CERES GROUP INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 COMMISSION FILE NUMBER 0-8483

CERES GROUP, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 34-1017531
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

17800 ROYALTON ROAD, CLEVELAND, OHIO 44136
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(Address of principal executive offices) (Zip Code)

(440) 572-2400
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(Registrant's telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

COMMON STOCK, PAR VALUE $0.001 PER SHARE
------------------------------------------------
(Title of class)

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 is not contained herein, and will not be contained, to the
best of the 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 check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
YES [X] NO [ ]

The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant was $97,133,537 computed based on the
closing price of $3.90 per share of the common stock on June 30, 2002.

The number of shares of common stock, par value $0.001 per share,
outstanding as of March 25, 2003 was 34,238,164.
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DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the registrant's definitive proxy statement for the annual meeting
of stockholders to be held May 20, 2003 are incorporated by reference into Part
III of this Form 10-K.
- --------------------------------------------------------------------------------

As used in this Form 10-K, the terms "Company," "Ceres," "Registrant," "we,"
"us," and "our" mean Ceres Group, Inc. and its consolidated subsidiaries, taken
as a whole, unless the context indicates otherwise. Except as otherwise stated,
the information contained in this Form 10-K is as of December 31, 2002.

CERES GROUP, INC.
INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002

PART I

ITEM 1. BUSINESS

RECENT EVENTS

Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's final statutory capital and surplus
as of March 31. Net proceeds of the sale were used as follows: (1) $10.0 million
to repay a portion of our bank debt, and (2) the remainder to strengthen the
statutory capital of our subsidiary, Continental General Insurance Company.

Immediately prior to the closing of the sale, Continental General acquired
Pyramid Life's Kansas City building and personal property and retained most of
its employees. Continental General will continue to administer its senior health
business out of the Kansas City location, as well as continue to administer
Pyramid Life's business during a six to 18 month transition period. Immediately
prior to the closing, Continental General also reinsured a small block of
certain life insurance policies of Pyramid Life.

AS A RESULT OF THE SALE OF PYRAMID LIFE, THE INFORMATION PROVIDED IN THIS
SECTION "BUSINESS" DOES NOT INCLUDE PYRAMID LIFE, ITS OPERATIONS OR RESULTS,
EXCEPT WHERE INDICATED. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS -- RECENT EVENTS" AND NOTE F. DISCONTINUED
OPERATIONS AND SUBSEQUENT EVENT TO OUR CONSOLIDATED FINANCIAL STATEMENTS FOR
ADDITIONAL INFORMATION REGARDING PYRAMID LIFE.

OVERVIEW

Ceres provides a wide array of health and life insurance products to
approximately 358,000 insureds through two primary business segments. Our senior
segment includes senior health, life and annuity products for Americans age 55
and over. The medical segment includes catastrophic and comprehensive major
medical health insurance for individuals, families, associations and small
businesses. To help control medical costs, we also provide medical cost
management services to our insureds. Our nationwide distribution channels
include approximately 36,000 independent agents and QQLink, our fully
transactional online distribution system.

We acquired Continental General Insurance Company, Provident American Life
& Health Insurance Company and United Benefit Life Insurance Company to
supplement our major medical platform at Central Reserve Life Insurance Company.
In addition, we acquired selected major medical insureds of Central Benefits
Mutual Insurance Company and a block of individual and small group health
insurance written by American Chambers Life Insurance Company. We entered into
the senior market by acquiring Continental General, with its significant senior
health insurance business.

Our health and life insurance products protect individuals, families,
associations, and small employer groups during the years up to retirement, while
our Medicare supplement, long-term care, home healthcare and senior life
products provide ongoing coverage for senior Americans.

In the past, our operating results have been adversely impacted by
industry-wide and historically high medical inflation. This environment caused
us to enhance and accelerate a number of programs to lessen the inflationary
impact, including:

- target marketing;

- premium rate increases;

- modified product lines for new sales;

- proactive medical cost management; and

- lowered administrative and sales expenses.

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Our senior segment continued to produce increasing profits for 2002,
totaling $14.9 million in pre-tax profits for the year ended 2002 compared to
$13.6 million in 2001. Our medical segment improved to a pre-tax loss of $6.0
million in 2002 compared to a pre-tax loss of $13.7 million in 2001.

We believe our focus on internal growth, along with increased statutory
capital, will lead to more predictable earnings, enhanced profitability and
higher financial agency ratings of our insurance subsidiaries, which in turn
should support greater internal growth capacity.

OUR CORE BUSINESSES

SENIOR HEALTH, LIFE AND ANNUITY PRODUCTS. We continue to focus on the
senior segment because we believe this market has the potential for greater
revenue growth and higher profit potential than our medical segment. These
products are designed specifically for Americans age 55 and over, one of the
country's fastest growing age segments that is projected to increase to 103
million people by 2025. In addition, the senior population controls 72% of the
nation's wealth. Our senior products supplement other programs, such as
Medicare, and also include specialty supplemental coverages and life insurance.
According to the Centers for Medicare and Medicaid Services (CMS), the number of
Medicare enrollees, age 65 and over, nearly doubled between 1966 and 2001,
growing to 34.0 million from 19.1 million. By 2007, the Medicare population is
expected to exceed 44 million.

CATASTROPHIC AND COMPREHENSIVE MAJOR MEDICAL INSURANCE. Historically,
major medical insurance has been our core business, accounting for a greater
percentage of our revenue than our senior segment. Our medical segment includes
insurance for individuals (under age 65), families, associations and small
businesses. With increasingly stringent federal and state restrictions on small
group insurance, we emphasize the sale of individual and association products,
which offer greater flexibility in both underwriting and design compared to
small group products. The associations we market to are groups that are formed
for the purpose of providing certain goods, services and information to
individuals who pay dues to be members in the association. Individual and
association products, which are individually underwritten for each applicant,
offer greater regulatory latitude in adjusting future premium rates,
establishing premium rates based on individual risk factors and rejecting
applicants with risk factors that exceed our pricing parameters. We plan to
maintain or slightly reduce the current premium level of our medical segment by
continuing to concentrate on targeted states, strengthening relationships with
selected distributors, emphasizing our most profitable products, adjusting
premium rates as necessary to keep pace with medical inflation and by focusing
on increasing profit margins through our medical management and expense
management programs.

We market and administer preferred provider organization (PPO) and
traditional indemnity medical plans. We believe that increased costs and
consumer dissatisfaction with limitations on choice of doctors and treatment
have caused health maintenance organization (HMO) enrollments to decrease. We
believe that PPO coverage, provides greater freedom of choice of doctors and
opportunity to seek care from doctors and facilities within networks to deliver
healthcare at favorable rates compared to HMOs and traditional indemnity plans.
PPO members generally are charged periodic prepaid premiums, co-payments and
deductibles. Traditional indemnity insurance usually allows policyholders
substantial freedom of choice in selecting healthcare providers but without the
financial incentives or cost-control measures typical of managed care plans.

BUSINESS STRATEGY

Principal elements of our business strategy include:

INCREASING SENIOR MARKET FOCUS. Because of favorable demographics and
higher profit potential in the senior segment and with the strengthened
statutory capital at Continental General as a result of the Pyramid Life sale,
we intend to continue to focus our sales efforts on this part of our business.
We believe the senior market will continue to produce more predictable earnings,
particularly since these products are not as sensitive to medical inflation as
major medical products. We will be concentrating more on our agent recruiting
and a significant amount of our product development efforts on the senior
market. We also intend to transition our major medical insureds into our senior
products as they age. For the year ended December 31,
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2002, our senior segment comprised 31% of our total net premium revenues
compared to 28% for 2001. Our senior segment products are administered at our
Kansas facility.

IMPROVING UNDERWRITING AND PRODUCT DESIGN. We believe that we have
improved our underwriting through more consistent and rigorous risk evaluation
and controls that reflect current medical practices and treatment patterns. To
anticipate and respond to regulatory changes and actual market and profitability
experience, we closely monitor and manage premium rate adjustments and provide
our policyholders opportunities to adjust their co-insurance and deductible
provisions to keep their premiums affordable. We actively pursue product
redesign and curtailment of unprofitable product offerings, where necessary.

An underwriting philosophy based on rational selection of risks has
produced a number of changes to our underwriting guidelines. We have aligned our
pricing decisions to more accurately reflect the associated morbidity. Through
review of claim charges, we have also made general enhancements to our
underwriting guidelines to better reflect current medical practices and
treatment patterns.

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) has
placed major restrictions on the sale of group insurance for small businesses
with two to 50 employees. In effect, HIPAA requires guaranteed issuance of major
medical insurance for small groups that meet continuing coverage and
participation guidelines. HIPAA also includes specific rules on underwriting and
coverage of pre-existing conditions. See "Government Regulation - Healthcare
Regulations."

Within our current small group business, we are more strictly enforcing
group participation and eligibility requirements to maintain profitability
targets. HIPAA allows insurance companies to require specific levels of employee
participation in group health insurance plans offered by their employers. If
participation falls below these levels, a group policy can be terminated after a
required notification period. In addition, participants must be full-time
employees of the group. Through a re-certification process, we have improved
compliance with these requirements.

Because of HIPAA and state regulatory restrictions, we place greater
emphasis on the sale of individual and association major medical products. For
2002, our major medical certificates included 70.0% for individual and
association products and 30.0% for small group products, which were consistent
with levels experienced in 2001.

One advantage of marketing individual and association products is greater
flexibility in underwriting. We can accept, reject or apply higher premium rates
to specific individuals with higher health risks. We can restrict or limit
coverage for pre-existing conditions. We also have greater ability to raise
future premium rates, if necessary, based on medical inflation and actual claims
experience of our products.

"Ceres Standards," a guideline of our best practices for underwriting of
new business, are implemented for all major medical business processed at our
insurance subsidiaries, and include standardization of organizational design,
business rules, risk selection and processing requirements.

We selectively pursue geographic markets, products and sales agencies that
provide us the greatest potential for profitability. This strategy includes
exiting markets that are unprofitable. In addition, our ongoing product design
efforts in both of our business segments keeps our product portfolio attractive
to our sales force. In our medical segment, we are emphasizing new product lines
that provide consumers with lower monthly premiums offset by greater
out-of-pocket payments for discretionary medical services and brand-name
pharmaceuticals.

ENHANCING MEDICAL COST MANAGEMENT. Our approach is to manage the cost of
healthcare. We focus on reducing medical costs for our insureds by actively
managing medical inflation and utilization rate costs. National health
expenditures have grown from $1,872 per capita in 1986 to $4,177 per capita in
1999, according to statistics compiled by CMS. Several factors have contributed
to the dramatic increase in healthcare expenditures, including increased costs
and utilization of high-technology diagnostic testing and treatments, the rising
cost of malpractice insurance, higher operating costs for hospitals and
physicians, changes in federal and state healthcare regulations, increased
utilization and cost of pharmaceuticals and the aging of the population.

3

In addition to monthly reviews of premium rate adequacy and taking actions
to adjust rates on a product and state basis as needed, we also have numerous
programs designed to lower medical costs for our insureds. Some of these
programs include:

- focusing our business with national and regional preferred provider
organizations with superior pricing and management of costs;

- use of a "Centers of Excellence" network providing our insureds access to
transplant and other necessary high-risk procedures at approximately 50
renowned medical institutions that have the staff, experience and volume
of patients to produce higher recovery rates while offering discounted
costs;

- a multiple benefit level pharmacy coverage to promote use of lower cost
drugs when possible;

- screening techniques to identify and move high-cost and high-risk
insureds as early as possible into case management programs to enhance
treatment programs and lower the long-term total medical expenses;

- a program to detect fraud and abuse by medical providers, policyholders
or agents;

- medical protocol use to avoid claims for unnecessary procedures;

- claims cost negotiation for long-term care expenses;

- product design geared to encourage use of PPOs; and

- enhanced communication to insureds on the features and benefits of these
programs, emphasizing how they can reduce their total healthcare costs.

The purpose of these programs is to provide quality care and improved treatment
outcomes while reducing total costs for both the company and our insureds. We
also offer insureds opportunities to make changes in their benefits to lower
their premium payments. Our benefit design department works with our insureds to
structure benefit packages to meet their budgets.

Our care coordination program provides our insureds with 24-hour access to
medical information, case management early intervention programs and non-network
negotiation processes to lower medical expenses, as well as additional services
to help them extend and make better use of insurance benefits.

Since the beginning of 2001, we reduced our PPO networks from 51 to 23.
This reduction has resulted in reduced network access fees and additional
provider discounts, along with quicker claims processing for our insureds.

REDUCING ADMINISTRATIVE COSTS. We are committed to reducing administrative
costs through increases in efficiency, streamlined procedures and consolidation
of operations and services. Our areas of focus include reductions in facility
management costs, printing and supply costs, travel expenses, consolidation of
corporate services, such as accounting, marketing, and distribution, and the
utilization of new electronic technology. We expect to improve our efficiency
and service as we move closer to a paperless environment. Our COAST (Ceres
Online Access SysTem) program provides direct online communication for our
agents who are able to check the status of business they submit via their
computers 24 hours a day.

We review expense variances to budgets on a monthly basis and make needed
adjustments. If cost-effective, we outsource certain functions to independent
third parties. We currently outsource all information and telephone systems at
our Cleveland headquarters, claims processing for our Central Reserve Life Ohio
insureds, and claims processing and other administrative services for the
American Chambers Life Insurance Company business and for our insurance
subsidiaries, Provident American Life and United Benefit Life. We believe this
outsourcing offers us the following advantages:

- predictable operational, administrative and systems costs;

- variable expenses based upon volume of business;

- the benefits of the vendors' expertise in specialized areas;

4

- freeing our capital to be used for other aspects of our growth strategy;

- efficiency and economies of scale; and

- system consolidation and integration.

We expect to continue streamlining operations and reducing our general and
administrative expenses through efficiency improvements and elimination of
functions that do not support our core businesses.

PRODUCTS AND SERVICES

We primarily market health, life and annuity insurance products tailored to
meet the needs of individuals, families, associations and small businesses, and
senior Americans. We have specialized teams that focus on new product
development for each of our markets. These teams review our current product
offerings and compare them with our competitors' products and changing insured
needs. We systematically review our individual and small group major medical
plans to help us further develop our product mix.

MAJOR MEDICAL. Our major medical products include catastrophic,
comprehensive and basic coverage options from PPO benefit plans to traditional
indemnity health insurance plans. Our major medical plans can also be configured
as medical savings account plans.

Because our PPO products provide for healthcare delivery at lower premium
costs than traditional indemnity plans, we emphasize our PPO products and
encourage our insureds to purchase them or convert from traditional indemnity
health insurance. Our medical networks provide favorable rates and include other
cost control measures to save money for our insureds.

Our traditional indemnity health insurance products provide coverage for
services from any qualified medical provider. Like our PPO products, our
traditional indemnity health insurance products offer access to our negotiated
network savings. Although our indemnity insureds are not required to use our
network providers, we have established programs that reduce claims costs and
out-of-pocket expenses for our insureds who do use network providers. We
communicate these cost saving methods to our insureds.

We also have a program that reduces claims costs for prescription drugs on
our medical products that include prescription drug coverage. We developed a
system with varying levels of co-payment amounts to encourage insureds to use
generic drugs and a money-saving mail-order program for all maintenance
prescription drugs.

Our Simplicity Series products are designed with higher profit margins.
These products provide higher deductibles and co-payments and are designed to
shift to consumers a greater portion of the risk for discretionary medical and
brand-name pharmaceutical benefits. This benefit structure reduces premium
payments for consumers and is designed to lower the level of future premium rate
adjustments. We are also emphasizing medical savings account plans, which
enables insureds to lower their insurance costs and have more control over their
healthcare dollars. In addition, we are marketing a new hospital-only plan.

SHORT-TERM MAJOR MEDICAL. This product provides major medical coverage for
a limited amount of time for people who, for example, are between jobs or are
recent graduates.

SMALL GROUP PRODUCTS. Our Employer's Choice product provides higher
deductibles and co-payments and lower premium payments for our small business
customers. In addition, we offer small businesses with 2-100 employees our
Partnership Plan, a major medical product in which we share the medical cost
risk with the employer. This alternate funding mechanism allows the employer to
limit expense and risk by self-insuring part of the coverage. This product can
produce a year end refund or carryover feature for low claims experience that is
attractive to businesses with healthy employees. The savings generated with this
plan can be used to provide other employee benefits.

LIFE AND ANNUITY. We also market group life insurance and annuity plans.
We offer term life insurance as an ancillary product to our major medical
insureds. We also offer various single premium deferred annuities.

5

SENIOR HEALTH INSURANCE PRODUCTS. Our senior market products include a
wide range of comprehensive and supplemental major medical benefit products,
including Medicare supplement, long-term care, home healthcare, extended
convalescent care, cancer coverage and acute recovery care that includes shorter
length facility care.

We are focusing more product development attention in our senior segment on
Medicare supplement and long-term care insurance products. Long-term care
products provide needed benefits to supplement Medicare and Medicare Supplement
coverage for nursing home and home healthcare expenses.

SENIOR LIFE INSURANCE AND ANNUITIES. Our life insurance and annuity
products include lower face amount life insurance policies offering coverages up
to $50,000 and annuity plans with first-year bonus interest or interest rate
guarantees.

SERVICES AND NON-INSURANCE PRODUCTS. We offer the Senior Savers Plus Plan,
which provides discounts on extended care and home healthcare services in
addition to the other product and service discounts. We also added our care
coordination program to most of our major medical products to provide service
enhancements for our insureds.

MARKETING AND SALES

Our distribution is critical for our continued growth. We market our
products through approximately 36,000 independent agents in 49 states, the
District of Columbia and the U.S. Virgin Islands. We have initiated a systematic
program to focus our marketing expenses on more productive agents and reduce the
number of low and non-producing agents. We compensate our agents for business
produced by them on a commission basis at rates that we believe to be
competitive with those of other life and health insurance companies.

DISTRIBUTION CHANNELS. We use a variety of distribution systems in
marketing our products. Because product lines vary among many of these
distribution systems, we have some overlap of agents between channels. Some of
our agents are licensed and contracted with more than one of our distribution
channels.

We base our four distribution channels on organization of the agents and
specific markets or products:

1. SENIOR BROKERAGE. These Continental General agents target Americans age
55 and over with a comprehensive product line.

2. MEDICAL CAREER. This channel is comprised of well-established marketing
organizations that primarily market both Central Reserve and Continental
General health insurance and supplemental health insurance.

3. MEDICAL BROKERAGE. Our Central Reserve brokerage agents concentrate on
individuals, families, associations and small business owners. The
product portfolio includes catastrophic medical coverage, individual
medical plans, small group medical plans, medical savings account plans,
basic medical coverage, short-term major medical, dental, life insurance
and annuities. These agents may represent multiple insurance carriers.

4. QQLINK ELECTRONIC DISTRIBUTION. QQLink is our fully transactional online
platform for Continental General's major medical and senior life and
health products. QQLink, founded in late 2000, combines a traditional
agent distribution system with direct online sales of insurance.
Consumers are able to review and receive premium quotes and apply for
insurance online, with or without the assistance of an agent. We believe
that QQLink will enable agents to substantially increase the client base
they serve. These agents may represent multiple insurance carriers.
QQLink is 94% owned by Ceres with the remaining 6% primarily owned by 16
of our agents.

MARKETING SUPPORT. We compete with other insurance companies and other
sales operations for our agents. In addition, we compete with other companies
that our independent agents represent. Our marketing systems concentrate on
broad product portfolios and sales support to agents. Our strategy is to provide
the tools and resources needed by the sales force, so that our agents can devote
their time to selling.

6

We provide comprehensive support programs to attract and retain agents,
including:

- competitive products and commission structures;

- advanced commissions on selected products for agents who qualify;

- lead generation programs;

- ongoing product development;

- special incentive awards to new agents;

- website development for QQLink participating agents;

- user-friendly proposal software;

- training seminars to introduce new products and sales material for our
agents; and

- consistent agent communication and quality sales materials.

CUSTOMER BASE

We had approximately 265,000 certificates and individual policies in force
as of December 31, 2002, representing approximately 358,000 insureds. One
association, Eagle Association, had approximately 24,200 certificate holders, or
9.1% of all our certificates and individual policies in force as of December 31,
2002. Each group certificate represents an insured and any spouse, children and
other dependents. The following table reflects the breakdown by product of the
group certificates and individual policies for the years ended December 31, 2002
and 2001.

The geographic distribution of direct and assumed premiums, before
reinsurance ceded, on a statutory basis of all of our subsidiaries in 2002 and
2001 is presented in the table below. The presentation on a statutory basis
differs from generally accepted accounting principles (GAAP) in that our fee
income and annuity considerations are considered premiums for statutory
purposes.

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PRICING AND UNDERWRITING

Effective, consistent and accurate underwriting is a critical element of
our profitability and depends on our ability to adequately predict claims
liability when determining the prices for our products. Premiums charged on
insurance products are based, in part, on assumptions about expected mortality
and morbidity experience and competitive factors. We have adopted and follow
"Ceres Standards," a guideline for the underwriting of new business. These
detailed uniform underwriting procedures are designed to assess and quantify
certain insurance risks before issuing individual life insurance, certain health
insurance policies and certain annuity policies to individuals. These procedures
are generally based on industry practices, reinsurer underwriting manuals and
our prior underwriting experience. To implement these procedures, we employ an
experienced professional underwriting staff.

In most circumstances, our pricing and underwriting decisions follow a
prospective rating process. A fixed premium rate is determined at the beginning
of the policy period. Unanticipated increases in medical costs may not be able
to be recovered in the current policy year. However, prior experience, in the
aggregate, is considered in determining premium rates for future periods.

Applications for insurance are reviewed on the basis of answers to
application questions. Where appropriate, based on the type and amount of
insurance applied for and the applicant's age and medical history, additional
information is required, such as medical examinations, statements from doctors
who have treated the applicant in the past, and where indicated, special medical
tests. For certain coverages, we may verify information with the applicant by
telephone. After reviewing the information collected, we either issue the policy
as applied for, issue the policy with an extra premium charge due to unfavorable
factors, issue the policy excluding benefits for certain conditions, either
permanently or for a period of time, or reject the application. For some of our
products, we have adopted simplified policy issue procedures in which the
applicant submits an application for coverage typically containing only a few
health-related questions instead of a complete medical history.

Our profitability depends on our ability to adequately increase rates for
both new business and at renewal. We have implemented procedures that permit us
to apply to regulatory authorities for corrective rate actions on a timely basis
with respect to both new business rates and the current market rates. This
allows us to analyze whether these rates sufficiently cover benefits, expenses
and commissions. For renewal business, we analyze our loss ratios and compare
them to our target loss ratios. When this analysis is complete, we immediately
implement any necessary corrective action, including rate increases.

8

CLAIMS

All claims for policy benefits are currently either processed by our claims
department or outsourced to third party administrators. We outsource claims
processing for our Central Reserve Ohio insureds and claims processing and other
administrative services for the Chambers and Provident American Life's
HealthEdge business to Antares Management Solutions, a division of Medical
Mutual Services, which is a subsidiary of Medical Mutual of Ohio. We also
outsource claims processing for the run-off business of Provident American Life
and United Benefit Life to HealthPlan Services Corporation.

We periodically utilize the services of personnel from our medical cost
management subsidiary to review certain claims. When a claim is filed, we may
engage medical cost management personnel to review the claim, including the
specific health problem of the insured and the nature and extent of healthcare
services being provided. Medical cost management personnel often assist the
insured by determining that the services provided to the insured, and the
corresponding benefits paid, are appropriate under the circumstances.

All of our claims processing, including the claims that are outsourced,
must apply the same claims management standards. In addition, we perform random
audits of both our internal and outsourced claims processing.

SYSTEMS

Our ability to continue providing quality service to our insureds and
agents, including policy issuance, billing, claims processing, commission
reports and accounting functions is critical to our ongoing success. We believe
that our overall systems are an integral part in delivering that service. We
regularly evaluate, upgrade and enhance the information systems that support our
operations.

Our business depends significantly on effective information systems. We
have many different information systems for our various businesses, including
the use of our third party vendors' systems. Our information systems require an
ongoing commitment of significant capital and human resources to maintain and
enhance existing systems and develop new systems or relationships with third
party vendors in order to keep pace with continuing changes in information
processing technology, evolving industry and regulatory standards, and changing
customer preferences. A significant portion of our support systems is obtained
from third party vendors.

Pursuant to an administrative services agreement with Antares Management
Solutions, we outsource all information and telephone systems at our Cleveland
headquarters, as well as claims processing for our Central Reserve Ohio
insureds. In addition, we outsource claims processing and other administrative
services for the Chambers and Provident American Life's HealthEdge business to
Antares. The claims processing and other administrative services for our
insurance subsidiaries, Provident American Life and United Benefit Life, prior
to their termination or replacement, are outsourced to HealthPlan Services. We
receive regular reports from our third party vendors that enable us to closely
monitor our business on those systems.

INVESTMENTS

We attempt to minimize our business risk through conservative investment
policies. Our investment objectives are to maximize yields, preserve principal
and maintain liquidity. Investments for insurance companies must comply with the
insurance laws of the state of domicile. These laws prescribe the kind, quality
and concentration of investments that may be made. Due to the restrictive nature
of these laws, there may be occasions when we may be precluded from making
certain otherwise attractive investments. We periodically evaluate these
securities. The effective durations of our investments vary from subsidiary to
subsidiary with the life insurance subsidiaries between four and five years and
the health companies between two and three years.

At December 31, 2002, approximately 99.0% of our invested assets were fixed
maturity securities, including surplus notes. At December 31, 2002, 94.0% of our
fixed maturity securities were of investment grade quality with 81.7% in
securities rated A or better (typically National Association of Insurance
Commissioners (NAIC) I) and 12.3% in securities rated BBB (typically NAIC II).
We do not invest in derivatives, such as futures, forwards, swaps, option
contracts or other financial instruments with similar characteristics.

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At December 31, 2002, our investments in mortgage-backed securities totaled
$140.9 million, or 35.5% of total invested assets. We minimize the credit risk
of our mortgage-backed securities by holding primarily issues of U.S. Government
agencies or high-quality non-agency issuers rated AA or better. Among the agency
mortgage-backed securities, which comprises 16.0% of the portfolio, the
securities are comprised of pass-through securities and planned amortization
class collateralized mortgage obligations. The pass-through securities primarily
are invested in current market coupons that should exhibit only moderate
prepayments in a declining interest rate environment, while the planned
amortization class collateralized mortgage obligations provide strong average
life protection over a wide range of interest rates. The non-agency
mortgage-backed securities, which represent 19.5% of the portfolio, consist of
commercial and jumbo residential mortgage securities. The commercial
mortgage-backed securities provide very strong prepayment protection through
lockout and yield maintenance provisions, while the residential mortgage-backed
securities are concentrated in non-accelerating securities that have several
years of principal lockout provisions.

The amortized cost and estimated fair value of invested assets as of
December 31, 2002, were as follows:

RESERVES

We establish and report liabilities or reserves on our balance sheet for
unpaid healthcare costs by estimating the ultimate cost of incurred claims that
have not yet been reported to us by our policyholders or their providers and
reported claims that we have not yet paid. Since these reserves represent our
estimates, the process requires a degree of judgment. Reserves are established
according to Actuarial Standards of Practice and generally accepted actuarial
principles and are based on a number of factors, including experience derived
from historical claims payments and actuarial assumptions to arrive at loss
development factors.

Such assumptions and other factors include:

- healthcare cost trends;

- the incidence of incurred claims;

- the extent to which all claims have been reported; and

- internal claims processing charges.

Due to the variability inherent in these estimates, reserves are sensitive to
changes in medical claims payment patterns and changes in medical cost trends. A
deterioration, or improvement, of the medical cost trend or changes in claims
payment patterns from the trends and patterns assumed in estimating reserves
would trigger a change.

10

The majority of Central Reserve's, Provident American Life's and United
Benefit Life's reserves and liabilities for claims are for the health insurance
business. The majority of Continental General's reserves and liabilities for
claims are for the life and annuity and long-term care business. For our
individual and group accident and health business, we establish an active life
reserve plus a liability for due and unpaid claims, claims in course of
settlement and incurred but not yet reported claims, as well as a reserve for
the present value of amounts not yet due on claims. These reserves and
liabilities also are impacted by many factors, such as economic and social
conditions, inflation, hospital and pharmaceutical costs, changes in doctrines
of legal liability and damage awards for pain and suffering. Therefore, the
reserves and liabilities established are necessarily based on estimates and
prior years' experience.

Liabilities for future policy reserves on ordinary life insurance have
generally been provided on a net level premium method based upon estimates of
future investment yield, mortality, and withdrawals using our experience and
actuarial judgment with an allowance for possible unfavorable deviation from the
expected experience. The various actuarial factors are determined from mortality
tables and interest rates in effect when the policy is issued.

Liabilities for interest sensitive contracts such as deferred annuities and
universal life-type contracts are based on the retrospective deposit method.
This is the full account value before any surrender charges are applied.

We may from time to time need to increase our claims reserves significantly
in excess of our initial estimates. An inadequate estimate in reserves could
have a material adverse impact on our business, financial condition and results
of operations.

REINSURANCE

GENERAL. Consistent with the general practice of the insurance industry,
we reinsure portions of the coverage provided by our insurance products to
unaffiliated insurance companies under reinsurance agreements. Reinsurance
provides a greater diversification of underwriting risk, minimizes our aggregate
exposure on major risks and limits our potential losses on reinsured business.
Reinsurance involves one or more insurance companies participating in the
liabilities or risks of another insurance company in exchange for a portion of
the premiums. Although the effect of reinsurance is to lessen our risks, it may
lower net income. We have entered into a variety of reinsurance arrangements
under which we cede business to other insurance companies to mitigate risk. We
also have assumed risk on a "quota share" basis from other insurance companies.

Under quota share reinsurance, the reinsurer assumes or cedes an agreed
percentage of certain risks insured by the ceding insurer and shares premium
revenue and losses proportionately. When we cede business to others, reinsurance
does not discharge us from our primary liability to our insureds. However, the
reinsurance company that provides the reinsurance coverage agrees to become the
ultimate source of payment for the portion of the liability it is reinsuring and
indemnifies us for that portion. However, we remain liable to our insureds with
respect to ceded reinsurance if any reinsurer fails to meet its obligations to
us.

EXISTING ARRANGEMENTS. In the ordinary course of business, we maintain
reinsurance arrangements designed to limit the maximum amount of exposure that
we retain on a given policy. For ordinary and group life claims, Continental
General's maximum retention is $125,000 and Central Reserve's maximum retention
is $50,000 with no retention maintained over age 70. For accident and health
claims, maximum retention on individual claims is $500,000. For a complete
discussion of our material reinsurance agreements, including recent reinsurance
agreements, see Note M. Reinsurance Arrangements to our consolidated financial
statements.

A significant portion of our risks are reinsured with a single reinsurance
company, Hannover Life Reassurance Company of America, a health and life
reinsurance company. Hannover accounted for 91.7% of the total premiums ceded by
our subsidiaries. Hannover has entered into reinsurance agreements with several
of our subsidiaries, including Central Reserve, Provident American Life, United
Benefit Life and Continental General. Our reinsurance agreements with Hannover
are not cancelable or terminable by Hannover. In recent

11

years, we have reduced our reliance on reinsurance. Our arrangements are
generally for closed blocks of business which means that Hannover is not
reinsuring any new sales or business of any of our subsidiaries under these
reinsurance agreements.

In July 2001, we implemented a program to terminate or replace the United
Benefit Life and Provident American Life policies. Some policyholders in some
states were offered a replacement product, HealthEdge, underwritten by Provident
American Life. Through June 30, 2002, Hannover reinsured the HealthEdge product
on the same basis as the reinsurance under the prior reinsurance agreements.
Beginning July 1, 2002, Provident American Life retained 100% of the business
and risk on the remaining HealthEdge policies in force. At the end of 2001, all
other health policies of United Benefit Life and Provident American Life were
terminated.

To evaluate the claims paying ability and financial strength of Hannover,
we review financial information provided to us by Hannover, and hold meetings
with its management to review operations, marketing, reinsurance and financial
issues. Hannover has suffered significant losses as a result of our reinsurance
agreements with respect to United Benefit Life and Provident American Life.

The total premiums ceded by our subsidiaries in 2002 to unaffiliated
reinsurers amounted to $113.0 million, of which Hannover represented
approximately 91.7%. Our gross reinsurance receivables from unaffiliated
reinsurers amounted to $170.1 million as of December 31, 2002, of which
approximately 93.6% was attributable to Hannover.

Hannover is a subsidiary of Hannover Rueckversicherungs, a German
corporation, which had assets of $29.1 billion and total stockholders' equity of
$1.5 billion at December 31, 2001. Moody's has assigned Hannover
Rueckversicherungs a financial strength rating of A2 (good). Hannover maintains
an A (excellent) rating and Hannover Rueckversicherungs maintains an A+
(superior) rating from A.M. Best Company, Inc. and a financial strength rating
of AA (rated very strong) from Standard & Poor's. Hannover's failure to pay our
claims in full or on a timely basis could have a material adverse effect on our
business, financial condition and results of operations.

Our future growth may be dependent on our ability to obtain reinsurance in
the future. While we expect to continue our relationship with Hannover in the
future, we will continue to identify new companies with respect to new
reinsurance agreements. The amount and cost of reinsurance available to us would
be subject, in large part, to prevailing market conditions beyond our control.
We may be unable to obtain reinsurance in the future, if necessary, at
competitive rates or at all.

COMPETITION

The insurance business is highly competitive. In our major medical
business, we compete with large national, regional and specialty health
insurers, including Golden Rule Resources Ltd., Mutual of Omaha Insurance Co.,
Fortis Benefits Insurance Company, American Medical Security Group, Inc.,
various Blue Cross/Blue Shield companies and United Healthcare Corporation. In
our senior business, we compete with other national, regional and specialty
insurers, including Universal American Financial Corp., Penn Treaty American
Corp., Mutual of Omaha and Conseco, Inc. Many of our competitors have
substantially greater financial resources, broader product lines, or greater
experience than we do. In addition to claims paying ratings, we compete on the
basis of price, reputation, diversity of product offerings and flexibility of
coverage, ability to attract and retain agents and the quality and level of
services provided to agents and insureds.

We face competition from a trend among healthcare providers and insurance
companies to combine and form networks in order to contract directly with small
businesses and other prospective customers to provide healthcare services. In
addition, because many of our products are marketed through independent agents,
most of which represent more than one company, we compete with other companies
for the marketing focus of each agent.

12

RATINGS

Our ratings assigned by A.M. Best Company, Inc. and other nationally
recognized rating agencies are important in evaluating our competitive position.
Best ratings are based on an analysis of the financial condition of the
companies rated. Best ratings are primarily based upon factors of concern to
policyholders and insurance agents. In January 2003, the Best ratings of our
insurance subsidiaries were affirmed. Additionally, the outlook for Central
Reserve was upgraded to stable. However, Continental General's negative rating
outlook remains unchanged due to the need to strengthen Continental General's
capital. Central Reserve's rating is a B (fair) rating. Continental General's
ratings is B+ (very good). Provident American Life's and United Benefit Life's
ratings for 2001 were affirmed NR-3 (rating procedure inapplicable). This rating
is defined by Best to mean that normal rating procedures do not apply due to
unique or unusual business features. Provident American Life and United Benefit
Life fall into this category because, due to reinsurance, they both retain only
a small portion of their gross premiums.

In December 2002, Fitch maintained Continental General's BBB (good credit
quality) financial strength rating with "rating watch evolving" and placed
Central Reserve's BB (speculative credit quality) financial strength rating on
"rating watch positive." In light of the recent statutory capitalization and
strengthened balance sheet from the sale of Pyramid Life, we are hopeful that
the major rating agencies will give favorable consideration to our financial
ratings in 2003.

GOVERNMENT REGULATION

Government regulation of health and life insurance, annuities and
healthcare coverage and health plans is a changing area of law and varies from
state to state. We strive to maintain compliance with the various federal and
state regulations applicable to our operations. To maintain compliance with
these changing regulations, we may need to make changes occasionally to our
services, products, structure or operations. We are unable to predict what
additional government regulations affecting our business may be enacted in the
future or how existing or future regulations might be interpreted. Additional
governmental regulation or future interpretation of existing regulations could
increase the cost of our compliance or materially affect our operations,
products or profitability. We carefully monitor state and federal legislative
and regulatory activity as it affects our business. We believe that we are
compliant in all material respects with all applicable federal and state
regulations.

INSURANCE REGULATION. We are subject to regulation and supervision by
state insurance regulatory agencies. This regulation is primarily intended to
protect insureds rather than investors. These regulatory bodies have broad
administrative powers relating to standards of solvency which must be met on a
continuing basis, granting and revoking of licenses, licensing of agents,
approval of policy forms, approval of rate increases, maintenance of adequate
reserves, claims payment practices, form and content of financial statements,
types of investments permitted, issuance and sale of stock, payment of dividends
and other matters pertaining to insurance. We are required to file detailed
annual statements with the state insurance regulatory bodies and are subject to
periodic examination. The most recent completed regulatory examination for
Central Reserve, Provident American Life and United Benefit Life was performed
by the State of Ohio as of December 31, 1999. For Continental General, the
examination was performed by the State of Nebraska as of December 31, 2001.
State insurance departments have also periodically conducted market conduct
examinations of our insurance subsidiaries.

Although many states' insurance laws and regulations are based on models
developed by the 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 state, and variation from the model laws within the
state is common.

The National Association of Insurance Commissioners revised the Accounting
Practices and Procedures Manual in a process referred to as Codification. The
revised manual was effective January 1, 2001. The
13

domiciliary states of Ceres and its insurance subsidiaries have adopted the
provisions of the revised manual. The revised manual has changed, to some
extent, prescribed statutory accounting practices and has resulted in changes to
the accounting practices that our insurance subsidiaries use to prepare their
statutory-basis financial statements. The impact of these changes to
statutory-basis capital and surplus of the insurance subsidiaries was not
significant.

The NAIC has Risk-Based Capital (RBC) requirements for life and health
insurers to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks associated with asset quality, mortality and
morbidity, asset and liability matching and other business factors. The RBC
formula is used by state insurance regulators to monitor trends in statutory
capital and surplus for the purpose of initiating regulatory action. In general,
under these laws, an insurance company must submit a report of its RBC level to
the insurance department of its state of domicile as of the end of the previous
calendar year. These laws require increasing degrees of regulatory oversight and
intervention as an insurance company's RBC declines. The level of regulatory
oversight ranges from requiring the insurance company to inform and obtain
approval from the domiciliary insurance commissioner of a comprehensive
financial plan for increasing its RBC to mandatory regulatory intervention
requiring an insurance company to be placed under regulatory control in a
rehabilitation or liquidation proceeding.

The RBC Model Act provides for four different levels of regulatory
attention depending on the ratio of a company's total adjusted capital, defined
as the total of its statutory capital, surplus and asset valuation reserve, to
its risk-based capital.

- The "Company Action Level" is triggered if a company's total adjusted
capital is less than 200% but greater than or equal to 150% of its
risk-based capital. At the "Company Action Level," a company must submit
a comprehensive plan to the regulatory authority that discusses proposed
corrective actions to improve its capital position. A company whose total
adjusted capital is between 250% and 200% of its risk-based capital is
subject to a trend test. The trend test calculates the greater of any
decrease in the margin (i.e., the amount in dollars by which a company's
adjusted capital exceeds its risk-based capital) between the current year
and the prior year and between the current year and the average of the
past three years, and assumes that the decrease could occur again in the
coming year. If a similar decrease in margin in the coming year would
result in a risk-based capital ratio of less than 190%, then "Company
Action Level" regulatory action would be triggered.

- The "Regulatory Action Level" is triggered if a company's total adjusted
capital is less than 150% but greater than or equal to 100% of its
risk-based capital. At the "Regulatory Action Level," the regulatory
authority will perform a special examination of the company and issue an
order specifying corrective actions that must be followed.

- The "Authorized Control Level" is triggered if a company's total adjusted
capital is less than 100% but greater than or equal to 70% of its
risk-based capital, at which level the regulatory authority may take any
action it deems necessary, including placing the company under regulatory
control.

- The "Mandatory Control Level" is triggered if a company's total adjusted
capital is less than 70% of its risk-based capital, at which level the
regulatory authority is mandated to place the company under its control.

We calculated the risk-based capital for our insurance subsidiaries as of
December 31, 2002, using the applicable RBC formula. Based on these
calculations, our risk-based capital levels for each of our subsidiaries, except
Continental General, exceeded the levels required by regulatory authorities.
Continental General's statutory capital level was below "Company Action Level"
at December 31, 2002. However, after the addition of the statutory capital
generated from the sale of Pyramid Life, Continental General's risk-based
capital level will exceed the levels required by regulatory authorities.

Dividends paid by our insurance subsidiaries to Ceres are limited by state
insurance regulations. The insurance regulator in the insurer's state of
domicile may disapprove any dividend which, together with other dividends paid
by an insurance company in the prior 12 months, exceeds the regulatory maximum
as computed for the insurance company based on its statutory surplus and net
income. In 2003, none of our
14

insurance subsidiaries can pay a dividend to Ceres without prior approval of
their respective state regulators as a result of their respective statutory
levels of unassigned surplus.

Many states have also enacted insurance holding company laws, which require
registration and periodic reporting by insurance companies controlled by other
corporations. These laws vary from state to state but typically require periodic
disclosure concerning the corporation which controls the insurer and prior
notice to, or approval by, the applicable regulator of inter-company transfers
of assets and other transactions, including payments of dividends in excess of
specified amounts by the insurer, within the holding company system. These laws
often also require the prior approval for the acquisition of a significant
direct or indirect ownership interest (for example, 10% or more) in an insurance
company. Our insurance subsidiaries are subject to these laws and we believe
they are in compliance in all material respects with all applicable insurance
holding company laws and regulations.

Additional regulatory initiatives my be undertaken in the future, either at
the federal or state level, to engage in structural reform of the insurance
industry in order to reduce the escalation of insurance costs or to make
insurance more accessible. These future regulatory initiatives could have a
material adverse effect on our business, financial condition and results of
operations.

HEALTHCARE REGULATION. Government regulation of the healthcare industry
also affects the manner in which we conduct our business. HIPAA mandates the
adoption of standards for the exchange of electronic health information in an
effort to encourage overall administrative simplification and enhance the
effectiveness and the efficiency of the healthcare industry. Ensuring privacy
and security of patient information -- "accountability" -- is one of the key
factors driving the legislation. The other factor -- "portability" -- refers to
Congress' intention to ensure that individuals may transfer insurability and
waiting periods for coverage if they change employers.

Among other things, HIPAA:

- addresses group and individual market reforms increasing the
transferability of health insurance;

- permits medical savings accounts on a trial basis; and

- increases the deductibility of health insurance for self-employed
persons.

Compliance with HIPAA's simplification mandate is required within the next
two to three years. We must comply with the following:

- standards for electronic transmission and medical procedure code sets;

- national standard healthcare provider identifier; and

- national standard employer identifier.

We have recently developed an electronic data interface (EDI) system with
one of our network providers to expedite our claims processing. Using the EDI
system, claims handled through the system for many of our insureds will be sent
directly from the medical providers to our network provider, who will image and
automatically adjust the claims to network rates. These re-priced claims will
then be electronically transmitted to our administrative facilities for
processing and payment according to policy benefits.

HIPAA's privacy requirements will govern who within our organization can
receive protected information, the manner in which it will be maintained, the
responsibility of third parties with whom we contract, and appropriate
identification at time of receipt of protected information so that it may be
appropriately controlled, maintained and retrieved as required.

The new standards:

- limit the routine and non-routine non-consensual use and release of
private health information;

- give patients new rights to access their medical records and to know who
else has accessed them;

- limit most disclosure of health information to the minimum needed for the
intended purpose;

15

- establish procedures to ensure the protection of private health
information;

- establish new criminal and civil sanctions for improper use or
disclosure; and

- establish new requirements for access to records by researchers and
others.

Final privacy rules adopted in 2001 require changes in the way health
information is handled. The privacy regulations require most covered entities to
be in compliance by April 2003. Final regulations regarding the standard formats
for the transmission of health care information have also been released and
require compliance by October 2003. We have implemented, and continue to
implement, new procedures to comply with the privacy regulations and continue to
take action to comply with the standardization regulations. The regulations will
have the effect of increasing our expenses. In recent years, we also have
implemented procedures to comply with the privacy standards for personal
information by the Gramm-Leach-Bliley Act.

We implemented procedures to comply with U.S. Department of Labor
regulations that revise claims procedures for employee benefit plans governed by
ERISA. The regulations became effective for claims filed on or after July 1,
2002 and govern the time frame for making benefit decisions for claims and
appeals and for notification of claimants' rights under the regulations.

In addition to federal regulation, many states have enacted, or are
considering, various healthcare reform statutes. These reforms relate to, among
other things, managed care practices, such as requirements with respect to
maternity stays, waiting period restrictions on pre-existing conditions, credit
for certain prior coverage, limitations on rate increases and guaranteed
renewability for small business plans and policies for individuals and
limitations on association business. Most states have also enacted patient
confidentiality laws that prohibit the disclosure of confidential medical
information. The federal privacy rule will establish minimum standards and
preempt conflicting state laws that are less restrictive than HIPAA regarding
health information privacy but will allow state laws that are more restrictive
than HIPAA. These laws or regulations may limit our operations and our ability
to control which providers are part of our networks and may hinder our ability
to effectively manage utilization and costs. We are unable to predict what state
reforms will be enacted or how they would affect our business.

Some states have also enacted small group insurance and rating reforms,
which generally limit the ability of insurers and health plans to use risk
selection as a method of controlling costs for small group businesses. These
laws may generally limit or eliminate use of pre-existing condition exclusions,
experience rating, and industry class rating and limit the amount of rate
increases from year to year. We have discontinued selling certain policies in
states where, due to these healthcare reform measures, we cannot function
profitably. We may discontinue sales in other states in the future. Our
operations also may be subject to PPO or managed care laws and regulations in
certain states. PPO and managed care regulations generally contain requirements
pertaining to provider networks, provider contracting, and reporting
requirements that vary from state to state.

One of the significant techniques we use to manage healthcare costs and
facilitate care delivery is contracting with physicians, hospitals and other
providers. As of December 31, 2002, our largest network, First Health Group
Corporation, accounted for 31.6% of our PPO certificates and policies in force.
A number of organizations are advocating for legislation that would exempt some
providers from federal and state antitrust laws. In any particular market,
providers could refuse to contract, demand higher payments or take actions that
could result in higher healthcare costs, less desirable products for insureds or
difficulty meeting regulatory or accreditation requirements. In some markets,
some providers, particularly hospitals, physician/hospital organizations or
multi-specialty physician groups, may have significant market positions or near
monopolies. In addition, physician or practice management companies, that
aggregate physician practices for administrative efficiency and marketing
leverage, continue to expand. These providers may compete directly with us. If
these providers refuse to contract with us, use their market position to
negotiate less favorable contracts or place us at a competitive disadvantage,
those activities could adversely affect our ability to market products or to be
profitable in those areas.

Congress and various states are considering some form of the "Patients'
Bill of Rights." This legislation, if enacted, is designed to provide consumers
more freedom of choice in the selection of doctors, facilities, and treatments.
Although the bill was originally conceived to regulate HMOs, it will affect all
facets of the nation's
16

healthcare delivery system, including medical providers, PPOs, exclusive
provider organizations, community-based healthcare organizations and indemnity
insurance plans. These changes, if enacted, are expected to result in higher
total medical costs, which could encourage more partnerships and associations
between medical providers and insurers to control costs, more community-based
health organizations, and greater use of higher deductibles to lower insurance
costs and reduce administrative expenses of smaller claims.

Statutory and regulatory changes may also significantly alter our ability
to manage pharmaceutical costs through restricted formularies of products
available to our members.

E-COMMERCE REGULATION. We may be subject to additional federal and state
statutes and regulations in connection with our changing product strategy, which
includes Internet services and products. On an increasingly frequent basis,
federal and state legislators are proposing laws and regulations that apply to
Internet based commerce and communications. Areas being affected by this
regulation include user privacy, pricing, content, taxation, copyright
protection, distribution and quality of products and services. To the extent
that our products and services would be subject to these laws and regulations,
the sale of our products and our business could be harmed.

EMPLOYEES

We had approximately 846 employees at December 31, 2002. We consider our
employee relations to be good. Our approximately 36,000 agents are independent
contractors and not employees.

AVAILABLE INFORMATION

Ceres Group, Inc. is a Delaware corporation. Our principal executive
offices are located at 17800 Royalton Road, Strongsville, Ohio 44136 and our
telephone number at that address is 440-572-2400.

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available
free of charge through the company's website at http://www.ceresgp.com as soon
as reasonably practicable after we electronically file such reports with the
Securities and Exchange Commission.

ITEM 2. PROPERTIES

OWNED PROPERTIES (OFFICE SPACE)

- ---------------

(1) Immediately prior to the closing of the Pyramid Life sale, Continental
General acquired Pyramid Life's building in Kansas. See Note F. Discontinued
Operations and Subsequent Event for further information.

LEASED PROPERTIES (OFFICE SPACE)

ITEM 3. LEGAL PROCEEDINGS

We are involved in various legal and regulatory actions occurring in the
normal course of business. Based on current information, we believe any ultimate
liability that may arise from these actions would not

17

materially affect our consolidated financial position or results of operations.
However, our evaluation of the likely impact of these actions could change in
the future and an unfavorable outcome could have a material adverse effect on
our consolidated financial position, results of operations or cash flow of a
future period.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

18

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock has traded on the Nasdaq National Market under the symbol
CERG since December 1998 and under the symbol CRLC before that date. The
following table shows the high and low closing prices of our common stock for
the quarters listed. These prices were taken from the Nasdaq Monthly Statistical
Reports. On March 25, 2003, our common stock closed at $1.73 per share.

As of March 25, 2003, we had 2,125 record holders.

We have not paid any cash dividends on our common stock since the end of
1996, and we do not anticipate paying any dividends in the foreseeable future.
Our credit agreement with the JPMorgan Chase, dated February 17, 1999, as
amended, contains financial and other covenants that, among other matters,
prohibit the payment of cash dividends on our common stock. For more information
on our credit agreement with Chase, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."

Dividends paid by our insurance subsidiaries to us are limited by state
insurance regulations. The insurance regulator in the insurer's state of
domicile may disapprove any dividend which, together with other dividends paid
by an insurance company in the prior 12 months, exceeds the regulatory maximum
as computed for the insurance company based on its statutory surplus and net
income. In 2002, none of our direct insurance subsidiaries (Central Reserve Life
and Continental General) could pay a dividend to Ceres without the prior
approval of their respective state insurance regulators as a result of their
respective statutory levels of unassigned surplus at December 31, 2002. In 2003,
none of our direct subsidiaries can pay a dividend without the prior approval of
their respective state insurance regulators as a result of their respective
statutory levels of unassigned surplus at December 31, 2002.

19

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data presented below as of and for each
of the five years ended December 31, 2002, 2001, 2000, 1999, and 1998 have been
derived from our audited consolidated financial statements. However, prior years
2001 and 2000 have been reclassed to reflect the sale of Pyramid Life. See Note
F. Discontinued Operations and Subsequent Event for further information. The
acquisitions of Provident American Life and Continental General occurred on
December 31, 1998 and February 17, 1999, respectively. These acquisitions had no
impact on our results of operations in 1998. Results for United Benefit Life are
included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and
thereafter as an acquired entity. The financial information for the year ended
December 31, 1999 includes the operations of Continental General since February
1, 1999 and for Provident American Life and United Benefit Life (through
reinsurance) for the entire period. The financial information for the years
ended December 31, 2000, 2001, and 2002 includes the operations of all our
subsidiaries for the entire year except for Pyramid Life (acquired in July
2000), which is presented separately as discontinued operations, as previously
noted. This data should be read in conjunction with the more detailed
information contained in the consolidated financial statements and accompanying
notes, "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and other financial information included elsewhere in this
filing.

- ---------------

(1) On December 20, 2002, we entered into a definitive agreement to sell the
stock of our subsidiary, Pyramid Life, to a subsidiary of Universal American
Financial Corp. The transaction closed on March 31, 2003 for a purchase
price of approximately $57.5 million in cash, subject to further adjustment
based on Pyramid Life's final statutory capital and surplus as of March 31,
2003. See Note F. Discontinued Operations and Subsequent Event to our
consolidated financial statements for further information.

(2) The exercise of options and warrants is not assumed when a loss from
operations is reported and the result would be antidilutive.

(3) We received proceeds from a December 2001 public offering and private
placement offerings in 2000, 1999 and 1998. For more information, see Note
B. Equity Transactions to our consolidated financial statements.

(4) "Accumulated other comprehensive income" relates primarily to the net
unrealized gain (loss) on available-for-sale securities.

21

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

This discussion should be read in conjunction with the consolidated
financial statements, notes and tables included elsewhere in this report.
Management's discussion and analysis contains forward-looking statements that
are provided to assist in the understanding of anticipated future financial
performance. However, future performance involves risks and uncertainties which
may cause actual results to differ materially from those expressed in the
forward-looking statements. See "Forward-Looking Statements."

OVERVIEW

Ceres Group, through its insurance subsidiaries, provides a wide array of
health and life insurance products to approximately 358,000 insureds through two
primary business segments. The senior segment includes senior health, life and
annuity products for Americans age 55 and over. The major medical segment
includes major medical health insurance for individuals, families, associations
and small businesses.

Ceres' insurance subsidiaries include Central Reserve Life Insurance
Company, Provident American Life & Health Insurance Company, United Benefit Life
Insurance Company and Continental General Insurance Company. Central Reserve
markets and sells major medical health insurance to individuals, families,
associations and small employer groups. Continental General markets and sells
both major medical and senior health and life products to individuals, families,
associations and Americans age 55 and over. United Benefit Life discontinued new
sales activities in July 2000 and terminated all of its existing business at the
end of 2001. United Benefit Life has no active policyholders and its business
was substantially wound down at December 31, 2002. Provident American Life also
has discontinued new sales activities and currently has approximately 3,000
active policyholders.

Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's statutory capital and surplus at
March 31, 2003. For more information on the Pyramid Life sale, see "Recent
Events."

CRITICAL ACCOUNTING POLICIES

Management has identified the following items that represent our most
sensitive and subjective accounting estimates that have or could have a material
impact on our financial statements. These estimates required management to make
assumptions about matters that were highly uncertain at the time the estimates
were made. Changes to these estimates occur from period to period and may have a
material impact on our financial statements. Management has discussed the
development, selection and disclosure of these estimates with our Audit
Committee.

LIABILITIES FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE. The most
significant accounting estimate in our consolidated financial statements is our
liability for other policy claims and benefits payable.

We recognize claim costs in the period the service was provided to our
insureds. However, claim costs incurred in a particular period are not known
with certainty until after we receive, process and pay the claim. The receipt
and payment date of claims may lag significantly from the date the service was
provided. Consequently, we must estimate our liabilities for claims that are
incurred but not yet paid.

Liabilities for unpaid claims are based on an estimation process that is
complex and uses information obtained from both company specific and industry
data, as well as general economic information. These estimates are developed
using actuarial methods based upon historical data for payment patterns, medical
inflation, product mix, seasonality, utilization of health care services and
other relevant factors. The amount recorded for unpaid claims liabilities is
sensitive to judgments and assumptions made in the estimation process. The most
significant assumptions used in the estimation process include determining
utilization and inflation trends, the expected consistency in the frequency and
severity of claims incurred but not yet reported,

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changes in the timing of claims submission patterns from providers, changes in
our speed of processing claims and expected costs to settle unpaid claims.

Actual conditions could differ from those assumed in the estimation
process. Due to the uncertainties associated with the factors used in these
assumptions, materially different amounts could be reported in our statement of
operations for a particular period under different conditions or using different
assumptions. As is common in the health insurance industry, we believe that
actual results may vary within a reasonable range of possible outcomes.
Management believes that our reasonable range of actual outcomes may vary up to
10% to 15% of the total liabilities for other policy claims and benefits payable
recorded at the end of a period.

Note L. Liabilities for Other Policy Claims and Benefits Payable to our
audited consolidated financial statements for the years ended December 31, 2002,
2001 and 2000 provides historical information regarding the accrual and payment
of our unpaid claims liability. Components of the total incurred claims for each
year include amounts accrued for current year estimated claims expense, as well
as adjustments to prior year estimated accruals.

Management considered the unfavorable claims experience in recent periods
when it established its liabilities for unpaid claims at December 31, 2002.
Management believes that the recorded liabilities for unpaid claims at December
31, 2002 is within a reasonable range of outcomes. Management closely monitors
and evaluates developments and emerging trends in claims costs to determine the
reasonableness of judgments made. A retrospective test is performed on prior
period claims liabilities and, as adjustments to the liabilities become
necessary, the adjustments are reflected in current operations. Management
believes that the amount of medical and other benefits payable is adequate to
cover our liabilities for unpaid claims as of December 31, 2002.

DEFERRED 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 directly related to the acquisition of the policy,
including commissions, underwriting and other policy issue expenses. The
amortization of deferred acquisition costs is determined using the same
projected actuarial assumptions used in computing policy reserves. Deferred
acquisition costs associated with traditional life and accident and health
contracts are charged to expense over the premium-paying period or as premiums
are earned over the life of the contract. Deferred acquisition costs associated
with interest-sensitive life and annuity products are charged to expense over
the estimated duration of the policies in relation to the present value of the
estimated gross profits from surrender charges and investments, mortality, and
expense margins.

We evaluate the recoverability of our deferred acquisition costs on a
quarterly basis. The recoverability of our deferred acquisition costs is
sensitive to judgments and assumptions made in projecting future cash flows on
our various blocks of business. The most significant assumptions are claim cost
trends, magnitude of rate increases, lapsation and persistency, and mortality.

During 2002 and 2001, we wrote off $4.2 million and $6.7 million,
respectively, of deferred acquisition costs associated with major medical
business in certain states due to the continuing unprofitability of the business
in that state or in which we terminated the in force policies due to continued
operating losses.

Management and our independent outside consultants believe the amount of
deferred acquisition costs as of December 31, 2002 is recoverable.

OTHER ACCOUNTING POLICIES AND INSURANCE BUSINESS FACTORS

Our results of operations are effected by the following accounting and
insurance business factors:

GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill represents the excess of
purchase price over the fair value of tangible and identifiable intangible net
assets acquired. At December 31, 2002, goodwill was $10.7 million and
represented approximately 1.2% of our total assets. Additionally, other
intangible assets represent purchased assets that also lack physical substance
but can be distinguished from goodwill because of other legal rights or because
the asset is capable of being sold or exchanged either on its own or in
combination

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with a related contract asset or liability. At December 31, 2002, our other
intangible assets consisted of $3.6 million in licenses, or 0.4% of our total
assets.

Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other
Intangible Assets issued by the Financial Accounting Standards Board, or FASB,
which provides that goodwill and intangibles with indefinite useful lives should
not be amortized but instead be tested for impairment annually at the reporting
unit level. In accordance with SFAS No. 142, we, together with our independent
consultants, completed a transitional goodwill impairment test, which indicated
that an impairment loss against our goodwill and other intangible assets was not
required. Goodwill and intangibles with indefinite useful lives are tested for
impairment on an annual basis and more often if indications of impairment exist.
The estimated fair value of goodwill of a reporting unit is determined by
applying the appropriate discount rates to estimated future cash flows for the
reporting unit. The estimated fair value of licenses was determined by
independent appraisals. The results of our analysis and analysis prepared by
independent consultants indicated that no reduction of goodwill and licenses was
required.

LONG-LIVED ASSETS. Property and intangible assets are reviewed for
possible impairment when events indicate that the carrying amount of an asset
may not be recoverable. Assumptions and estimates used in the evaluation of
impairment may affect the carrying value of long-lived assets, which could
result in impairment charges in future periods. Depreciation and amortization
policies reflect judgments on the estimated useful lives of assets.

REVENUE RECOGNITION. Life insurance premiums are recognized as revenue
when they become due. Health premiums are recognized as revenue over the terms
of the policies. Amounts received from interest sensitive contracts, principally
universal life and annuity products, are not reflected in premium revenue;
rather, such amounts are accounted for as deposits with the related liabilities
included in future policy benefits, losses and claims.

VALUE OF BUSINESS ACQUIRED. A portion of the purchase price paid for
Continental General Corporation was allocated to the value of business acquired
based on the actuarially-determined present value of the expected pre-tax future
profits from the business assuming a discount rate of 15.0%. Interest is accrued
on the balance annually at a rate consistent with the rate credited on the
acquired policies on the acquisition date, which ranges from 4.0% to 8.75%.
Recoverability of the value of business acquired is evaluated periodically by
comparing the current estimate of the present value of expected pre-tax future
profits to the unamoritized asset balance. If the current estimate is less than
the existing asset balance, the difference would be charged to expense, and if
the current estimate is higher than the existing asset balance, the difference
will emerge into profits as earned.

For accident and health and ordinary life business, the value of business
acquired is amortized over the estimated life of the in force business using
assumptions consistent with those in computing reserves. Interest of 6.5% for
Continental General is credited to the unamortized balance. For interest
sensitive products such as universal life and deferred annuities, the value of
business acquired is amortized over the expected profit stream of the in force
business. The expected profit stream is based upon actuarial assumptions as to
mortality, lapses and expenses. Earned interest was assumed to be 6.0% for
Continental General, the market rate at the time of acquisition.

THE NUMBER OF YEARS A POLICY HAS BEEN IN EFFECT. Claims costs tend to be
higher on policies that have been in force for a longer period of time. As the
policy ages, it is more likely that the insured will need services covered by
the policy. However, generally, the longer the policy is in effect, the more
premium we will receive for major medical and Medicare supplement policies. For
other health, life and annuity policies/contracts, reserve liabilities are
established for policy benefits expected to be paid for in future years.

LAPSATION AND PERSISTENCY. Other factors that affect our results of
operations are lapsation and persistency, both of which relate to the renewal of
insurance policies and certificates in force. Lapsation is the termination of a
policy for nonrenewal and, pursuant to our practice, is automatic if and when
premiums become more than 31 days overdue, however, policies may be reinstated,
if approved, within six months after

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the policy lapses. Persistency represents the percentage of total certificates
in force at the end of a period less any newly-issued certificates divided by
the total certificates in force at the beginning of the period.

Policies renew or lapse for a variety of reasons, due both to internal and
external causes. We believe that our efforts to address any concerns or
questions of our insureds in an expedient fashion help to ensure ongoing policy
renewal. We work closely with our licensed agents, who play an integral role in
obtaining policy renewals and communicating with our insureds.

EXTERNAL FACTORS ALSO CONTRIBUTE TO POLICY RENEWAL OR LAPSATION. Economic
cycles can influence an insured's ability to continue to pay insurance premiums
when due. New government initiatives have raised public awareness of the
escalating costs of healthcare, which we believe boosts new sales and promotes
renewal payments.

Lapsation and persistency may positively or adversely impact future
earnings. Higher persistency generally results in higher renewal premium.
However, higher persistency may lead to increased claims in future periods.
Additionally, increased lapsation can result in reduced premium collection,
accelerated amortization of deferred acquisition cost and anti-selection of
higher-risk insureds.

REINSURANCE. Consistent with the general practice of the insurance
industry, we reinsure portions of the coverage by our insurance products to
unaffiliated insurance companies under reinsurance agreements. Reinsurance
provides a greater diversification of underwriting risk, minimizes our aggregate
exposure on major risks and limits our potential losses on reinsured business.
Reinsurance involves one or more insurance companies participating in the
liabilities or risks of another insurance company in exchange for a portion of
the premiums. Although the effect of reinsurance is to lessen our risks, it may
lower net income. We have entered into a variety of reinsurance arrangements
under which we cede business to other insurance companies to mitigate risk. We
also have assumed risk on a "quota share" basis from other insurance companies.
Our results of operations are presented net of reinsurance.

LIABILITIES FOR LITIGATION. We are involved in various litigation and
regulatory actions. Such actions typically involve disputes over policy coverage
and benefits, but may also relate to premium rates, agent and employment related
issues, regulatory compliance and market conduct, contractual relationships and
other matters. These disputes are resolved by settlement, dismissal or upon a
decision rendered by a judge, jury or regulatory official.

In determining the amount to be recorded as a litigation reserve, judgments
are generally made by management, in consultation with legal counsel and other
experts both within and outside the company, on a case-by-case basis based on
the facts and the merits of the case, the general litigation and regulatory
environment of the originating state, our past experience with outcomes of cases
in particular jurisdictions, historical results of similar cases and other
relevant factors. We closely monitor and evaluate developments and emerging
facts of each case to determine the reasonableness of judgments and assumptions
on which litigation reserves are based. Such assumptions relate to matters that
are highly uncertain. Estimates could be made based on other reasonable
assumptions or judgments that would differ materially from those estimates
recorded. We will accrue a liability if the likelihood of an adverse outcome is
probable of occurrence and the amount is estimable. We will not accrue a
liability if either the likelihood of an adverse outcome is only reasonably
possible or an estimate is not determinable. Our evaluation of the likely
outcome of these actions and the resulting estimate of the potential liability
are subject to periodic adjustments that may have a material impact on our
financial condition and results of operations of a future period.

Inherent uncertainties surround legal proceedings and actual results could
differ materially from those assumed in estimating the liabilities. The
possibility exists that a decision could be rendered against us, and, in some
circumstances, include punitive or other damage awards in excess of amounts
reserved, that may have a material impact on our financial condition, results of
operations or cash flow of a future period.

INSURANCE. We use a combination of insurance and self-insurance for a
number of risks including property, general liability, directors' and officers'
liability, workers' compensation, vehicle liability and employee-related
healthcare benefits. Liabilities associated with the risks that are retained are
estimated by considering various historical trends and forward-looking
assumptions. The estimated accruals for these
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liabilities could be significantly affected if future occurrences and claims
differ from these assumptions and historical trends. Over the past couple of
years, the cost and availability of commercial insurance as a result of
significant changes in the insurance market have impacted our insurance
coverages. We have renewed most of our insurance policies for 2003, although at
additional premium cost and with increased exposure to losses. Other policies
are up for renewal in mid-2003. We may not be successful in obtaining coverage
on terms favorable to us or at all.

RESULTS OF OPERATIONS

We have three reportable segments:

- medical -- includes catastrophic and comprehensive major medical plans;

- senior and other -- includes Medicare supplement, long-term care, dental,
life insurance and annuities; and

- corporate and other -- includes primarily interest income, interest
expense and corporate expenses of the holding company.

All of our acquisitions were accounted for using the purchase method of
accounting. The acquisitions of Provident American Life and Continental General
had no impact on our results of operations in 1998. Results for United Benefit
Life are included from August 1, 1998 to July 20, 1999 under a reinsurance
agreement and thereafter as an acquired entity. The financial information for
the year ended December 31, 1999 includes the operations of Continental General
since February 1, 1999 and of Provident American Life for the entire year. The
financial information for the years ended December 31, 2002 and 2001 include the
operation of all our subsidiaries for the entire period with the exception of
Pyramid Life. Consistent with Statement of Financial Accounting Standards, or
SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets,
Pyramid Life was classified as held for sale as of December 31, 2002, and was
measured at its fair value less cost to sell. Therefore, the financial
information for the years ended December 31, 2002, 2001 and 2000 excludes the
operations of Pyramid Life for all periods presented and the $11.6 million net
charge in the fourth quarter of 2002 related to the sale (each except where
specifically noted). Financial data for 2001 and 2000 has been reclassified to
reflect the sale of Pyramid Life. The net assets, results of operations, and
cash flows of Pyramid Life have been reported separately as discontinued
operations of a subsidiary in our consolidated financial statements for all
periods presented. See Note F. Discontinued Operations and Subsequent Event to
our consolidated financial statements for further information.

RECENT EVENTS

Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's statutory capital and surplus as of
March 31, 2003. Net proceeds of the sale were used as follows: (1) $10.0 million
to repay a portion of our bank debt, and (2) the remainder to strengthen the
statutory capital of Continental General.

Immediately prior to the closing of the sale, Continental General acquired
Pyramid Life's Kansas City building and personal property and retained most of
its employees. Continental General will continue to administer its senior health
business out of the Kansas City location, as well as continue to administer
Pyramid Life's business during a six to 18 month transition period. Immediately
prior to the closing, Continental General also reinsured a small block of
certain life insurance policies of Pyramid Life.

After the transaction, Continental General has approximately $55.0 million
in statutory capital and surplus with a risk based capital ratio in excess of
350%, an increase of approximately $21.0 million from December 31, 2002. In
addition, after the transaction, we have $13.7 million in outstanding bank debt
compared to $25.0 million at year end.

At December 31, 2002, Pyramid Life had assets of $157.8 million, net
premiums of $98.0 million, net revenues of $104.8 million and net income from
operations of $7.1 million.

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2002 COMPARED TO 2001