UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

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

CERES GROUP, INC.

(440) 572-2400

     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 o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

     The number of shares of common stock, par value $0.001 per share, outstanding as of November 1, 2004 was 34,508,048.

CERES GROUP, INC. and SUBSIDIARIES

Index

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CERES GROUP, INC. and SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CERES GROUP, INC. and SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

CERES GROUP, INC. and SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CERES GROUP, INC. and SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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CERES GROUP, INC. and SUBSIDIARIES

A. Summary of Business and Significant Accounting Policies

Summary of Business

     The accompanying unaudited condensed consolidated financial statements of Ceres Group, Inc. and subsidiaries, included herein, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

     The condensed consolidated financial statements for September 30, 2004 include the continuing operations of Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, and United Benefit Life Insurance Company. On March 31, 2003, we sold the stock of Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note D. Discontinued Operations for further information. As a result of the sale of Pyramid Life, our condensed consolidated financial statements for the nine months ended September 30, 2003 present the discontinued operations of Pyramid Life separate from continuing operations.

     The condensed consolidated balance sheet presented at December 31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2003.

     Unless the context indicates otherwise, “we,” “our” and “us” refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis.

Significant Accounting Policies

     For further information, refer to “Critical Accounting Policies” and “Other Accounting Policies and Insurance Business Factors” in our Annual Report on Form 10-K for the year ended December 31, 2003.

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

     Use of Estimates

     The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

     Cash and Cash Equivalents

     Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. At September 30, 2004 and December 31, 2003, restricted cash was $6.6 million and $7.0 million, respectively. Restricted cash primarily represents cash held related to fully insured employer shared risk plans, which is restricted from any other use. We are entitled to the investment income from these funds. A corresponding liability is included in the accompanying condensed consolidated balance sheets.

     Investments

     Our insurance subsidiaries have certificates of deposit and fixed maturity securities on deposit with various state insurance departments to satisfy regulatory requirements.

     Property and Equipment

     Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 35 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally three to seven years.

     Stock-Based Compensation

     Stock-based compensation plans are accounted for using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion 25). In accordance with the intrinsic value method, compensation cost is measured as the excess, if any, of the quoted market price of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Stock-based compensation costs are recognized over the period in which employees render services associated with the awards.

     We adopted Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123), which permits entities to continue to apply the provisions of APB Opinion 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS 123, had been applied. Additionally, in December 2002, the Financial Accounting Standards Board

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

(FASB) issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure (SFAS 148). SFAS 148 amends SFAS 123, to provide alternative methods of transition to SFAS 123’s fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting (APB Opinion 28). We elected to continue to apply provisions of APB Opinion 25 and provide the pro forma disclosure required by SFAS 123 and the amended disclosures required by SFAS 148.

     The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123.

     Reclassifications

     Certain prior period amounts have been reclassified to conform to the current period presentation.

     New Accounting Pronouncements

     In March 2004, the Financial Accounting Standard Board’s Emerging Issues Task Force concluded its discussion of Issue No. 03-01, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF 03-01). EITF 03-01 provides accounting guidance regarding the determination of when an impairment (i.e., fair value is less than carrying value) of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in earnings.

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

EITF 03-01 also requires annual disclosures of certain quantitative and qualitative factors of debt and marketable equity securities classified as available-for-sale or held-to-maturity that are in an unrealized loss position at the balance sheet date, but for which an other-than-temporary impairment has not been recognized. The disclosure requirements of EITF 03-01 were effective December 31, 2003. The recognition and measurement guidance of EITF 03-01 was effective on July 1, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delayed the original effective date of the recognition and measurement guidance of EITF 03-01 until the FASB deliberates certain issues related to the implementation of EITF 03-01.

     In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options and sales inducements to contract holders. The effective date of SOP 03-1 is for fiscal years beginning after December 15, 2003, with earlier adoption encouraged. We adopted SOP 03-1 on January 1, 2004. The adoption of SOP 03-1 did not have a material impact on our consolidated results of operations, cash flows or financial position.

B. Debt

     On December 23, 2003, we entered into a new credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of the new $13.0 million term loan facility were used to pay-off the then existing term loan balance and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the Company. The early pay-off of the former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the new credit agreement of 1.0% is being amortized over the lives of the new term loans.

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

     The new credit facility consists of a $4.0 million term loan A with National City Bank with quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group has quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.

     Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.25%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 4.00%, respectively. At September 30, 2004, the interest rate on our term loan A balance of $3.2 million was 5.04% per annum and the interest rate on our term loan B balance of $8.1 million was 5.79% per annum.

     Our obligations under the new credit agreement are guaranteed by certain non-regulated subsidiaries of the Company and are secured by pledges of the capital stock of Central Reserve, Continental General, and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.

     The new credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At September 30, 2004, we were in compliance with these covenants.

     We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees primarily in connection with our major medical business. As that business continues to decline, fee income will decline. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its level of statutory unassigned surplus.

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

C. Reinsurance

     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. 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, and an “A” rated carrier by A.M. Best Company, Inc. 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. 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. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products, which are amortized over the expected profit stream of the in force business.

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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

     The following table summarizes the net impact of our reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, commissions, and other operating expenses: