- -------- --------
Retained earnings, end of year $ 61,703 $ 92,141 $140,730
======== ======== ========
*Eliminated in consolidation.
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto.
Financial Pages (F) 37
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Statements of Cash Flows
for the Years Ended December 31, 2002, 2001 and 2000
(amounts in thousands)
2002 2001 2000
---- ---- ----
Cash flows from operating activities:
Net (loss) income $ (30,438) $ (48,589) $ 22,750
Adjustments to reconcile net (loss) income
to cash used in operations:
Equity in undistributed earnings of subsidiaries 21,545 42,745 (27,855)
Depreciation and amortization 2,999 437 491
Net realized losses - - 130
Increase (decrease) due to change in:
Due to/from subsidiaries 350 822 575
Other, net 439 (469) 99
--------- --------- --------
Net cash used in operations (5,105) (5,054) (3,810)
--------- --------- --------
Cash flows from investing activities:
Sales and maturities of investments - - 5,494
Purchase of investments - - (874)
Acquisition of property and equipment - (25) (50)
--------- ---------- --------
Net cash (used in) provided by investing activities - (25) 4,570
--------- --------- --------
Cash flows from financing activities:
Contribution to subsidiary - (18,000) -
Dividend from subsidiary 2,151 2,000 -
Proceeds from shares issued to financial advisor 393 12 139
Proceeds from note payable to subsidiary - - -
Repayment of mortgages and other borrowings (2,858) (2,696) (818)
Proceeds from rights offering 2,352 25,726 -
--------- --------- --------
Net cash (used in) provided by financing activities 2,038 7,042 (679)
--------- --------- --------
Increase (decrease) in cash and cash equivalents (3,067) 1,963 81
Cash and cash equivalents balances:
Beginning of year 3,126 1,163 1,082
--------- --------- --------
End of year $ 59 $ 3,126 $ 1,163
========= ========= ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $ 4,299 $ 4,843 $ 4,863
========= ========= ========
The condensed financial information should be read in conjunction with the
Penn Treaty American Corporation and Subsidiaries consolidated statements
and notes thereto.
Financial Pages (F) 38
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
No change of accountants and/or disagreements on any matter of accounting
principles or financial statement disclosures has occurred within the last two
years.
81
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required under this item is incorporated herein by reference to
the 2003 Proxy Statement.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this item is incorporated herein by reference to
the 2003 Proxy Statement. See Exhibits 10.1, 10.2, 10.11 and 10.17.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT and
related stockholder matters
The information required under this item is incorporated herein by reference to
the 2003 Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by
reference to the 2003 Proxy Statement.
ITEM 14. CONTROLS AND PROCEDURES
The Company carried out an evaluation of the effectiveness of its disclosure
controls and procedures within 90 days prior to the filing of this report. This
evaluation was carried out under the supervision and with the participation of
the Company's management, including the Company's President and Chief Executive
Officer and the Chief Financial Officer. Based on that evaluation, the Company's
President and Chief Executive Officer and the Chief Financial Officer concluded
that the Company's disclosure controls and procedures are effective. There have
not been any significant changes in the Company's internal controls, or in other
factors which would significantly affect internal controls subsequent to the
date the Company carried out its evaluation, or any corrective actions taken
with regard to significant deficiencies or material weaknesses.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this report:
(1) Financial Statements
82
(2) Exhibits.
3.1 Restated and Amended Articles of Incorporation of Penn Treaty American
Corporation. ****
3.1(b) Amendment to Restated and Amended Articles of Incorporation of Penn
Treaty American Corporation. *****
3.2 Amended and Restated By-laws of Penn Treaty American Corporation, as
amended. *****
3.3 Amended and Restated By-laws of Penn Treaty American Corporation, as
amended.
3.4 Amended and Restated By-laws of Penn Treaty American Corporation, as
amended.
4. Form of Penn Treaty American Corporation Common Stock Certificate. *
4.1 Indenture dated as of November 26, 1996 between Penn Treaty American
Corporation and First Union National Bank, as trustee (including forms
of Notes) (incorporated by reference to Exhibit 4.1 to Penn Treaty
American Corporation's current report on Form 8-K filed on December 6,
1996).
4.2 Form of Indenture between Penn Treaty American Corporation and Wells
Fargo Bank Minnesota, N.A (incorporated by reference to Exhibit 4.1 to
Penn Treaty American Corporation's Proscectus Supplement dated
December 24, 2002).
10.1 Penn Treaty American Corporation 1987 Employee Incentive Stock Option
Plan (incorporated by reference to Exhibit 99.1 to Registrant's
Registration Statement on Form S-8, No. 333-89927, filed on October
29, 1999).
10.2 Penn Treaty American Corporation 1995 Participating Agent Stock Option
Plan (incorporated by reference to Exhibit 10.2 to Registrant's Annual
Report on Form 10-K for the year ended December 31, 1997).
10.3 Penn Treaty American Corporation Employees' Pension Plan. *
10.4 Penn Treaty American Corporation 1998 Employee Incentive Stock Option
Plan (incorporated by reference to Exhibit 99.1 to Registrant's
Registration Statement on Form S-8, No. 333-89927, filed on October
29, 1999).
10.5 Form of General Agent's Contract of Network America Life Insurance
Company. ****
10.6 Form of Managing General Agency Agreement. ****
83
10.7 Regional General Agents' Contract dated August 1, 1971 between Penn
Treaty Life Insurance Company and Irving Levit of the Irv Levit
Insurance Management Corporation, as amended on August 15, 1971, May
26, 1976 and June 16, 1987, and by an undated override commissions
schedule. ***
10.8 Commission Supplement to General Agent's Contract dated December 7,
1993 between Network America Life Insurance Company and Network
Insurance. ****
10.9 Mortgage in the amount of $2,450,000 dated September 13, 1988 between
Penn Treaty Life Insurance Company and Merchants Bank, N.A. **
10.10 Amendments to Mortgage dated September 24, 1991, October 13, 1992 and
September 2, 1993. ****
10.11 Loan and Security Agreement by and between Penn Treaty American
Corporation and CoreStates Bank, N.A. dated December 28, 1994. ****
10.12 Form of Investment Counseling Agreement dated May 3, 1995 between
Penn Treaty American Corporation and James M. Davidson & Company. ****
10.13 Form of Assumption and Reinsurance Agreement dated December 22, 1997,
between Penn Treaty Life Insurance Company and Network America Life
Insurance Company. ***
10.14 Quota Share Reinsurance Agreement between Penn Treaty Network America
and London Life International.
10.15 Form of Change of Control Agreements with Executives. ***
10.16 Penn Treaty American Corporation 1998 Incentive Stock Option Plan.
***
10.17 Employment Contract with Executive Vice President. ***
10.48 Change of Control Employment Agreement. ******
10.49 Change of Control Employment Agreement. ******
10.50 Employment Agreement. ******
10.60 Reinsurance and Warrant Agreements by Centre Solutions (Bermuda)
Limited, filed on Form 8-K.++
10.61 Reinsurance and Warrant Agreements by Centre Solutions (Bermuda)
Limited, filed on Form 8-K.++
11. Earnings Per Share. See Notes to Consolidated Financial Statements,
"Note 1."
21. Subsidiaries of the Registrant. ****
84
23.1 Consent of PricewaterhouseCoopers LLP.
(b) Reports on Form 8-K:
---------------- -------------- -------------------- ---------------------
Report Item(s) No. Date of Report Date Filed
---------------- -------------- -------------------- ---------------------
Form 8-K 5 and 7 December 24, 2002 December 24, 2002
---------------- -------------- -------------------- ---------------------
* Incorporated by reference to the Registrant's Registration Statement
on Form S-1 dated May 12, 1987, as amended.
** Incorporated by reference to the Registrant's Registration Statement
on Form S-1 dated November 17, 1989, as amended.
*** Incorporated by reference to the Registrant's Annual Report on Form
10-K for the year ended December 31, 1998.
**** Incorporated by reference to the Registrant's Registration Statement
on Form S-1 dated June 30, 1995, as amended.
***** Incorporated by reference to the Registrant's Registration Statement
on Form S-3 dated February 19, 1999.
++ Incorporated by reference to the Registrant's Statement on Form 8-K
dated February 21, 2002.
Executive Compensation Plans - see Exhibits 10.1, 10.2, 10.11, 10.17,
10.48, 10.49 and 10.50.
85
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PENN TREATY AMERICAN CORPORATION
March 31, 2003 By: /s/ Irving Levit
------------------------------------
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities and on the dates indicated:
Signature Title Date
--------- ----- ----
/s/ Irving Levit Chairman of the Board March 31, 2003
-------------------------- and Chief Executive
Irving Levit Officer
/s/ Cameron B. Waite Exec. Vice President March 31, 2003
-------------------------- and Chief Financial Officer
Cameron B. Waite (principal financial officer)
/s/ Mark D. Cloutier Vice President and Chief March 31, 2003
-------------------------- Accounting Officer
Mark Cloutier
/s/ A.J. Carden Executive Vice President March 31, 2003
-------------------------- and Director
A.J. Carden
/s/ Domenic P. Stangherlin Director March 31, 2003
--------------------------
Domenic P. Stangherlin
/s/ Michael F. Grill Comptroller, Treasurer March 31, 2003
-------------------------- and Director
Michael F. Grill
/s/ Jack D. Baum Vice President and Director March 31, 2003
--------------------------
Jack D. Baum
/s/ Francis R. Grebe Director March 31, 2003
--------------------------
Francis R. Grebe
/s/ Alexander M. Clark Director March 31, 2003
--------------------------
Alexander M. Clark
/s/ Matthew Kaplan Director March 31, 2003
--------------------------
Matthew Kaplan
/s/ James Heyer Director March 31, 2003
--------------------------
James Heyer
86
CERTIFICATIONS
Certification of Principal Executive Officer
I, Irving Levit, Chief Executive Officer of Penn Treaty American Corporation,
certify that:
1. I have reviewed this annual report on Form 10-K of Penn Treaty
American Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: March 31, 2003 /s/ Irving Levit
-----------------------
Irving Levit
Chief Executive Officer
87
Certification of Principal Operating Officer
I, William H. Hunt, President and Chief Operating Officer of Penn Treaty
American Corporation, certify that:
1. I have reviewed this annual report on Form 10-K of Penn Treaty
American Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: March 31, 2003 /s/ William H. Hunt
-----------------------
William H. Hunt
Chief Operating Officer
88
Certification of Principal Financial Officer
I, Cameron B. Waite, Executive Vice President and Chief Financial Officer of
Penn Treaty American Corporation, certify that:
1. I have reviewed this annual report on Form 10-K of Penn Treaty
American Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: March 31, 2003 /s/ Cameron B. Waite
-----------------------
Cameron B. Waite
Chief Financial Officer
89
Exhibit 3.1
Microfilm Number 2001042 1366-1367
------------------
Filed with the Department of State on June 01, 2001
-------------
Entity Number 145993
------
/s/ Kim Pizzingrilli
--------------------
Secretary of the Commonwealth
ARTICLES OF AMENDMENT - DOMESTIC BUSINESS CORPORATION
OF
PENN TREATY AMERICAN CORPORATION
In compliance with the requirements of 15 Pa.C.S. ss. 1915 (relating to articles
of amendment), the undersigned business corporation, desiring to amend its
Articles, hereby states that:
1. The name of the corporation is Penn Treaty American Corporation
(hereinafter referred to as the "Corporation").
2. The address of the Corporation's current registered office in this
Commonwealth is:
3440 Lehigh Street
Allentown, Pennsylvania, 18103
Lehigh County
3. The statute by or under which it was incorporated is the Pennsylvania
Business Corporation Law, Act of May 5, 1933, P.L. 364, as amended.
4. The date of its incorporation is May 13, 1965.
5. The Amendment shall be effective upon filing these Articles of Amendment in
the Department of State.
6. The Amendment was adopted by the shareholders pursuant to 15
Pa.C.S.ss.1914(a) and (b).
7. The Amendment adopted by the Corporation, set forth in full, is as follows:
The first paragraph of Article Fifth shall be amended and restated in
its entirely [sic] as follows: "Fifth: The aggregate number of shares
which the Corporation shall have authority to issue is 40,000,000
shares of common stock, par value $.10 per share ("Common Stock"); and
5,000,000 shares of preferred stock, par value $1.00 per share
("Preferred Stock")".
90
IN TESTIMONY WHEREOF, the undersigned corporation has caused these Articles
of Amendment to be signed by a duly authorized officer thereof this 30th day
of May, 2001.
PENN TREATY AMERICAN CORPORATION
BY: /s/ A. J. Carden
------------------
TITLE: Executive Vice President
91
Exhibit 3.1b
PENNSYLVANIA DEPARTMENT OF STATE
CORPORATION BUREAU
Articles of Amendment - Domestic Corporation
(15 Pa.C.S.)
Entity Number X Business Corporation (ss.1915)
145993 ---
Nonprofit Corporation (ss.5915)
---
Name: Penn Treaty American Corporation Document will be returned to the name
ATTN: Linda G. Carraghan, Esq. and address you enter to the left.
3440 Lehigh Street
Allentown, PA 18103
Filed with the Department of State on
-----------------------------
Secretary of the Commonwealth
In compliance with the requirements of the applicable provisions (relating
to articles of amendment), the undersigned, desiring to amend its articles,
hereby states that:
1. The name of the corporation is: Penn Treaty American Corporation
2. The (a) address of this corporation's current registered office in this
Commonwealth or (b) name of its commercial registered officer provider and
the county of venue is (the Department is hereby authorized to correct the
following information to conform to the records of the Department):
a. Number and Street City State Zip County 3440 Lehigh Street Allentown
PA 18103 Lehigh
b. Name of Commercial Registered Officer Provider: N/A
3. The statute by or under which it was incorporated: Pennsylvania Business
Corporation Law, Act of May 5, 1933, P.L. 364, as amended
4. The date of its incorporation: May 13, 1965
5. Check, and if appropriate complete, one of the following:
X The amendment shall be effective upon filing these Articles of Amendment in
the Department of State. ------ ____ The amendment shall be effective on:
______________ at ___________. Date Hour
6. Check one of the following:
X The amendment was adopted by the shareholders or members pursuant to
--- 15 Pa.C.S. ss. 1914(a) and (b) or ss.5914(a).
The amendment was adopted by the board of directors pursuant to 15
--- Pa.C.S. ss. 1914(c) or ss. 5914(b).
7. Check, and if appropriate, complete one of the following:
The amendment adopted by the corporation, set forth in full, is as
--- follows: ______________________
X The amendment adopted by the corporation is set forth in full in
--- Exhibit A attached hereto and made a part hereof.
8. Check if the amendment restates the Articles:
___ The restated Articles of Incorporation supercede the original articles
and all amendments thereto.
IN TESTIMONY WHEREOF, the undersigned corporation has caused these Articles of
Amendment to be signed by a duly authorized officer thereof this
28th day of March, 2003.
PENN TREATY AMERICAN CORPORATION
/s/ Michael F. Grill
--------------------------
Vice President & Treasurer
92
EXHIBIT "A"
-----------
The first paragraph of Article FIFTH of the Restated Articles of Incorporation,
as amended, shall be amended and restated so that such first paragraph of such
Article FIFTH shall be and read in its entirety as follows:
"FIFTH: The aggregate number of shares which the Corporation shall have
authority to issue is 150,000,000 shares of common stock, par value $.10
per share ("Common Stock"); and 5,000,000 shares of preferred stock, par
value $1.00 per share ("Preferred Stock")."
93
Exhibit 23
Consent of Independent Accountants
We hereby consent to the incorporation by reference in the Registration
Statements on Form S-8 (No. 333-89927 and No. 333-89929) of Penn Treaty American
Corporation of our report dated March 31, 2003 relating to the financial
statements, which appears in this Form 10-K.
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
March 31, 2003
94
Exhibit 99.1
Certification of Principal Executive Officer
In connection with the Annual Report of Penn Treaty American Corporation
(the "Company") on Form 10-K for the period ended December 31, 2002 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"),
I, Irving Levit, 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.
Date: March 31, 2003 /s/ Irving Levit
-----------------------
Irving Levit
Chief Executive Officer
95
Exhibit 99.2
Certification of Principal Operating Officer
In connection with the Annual Report of Penn Treaty American Corporation
(the "Company") on Form 10-K for the period ended December 31, 2002 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"),
I, William H. 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.
Date: March 31, 2003 /s/ William H. Hunt
-----------------------
William H. Hunt
President and
Chief Operating Officer
96
Exhibit 99.3
Certification of Principal Financial Officer
In connection with the Annual Report of Penn Treaty American Corporation
(the "Company") on Form 10-K for the period ended December 31, 2002 as filed
with the Securities and Exchange Commission on the date hereof (the "Report"),
I, Cameron B. Waite, Chief Financial 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.
Date: March 31, 2003 /s/ Cameron B. Waite
-----------------------
Cameron B. Waite
Chief Financial Officer
97