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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, 1998 COMM. FILE NO. 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 NUMBER
INCORPORATION OR ORGANIZATION)
17800 Royalton Road, Strongsville, 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 Shares, par value $0.001 per share
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(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. [ ]
State the aggregate market value of the voting stock held by non-affiliates
of the Registrant. (The Registrant considers affiliates to be directors,
executive officers and those persons subject to the Voting and Stockholders'
Agreements.)
$28,494,220 computed based on the closing price of the Common Shares on
March 22, 1999.
The number of Common Shares, par value $0.001 per share, outstanding as of
March 22, 1999: 13,497,732.
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DOCUMENTS INCORPORATED BY REFERENCE:
Definitive Proxy Statement for the Annual Meeting of Shareholders to be held
June 10, 1999, into Part III, Items 10, 11, 12 and 13.
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CERES GROUP INC.
INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1998
PAGE
----
PART I
Item 1 Business.................................................... 1
Item 2 Properties.................................................. 10
Item 3 Legal Proceedings........................................... 11
Item 4 Submission of Matters to a Vote of Security Holders......... 11
Executive Officers of the Company.................................... 12
PART II
Item 5 Market for Registrant's Common Equity and Related
Shareholder Matters......................................... 13
Item 6 Selected Financial Data..................................... 14
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 15
Item 7A Quantitative and Qualitative Disclosures About Market
Risk........................................................ 24
Item 8 Financial Statements and Supplemental Data.................. 24
Schedule II -- Condensed Financial Information of
Registrant.................................................. 50
Schedule III -- Supplementary Insurance Information......... 53
Schedule IV -- Reinsurance.................................. 54
Item 9 Changes in and Disagreement with Accountants on Accounting
and Financial Disclosure.................................... 55
PART III
Item 10 Directors and Executive Officers of the Registrant.......... 55
Item 11 Executive Compensation...................................... 55
Item 12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 55
Item 13 Certain Relationships and Related Transactions.............. 55
PART IV
Item 14 Exhibits, Financial Statements, Financial Statement
Schedules, and Reports on Form 8-K.......................... 56
Signatures........................................................... 61
Index to Exhibits.................................................... 62
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PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
Ceres Group, Inc. (the "Company") formerly Central Reserve Life
Corporation, was incorporated in 1964 as Citation Life Insurance Company under
the laws of the State of Ohio. "Ceres Group, Inc." became the Company's name in
December 1998 following shareholder approval of the change of the Company's
state of incorporation from Ohio to Delaware through a merger of the Company
into a wholly-owned subsidiary. The Company is a holding company, which through
its subsidiaries, specializes in meeting the accident and health insurance needs
of individuals and small to mid-sized businesses and the health and life
insurance needs of Americans age 65 and older. In 1998, the Company's business
was conducted primarily through its then principal operating subsidiary, Central
Reserve Life Insurance Company ("Central"). Unless the context indicates
otherwise, the term "Company" as herein used will refer to Ceres Group, Inc. and
its subsidiaries.
Regulatory History. In 1996 and 1997, Central experienced substantial
losses incurred in connection with newly-issued health plans, greater
utilization than anticipated, new state mandates such as guaranteed issue and
preventative benefits and overall reductions in profitability arising out of
industry-wide pricing competition. At December 31, 1996, Central's statutory
capital levels were at an amount that subjected Central to mandatory examination
or analysis by the insurance commission of the State of Ohio and possible
required corrective action. In response to the losses and in order to provide a
financial plan to the Ohio Department of Insurance ("ODI") (mandated by the
decline in Central's capital and surplus), the Company retained Advest, Inc.
("Advest") in February 1997 as its financial advisor for the purpose of raising
equity capital and resolving Central's and the Company's financial concerns.
Following Advest's engagement, through June 1997, Advest and the Company
pursued a number of different financing alternatives, including a possible
rights offering and a private placement of equity securities, none of which came
to fruition. In June 1997, in order to address the continued decline in
Central's surplus, the Company borrowed $5.2 million from Huntington National
Bank, $5 million of which was contributed to the surplus of Central.
In December 1997, Central entered into a reinsurance treaty with
Reassurance Company of Hannover ("Hannover") in which Central transferred to
Hannover $24.6 million of reserve liability. In return for Hannover's assumption
of this liability, Central transferred $14.6 million in assets to Hannover. The
reinsurance treaty, which is on a 50/50 quota-share basis, provided Central with
a $10 million initial ceding allowance, which increased Central's statutory
surplus. The treaty was effective January 1, 1997 and accounted for as
retroactive reinsurance in Central's statutory financial statements. The
combination of the surplus note of $14 million (described below) and the $10
million ceding allowance provided an additional $24 million to the statutory
capital and surplus of Central increasing statutory levels in excess of
regulatory risk-based capital requirements and alleviating the regulatory
concerns that were created in 1996 and continued in 1997.
Equity Financing. To further resolve the regulatory problems that arose in
1996 and 1997, on March 30, 1998, the Company entered into an amended and
restated Stock Purchase Agreement, with Strategic Acquisition Partners, LLC
("Strategic Partners") and Insurance Partners, L.P. and Insurance Partners
Offshore (Bermuda), L.P. The March 30, 1998 agreement amended and restated an
agreement entered into on November 26, 1997 between the Company and Strategic
Partners. Following the receipt of shareholder approval, the transaction closed
on July 3, 1998, at which time the Company issued and sold 7,300,000 shares of
its common stock (the "Common Shares") at $5.50 per share and warrants to
purchase an additional 3,650,000 Common Shares at an exercise price of $5.50 per
share (the "Equity Warrants") for an aggregate purchase price of $40.2 million
(the "July Equity Financing").
Concurrent with the signing of the original agreement with Strategic
Partners in November 1997, Strategic Partners had arranged for an interim loan
(the "Bridge Loan") of $20.0 million to the Company.
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The proceeds of the Bridge Loan were used: (i) to repay $5.2 million to
Huntington National Bank, (ii) approximately $14.0 million to invest in the
surplus of Central, evidenced by a surplus note in favor of the Company (the
"$14.0 million Surplus Note"), (iii) approximately $0.8 million to establish an
interest reserve at the Company; and (iv) to pay transaction expenses. In
consideration for the arrangement of the Bridge Loan, the Company issued
warrants to purchase 800,000 Common Shares at $6.00 per share and an additional
200,000 Common Shares upon receipt of shareholder approval in July 1998 (the
"Guarantee Warrants"). The Bridge Loan was paid in full on July 3, 1998 in
connection with the closing of the July Equity Financing. The proceeds of the
July Equity Financing were used to: (i) pay off the Bridge Loan, plus interest,
(ii) pay related transaction expenses, such as legal, printing, accounting and
investment banking fees, and (iii) to make a $5.0 million contribution to the
surplus of Central. The remaining $13.0 million was used for working capital at
the Company. The July Equity Financing resulted in a change of control of the
Company.
Business Plan. In connection with the Bridge Loan obtained by Strategic
Partners for the Company, the Company's Board of Directors approved a
comprehensive business plan which was implemented beginning January 1, 1998, and
has been updated since then. The Company's business plan for future growth is
centered upon further development of its core competencies. These competencies
include the management of health care costs, consolidation of blocks of
business, capitalizing on acquired distribution systems, and the creation of
innovative specialty product lines.
Ceres Health Care, Inc., a wholly-owned subsidiary of the Company, was
established to provide the Company's insurance subsidiaries and acquired blocks
of business with their own proprietary managed care programs. By directly
controlling these activities, the Company expects to achieve greater efficiency,
increased cost savings, and more flexibility in adjusting programs to meet
product and profitability requirements. Some of the managed care programs
developed by Ceres Health Care include:
- Expanded Centers of Excellence programs for catastrophic medical care
- Specialized case management for special conditions such as neonatal care,
cancer and cardiovascular surgery
- Enhanced communication to members on how to maximize benefits for
medically necessary services
- Simplified administration of managed care provisions
- Expanded use of ancillary facility provider discount networks
The Company is positioned financially, organizationally, administratively,
and by its new management to take on a major role as a marketer and consolidator
in the health insurance industry. The Company expects to be an active acquirer
of other insurance companies and blocks of insurance business to increase its
size, efficiency and markets. The Company expects that the resulting
consolidation will streamline corporate functions and lower overall general
expense ratios. The Company may enter into reinsurance transactions with other
reinsurance companies to help accomplish some of the acquisitions. At this time,
the Company has an outstanding purchase agreement with United Benefit Managed
Care Corporation ("United Benefit") to acquire United Benefit Life Insurance
Company, a life and accident and health insurer in Texas ("UBL").
The Company's national distribution force is a key element for continued
growth. The Company plans to maximize the effectiveness and productivity of its
distribution systems through enhanced marketing support programs, expanded sales
activities, and increased product offerings. The Company has initiated a
National Seminar Program in which meetings are held across the nation to
introduce new products and services to both existing and newly-recruited agents.
As new companies and blocks of insurance business are acquired, the Company will
also focus on cross-selling opportunities. Agents will be encouraged to be
licensed by other subsidiaries of the Company in order to expand the portfolio
of products they will be able to offer to their clients.
The Company expects to meet the needs of its agents and customers through
ongoing product development as well as development of work-site marketing
programs. Supplemental products are being introduced that can be sold with or
after the basic plan sale is made to the customer. Such products include cancer
expense, accidental death and injury, critical illness, and dental coverage.
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The senior market has been selected as one of the Company's niches,
representing one of the fastest growing age segments in the country. With the
acquisition of Continental General Corporation and its wholly-owned subsidiary,
Continental General Insurance Company ("CGIC"), from Western and Southern Life
Insurance Company of Cincinnati, Ohio, the Company has accelerated its entrance
into this marketplace. A new series of senior plans are planned to be
introduced, including Medicare supplement, long-term care, home health care, and
senior life and annuities. The development of new products, in conjunction with
the Company's existing portfolio, will provide a broad selling opportunity for
our existing distribution force as well as newly-acquired or recruited agents.
Acquisition of United Benefit Life Insurance Company. On August 1, 1998,
Central entered into an agreement with UBL to reinsure 100% of the major medical
policies of UBL, covering approximately 100,000 lives with estimated annual
premiums of $100 million. Concurrently therewith, Central ceded 80% of the
business to Hannover, thereby assuming a net risk of 20%. Reserves for estimated
claims of $36.5 million were assumed by Central for which UBL transferred assets
of $16.5 million, net of a $20 million ceding allowance provided by Central. In
addition, reserve liabilities assumed by Central exceeded the cash transferred
to Central by UBL as reimbursement for this assumption by $3.0 million, which is
reflected in a note receivable. Central received a $20 million ceding allowance
from Hannover for the 80% thereby creating a zero effect on statutory surplus
regarding the allowances. The agreement also provides Central with access to
UBL's sales force. On March 18, 1999, Central announced the execution of an
agreement with United Benefit to purchase all of the outstanding shares of its
subsidiary, UBL. The agreement is subject to board of directors' approval and
approval by the shareholders of United Benefit, and is also subject to Central's
due diligence, as well as other customary terms and conditions. There is no
assurance that the transaction will be closed.
Acquisition of Provident American Life and Health Insurance Company. On
December 31, 1998, Central acquired Provident American Life and Health Insurance
Company ("PALHIC") from Provident American Corporation ("PAMCO") for $5.5
million in cash. PALHIC is a life and accident and health insurer that markets
managed care health insurance products to individuals and small businesses.
Funds for the acquisition were provided from Central's working capital. In
addition, Central, in conjunction with Hannover, assumed, through reinsurance,
all the individual and small group health insurance in force at December 31,
1998 of Provident Indemnity Life Insurance Company, a subsidiary of PAMCO, for
approximately $10 million. Central's portion of the reinsurance is 10% and
Hannover's is 90%. Central will also have an ongoing relationship with PAMCO and
its e-commerce subsidiary, HealthAxis.com. This provides the Company's insurance
subsidiaries their first entry into mass marketing of insurance products through
the Internet.
Acquisition of Continental General Corporation. On February 17, 1999, the
Company acquired CGIC for $84.5 million in cash. CGIC provides health and life
insurance products for the senior market, including long term care, Medicare
supplement, and senior life and annuity products, as well as major medical
plans. Funds for the acquisition of CGIC were provided as follows: $40 million
by a syndicate of banks arranged by Chase Securities Inc.; $15 million from
2,000,000 newly-issued Common Shares (together with the $40 million loan from
Chase, the "February 1999 Financing"); and the balance from cash available at
the Company. Concurrently with the closing, CGIC entered into a reinsurance
agreement with Hannover reinsuring 50% of all business in force at CGIC on
February 1, 1999 for a ceding allowance of $13 million.
CGIC had approximately $215 million in premiums in 1998 and at December 31,
1998 had approximately $400 million in assets and $37 million in statutory
capital and surplus. The administrative functions of CGIC are expected to remain
in Omaha, Nebraska and will be the base for the Company's senior market
operations.
Because of the July Equity Financing, the implementation of the Company's
new business plan, the reinsurance agreement with UBL and the acquisitions of
PALHIC and CGIC, the Company has undergone numerous changes since January 1,
1998. Although the acquisitions of PALHIC and CGIC had no impact on the
Company's results of operations in 1998, this Form 10-K includes information
with respect to the acquisitions, in addition to information regarding the
historical operations of Central. The Company believes
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this information regarding PALHIC and CGIC is necessary to enable investors to
understand the Company's business in 1999.
INSURANCE OPERATIONS.
Central. The Company owns 100% of Central, which was its principal
operating subsidiary at December 31, 1998. Central is an Ohio domiciled Life and
Accident and Health insurance company. Central was incorporated in 1963 and
commenced business in 1965. The Company acquired Central in 1973. As of December
31, 1998, Central was licensed to transact business in 36 states.
PALHIC. Central owns 100% of PALHIC. PALHIC is a Pennsylvania domiciled
Life and Accident and Health insurance company. PALHIC was incorporated in 1949
and acquired by Central on December 31, 1998. As of December 31, 1998, PALHIC
was licensed to transact business in 40 states and the District of Columbia.
CGIC. The Company owns 100% of CGIC. CGIC is a Nebraska domiciled Life and
Accident and Health insurance company. CGIC was incorporated in 1961 and
acquired by the Company on February 17, 1999. As of February 17, 1999, CGIC was
licensed to transact business in 49 states, the District of Columbia and the
U.S. Virgin Islands.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company's reporting segments organization comprises three segments:
group life and health; life insurance and annuities; and corporate and other,
which consists of primarily interest income and interest expense. FASB Statement
No. 131, Disclosurers for Derivative Instruments and Hedging Activities, now
requires disclosure of more information about operating segments. In 1998, the
Company expanded the detail of its disclosures for 1998, 1997 and 1996 which
also included certain reclassifications.
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The following tables present the revenues, expenses and profit (loss),
before federal income taxes, on a GAAP basis for the last three years
attributable to the Company's industry segments. The Company does not allocate
investment assets or other identifiable assets by industry segment.
1998 1997 1996
------------ ------------ ------------
Group Life and Health
Revenues:
Net Premiums............................... $160,201,806 $258,170,130 $257,495,315
Investment income.......................... 5,817,656 5,021,692 5,014,262
Other income............................... 1,696,690 -- --
------------ ------------ ------------
167,716,152 263,191,822 262,509,577
============ ============ ============
Expenses:
Benefits and claims........................ 114,181,891 208,933,873 202,074,527
Other operating expenses................... 52,762,598 73,589,360 70,960,571
------------ ------------ ------------
166,944,489 282,523,233 273,035,098
============ ============ ============
Segment profit (loss) before federal income
taxes...................................... $ 771,663 $(19,331,411) $(10,525,521)
============ ============ ============
Life and Annuity
Revenues:
Net premiums............................. $ 583,091 $ 689,177 $ 680,022
Investment income........................ 1,362,251 1,459,718 1,506,162
------------ ------------ ------------
1,945,342 2,148,895 2,186,184
============ ============ ============
Expenses:
Benefits and claims........................ 1,876,784 1,842,493 1,602,705
Other operating expenses................... 366,505 551,986 767,474
------------ ------------ ------------
2,243,289 2,394,479 2,370,179
============ ============ ============
Segment profit (loss) before federal income
taxes...................................... $ (297,947) $ (245,584) $ (183,995)
============ ============ ============
Corporate and Other
Revenues:
Investment income........................ $ 485,130 $ 192,605 $ 189,834
============ ============ ============
Expenses:
Interest and financing expenses............ 1,841,334 1,078,198 812,833
Other operating expenses................... 1,886,283 626,299 801,435
------------ ------------ ------------
3,727,617 1,704,497 1,614,268
============ ============ ============
Segment profit (loss) before federal income
taxes...................................... $ (3,242,487) $ (1,511,892) $ (1,424,434)
============ ============ ============
The Company does not separately allocate investment or other identifiable
assets by industry segment, nor are income tax (benefits) expenses allocated by
industry segment.
(c) NARRATIVE DESCRIPTION OF BUSINESS
The operational aspects of the Company's business at December 31, 1998 were
in Central.
CENTRAL
(1) BUSINESS AND PRINCIPAL PRODUCTS
Products
Central specializes in meeting the accident and health insurance needs of
small businesses and individuals by offering major medical insurance plans for
small employer groups and individuals, employer partially self-funded plans,
employer stop/loss plans, short-term major medical, and various supplemental
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health insurance plans, such as critical illness, cancer coverage, accident
disability, accidental death and dental.
Central's principal product is group accident and health insurance, which
accounted for about 95% of its premiums in 1998.
The health insurance products offered by Central include programs designed
to manage the cost of health care, in order to keep insureds' premiums at
affordable levels and out-of-pocket expenses as low as possible. These managed
care programs include: pre-certification of care to move high-cost/high-risk
insureds into case management; specialized case management for critical
conditions such as neonatal care, cancer and cardiovascular surgery; utilization
management; maintaining standards of usual and customary charge levels; use of
medical appropriateness protocols; use of ancillary facility discount programs;
and product design for steerage to preferred provider organizations (PPOs).
Central's PPO networks include hospitals and physicians across the nation
which have agreed to provide medical services at discounted rates. In certain
areas, Central also utilizes secondary networks to increase the total discounts
available.
In addition to these provider networks, Central utilizes a Centers of
Excellence network which provides insureds access to transplant and other
necessary high-risk procedures at renowned medical institutions. These selected
facilities have the staff, the experience and the volume of patients to produce
higher recovery rates while offering discounted rates. The purpose of the
program is to provide quality care and improved treatment outcomes in a more
cost-efficient manner.
Through its association with the nation's largest pharmacy benefits
manager, Central also provides its insureds discounts on drug prescription
purchases at over 50,000 participating pharmacies and through mail-order
services.
In 1998, Central established a Benefit Design Department, a new customer
service function which concentrates on retaining more insureds during renewal
periods. The department uses a proactive approach in offering alternatives to
premium rate increases, such as adjustments to deductible levels, coinsurance
amounts and other benefit changes.
Through Central's websites, insureds can communicate directly with the
company and request information or policy and benefit changes.
Marketing
Central's products are marketed through managing general agents throughout
the nation. Regional sales directors are responsible for recruiting managing
general agents and general agents and training them in the benefits,
underwriting requirements and general conditions under which Central's insurance
plan operate.
Central supports its agents through product sales brochures, new product
development, lead generation programs, a national advertising program and
cross-selling opportunities. In addition, Central's national seminar program
assists in recruiting and training new agents and in introducing new products to
existing agents. Regular agent communication includes a monthly newsletter,
commission inserts, special announcements to managing general agents, and access
to the company via the Internet and e-mail.
(2) INSURANCE VOLUME, POLICIES AND CERTIFICATES
Although insurance volume (amount of life insurance) is generally a guide
to statistical information for most insurance companies, policies and
certificates in force are a more informative statistic for Central because of
the large percent of business generated in the group accident and health area.
Central requires each insured to carry group life insurance, but the average
requirement is only $10,000. Accordingly, it is more informative to focus on the
number of certificates in force as opposed to volume of insurance.
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Following are tables reflecting statistical information on Central's
business.
1998 1997 1996
-------------- -------------- --------------
LIFE INSURANCE VOLUME:
Insurance Written......................... $ 582,149,000 $ 496,653,000 $ 458,000,000
In force.................................. $1,239,853,000 $1,192,280,000 $1,293,673,000
Reinsured................................. $ 88,477,000 $ 95,249,000 $ 80,895,000
GROUP POLICIES:
Beginning of Year......................... 40,448 43,542 41,884
Issued during Year........................ 25,629 21,170 19,732
Terminations.............................. (21,415) (24,264) (18,074)
-------------- -------------- --------------
End of Year............................... 44,662 40,448 43,542
============== ============== ==============
GROUP CERTIFICATES:
Beginning of Year......................... 104,687 116,304 113,720
Issued during Year (new).................. 35,178 30,377 36,574
Terminations (net of additions)........... (35,871) (41,994) (33,990)
-------------- -------------- --------------
End of Year............................... 103,994 104,687 116,304
============== ============== ==============
(3) GEOGRAPHIC DISTRIBUTION
The geographic distribution of direct premiums and annuity considerations
received (before reinsurance) by Central during 1998 is as follows:
STATE AMOUNT PERCENT OF TOTAL
----- ------ ----------------
Ohio............................................ $ 80,854,002 30.2%
Indiana......................................... 36,556,311 13.6
North Carolina.................................. 20,599,562 7.7
Arizona......................................... 15,077,048 5.6
Tennessee....................................... 13,980,354 5.2
South Carolina.................................. 13,628,793 5.1
Missouri........................................ 13,475,976 4.7
Kansas.......................................... 13,079,413 4.9
Michigan........................................ 12,678,939 4.7
Alabama......................................... 9,845,228 3.7
Virginia........................................ 9,779,842 3.6
Pennsylvania.................................... 9,744,715 3.6
West Virginia................................... 8,952,516 3.3
Colorado........................................ 5,731,896 2.1
Other........................................... 4,153,266 2.0
------------ -----
Total................................. $268,137,861 100.0%
============ =====
(4) AGENTS
Central's insurance policies are sold by licensed agents and general agents
(brokers). Regional Sales Managers service the brokers. Central does not have
agents who sell exclusively for it. The licensed agents and brokers who produce
insurance business for Central generally have affiliations with and serve in a
similar capacity for one or more other companies which may be competitive with
Central, and a portion of their business may be written by such other companies.
Such agents and brokers are compensated by Central for business produced by them
on a cash commission basis at rates which are believed to be competitive with
those of other life insurance companies.
As of December 31, 1998, Central had 105 brokers/general agents and 14,769
agents licensed.
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In August, Central began an agency agreement with the sales force of
Insurance Advisors of America, Inc. ("IAA"), an insurance agency subsidiary of
United Benefit which primarily markets products of UBL, another United Benefit
Subsidiary. Central acquired through reinsurance all of the health insurance
business of UBL. In order to maintain and grow this block of business, Central
enhanced the product portfolio and marketing programs for IAA, the UBL sales
organization. The agency agreement bolsters the Company's sales force in the
Southwest and Southeast.
(5) INVESTMENTS
An important earnings factor for Central, as well as all insurance
companies, is the income from its investment portfolio. The investment
objectives for insurance companies are to maximize yields, preserve principal
and maintain liquidity. Investments must comply with the insurance laws of the
state of domicile. These laws prescribe the kind, quality and concentration of
investments which may be made. Due to the restrictive nature of these laws,
there may be occasions when Central may be precluded from making certain
otherwise attractive investments. As of December 31, 1998, 100% of Central's
fixed maturities was of investment grade quality. Central and the Company do not
invest in "junk" bonds or derivatives such as futures, forwards, swaps, and
option contracts, and other financial instruments with similar characteristics
and substantially all its investments are in fixed maturities. However, Central
does invest in mortgage-backed securities some of which are collateralized
mortgage obligations (CMOs). These investments, besides having a credit risk,
also have the risk of prepayment, during a decline in interest rates, and the
risk of extension during a rise in interest rates. Central constantly monitors
these securities and has reduced its exposure in CMOs from $24.7 million in 1997
to $18.2 million in 1998. The proceeds were primarily invested in corporate
bonds.
(6) RESERVES
Central is required by the insurance laws of the states in which it is
licensed to set up statutory reserves to meet policy obligations on its ordinary
life policies. These reserves are amounts which, with additions from premiums to
be received and with interest on such reserves compounded annually at certain
assumed rates, are calculated to be sufficient to meet policy obligations as
they mature. The various actuarial factors are determined from mortality tables
and interest rates in effect when the policy is issued. The ordinary life
policies currently issued by Central are valued on the Commissioners' Standard
Ordinary Table of Mortality of 1980 under the Commissioners' Reserve Valuation
Method and the Net Level Premium Method. The guaranteed interest rate on
policies currently being issued is 4.5%. On policies issued previously to the
current series, guaranteed interest rates were as specified in the various
policies and range from 2.5% to 6%. Under the Commissioners' Reserve Valuation
Method, the amount of reserve provided in the first policy year is less than
under the Net Level Premium Method, but in subsequent years greater additions to
reserves are required. To the extent that the rate of income realized on
investments is greater or less than the assumed interest rate used in the
calculation of reserves, reported earnings are increased or decreased, as the
case may be.
The majority of Central's reserves and liabilities for claims, however, are
for its group accident and health business. Statutory and regulatory
requirements are generally less explicit for health insurance reserves and
liabilities than for ordinary life insurance. For its group accident and health
business Central establishes an Active Life Reserve plus a liability for due and
unpaid claims, claims in course of settlement, and incurred but unreported
claims as well as a reserve for the present value of amounts not yet due on
claims. These reserves and liabilities are dependent upon many factors, such as
economic and social conditions, inflation (overall and hospital costs
specifically), changes in doctrines of legal liability and damage awards for
pain and suffering. Therefore, the reserves and liabilities established are
necessarily based on extensive estimates and prior years' statistics. A
consulting actuary is retained by Central to assist in the estimation process
and to certify to the statutory reserves.
(7) REINSURANCE
As is customary among many insurance companies, Central reinsures portions
of the life insurance policies it writes, thereby providing a greater
diversification of risk and minimizing Central's exposure on
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major risks. While the effect of reinsurance is to lessen risks to the writing
company, it may also lower income. Although the ceding of reinsurance does not
discharge the original insurer from its primary liability to its policyholder,
the insurance company that assumes the coverage assumes the related liability
and becomes the ultimate source of payment. The maximum amount of exposure that
Central retains on any life is $50,000 on ordinary life and group life. No
retention is maintained over age 70. Maximum retention on impaired risks is
$10,000. Central also has reinsurance on group accident and health claims.
Effective January 1, 1995, Central's reinsurance treaty provides that all
individual claims in excess of $500,000 are 100% reinsured.
In addition to the $500,000 excess reinsurance, Central also entered into a
retroactive reinsurance treaty in December 1997 with Hannover. The reinsurance
was effective January 1, 1997 and is on a 50/50 quota-share basis on certain
group accident and health policies in force and written during 1997. The treaty
provided an initial ceding allowance of $10 million which was accounted for as a
deferred reinsurance gain in the consolidated financial statements and accounted
for as special surplus on a statutory basis. The ceding allowance will be
amortized over approximately five years, the estimated settlement period of the
reinsured business. The Hannover treaty provides for repayment of the $10
million ceding allowance plus 10% interest, out of the statutory profits, if
any, of the reinsured business. Once the ceding allowance is paid back the
quota-share will change to 60/40, with Central retaining the 60%. The more
significant provisions of the Hannover treaty are: (i) no scheduled partial or
total recapture; (ii) no recapture after 24 months; (iii) experience refund
provisions allow offsetting against current and prior year losses; and (iv)
Central is not obligated to pay for negative experience amounts in the case of
termination due to expiration of in force policies or if termination is
triggered by action or inaction of Hannover.
Effective August 1, 1998, Central entered into a reinsurance treaty with
UBL, a life and accident and health insurer in Texas. Under the terms of the
treaty, Central agreed to assume 100% of UBL's book of business, until such time
as profits earned by Central on the assumed block reach a contractual threshold,
which approximates $20.0 million of pretax income. Upon reaching this threshold,
the quota share percentage is reduced from 100% to 80%, until a second
threshold, which approximates $16.0 million in pretax income, is reached. Upon
reaching the second threshold, the quota share percentage is further reduced
from 80% to 50%. In a separate agreement, IAA agreed to market UBL and Central
policies exclusively. Central paid to UBL a $20.0 million ceding allowance in
connection with this transaction.
In connection with the UBL reinsurance treaty, Central ceded 80% of the
assumed UBL book of business to Hannover. This treaty provided Central an
initial ceding allowance of $20.0 million, which is being accounted for as a
deferred reinsurance gain in the accompanying consolidated financial statements.
Reinsurance treaties in effect at December 31, 1998 were with Reliastar Life,
The Cologne Life Reinsurance Company, Life ReAssurance Corporation of America,
Business Men's Assurance Company and Reassurance Company of Hannover.
(8) REGULATION
The Company's insurance subsidiaries, in common with other insurance
companies operating in the states in which they are licensed, are subject to
regulation and supervision by state insurance regulatory agencies. 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, maintenance of adequate
reserves, form and content of financial statements, types of investments
permitted, issuance and sale of stock and other matters pertaining to insurance.
The insurance companies are required to file detailed annual statements with the
respective state regulatory bodies and are subject to periodic examination by
the regulators. The most recent regulatory examination for Central was performed
as of December 31, 1995, and for PALHIC and CGIC the examinations were performed
as of December 31, 1997.
Many states have also enacted insurance holding company laws which require
registration and periodic reporting by insurance companies controlled by other
corporations. Such laws vary from state to state but typically require periodic
disclosure concerning the corporation which controls the controlled insurer and
prior notice to, or approval by, the applicable regulator of intercorporate
transfers of assets and other transactions (including payments of dividends in
excess of specified amounts by the controlled insurer) within the holding
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company system. Such laws often also require the prior approval for the
acquisition of a significant ownership interest (e.g., 10% or more) in the
insurance holding company. The Company's insurance subsidiaries are subject to
such laws and the Company believes they are in compliance in all material
respects with all applicable insurance holding company laws and regulations.
(9) COMPETITION
The insurance business is highly competitive. There are over 1,600 legal
reserve life insurance companies in the United States. Many of these have been
in business for long periods of time, and have substantially greater financial
resources, larger selling organizations and broader diversification of risks
than the Company's insurance subsidiaries. Many of these companies are mutual
companies, whose earnings inure to the benefit of their policyholders. Central's
and PALHIC's principal marketing is in rural areas where they compete with
regional insurance companies. In other areas their PPO products compete with the
larger insurance companies. However, the Company believes that the policies and
premium rates of Central are generally competitive with those offered by other
companies selling similar types of insurance in Ohio.
(10) EMPLOYEES
The Company had approximately 1,000 employees under management at March 22,
1999. The Company considers its employee relations to be good. The dedicated
agents of the Company are independent contractors and not employees of the
Company.
PALHIC
PALHIC specializes in marketing managed care health insurance products to
individuals and small businesses in 40 states, through a distribution system of
27,000 agents. The majority of its business is derived from group association
major medical products sold to individuals. A smaller portion of its business is
derived from traditional life (whole life and limited pay) products. Agents of
PALHIC will be provided with Central products as well, including Central's small
and large group health line, specialty health insurance products, in addition to
CGIC's senior health and life insurance product lines. Through PAMCO and
Internet marketing subsidiary, HealthAxis.com, the Company will have the ability
to offer direct on-line health insurance products through the Internet. In
addition, Central, in conjunction with Hannover, assumed, through reinsurance,
all the individual and small group health insurance in force at December 31,
1998 of Provident Indemnity Life Insurance Company, a subsidiary of PAMCO, for
approximately $10 million. Central's portion of the reinsurance is 10% and
Hannover's is 90%.
CGIC
CGIC, acquired in February 1999, provides health and life insurance
products for the senior market. These products are sold through a distribution
system of 30,000 agents throughout 49 states. CGIC's Omaha facility will be the
base for all of the senior market operations of the Company. CGIC plans to
significantly expand its senior product line by introducing a completely revised
portfolio of senior products, including Medicare supplement, long-term care,
home health care, and senior life and annuity products. In addition, a new line
of major medical and small group health products will be developed for CGIC's
distribution system. These products will also be made available to all of the
Company's distribution force.
(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS
The Company has no foreign operations. Its domestic operations during 1998
were primarily in Ohio.
ITEM 2. PROPERTIES
The Company owns a building in Strongsville, Ohio, which consists of
121,625 square feet and is occupied by Central. At December 31, 1998, the
outstanding principal balance of the mortgage note on the building was
approximately $8.3 million. PALHIC leases space in Norristown, Pennsylvania of
approximately 20,000 square feet. CGIC owns and occupies a building in Omaha,
Nebraska which consists of approximately 61,400 square feet.
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ITEM 3. LEGAL PROCEEDINGS
Other than ordinary routine litigation incidental to the business, and the
matter regarding Federal income taxes reflected in Note G to the consolidated
financial statements, neither the Company nor any of its subsidiaries is party
to any material pending legal proceeding nor is any of their property the
subject thereof.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) A Special Meeting of Shareholders in lieu of the Annual Meeting of
Shareholders was held on December 7, 1998.
b) Proxies were solicited for the election of directors by the Company's
management pursuant to Regulation 14A under the Securities Exchange Act of 1934.
No solicitation in opposition to management's nominees as listed in the proxy
statement was made. All of management's nominees were elected to hold office
until the next annual election of directors and until their successors are
elected and qualified pursuant to the vote of the stockholders.
c) The matters voted upon were the following:
1. With respect to the election of nine directors to serve until the
next annual election of directors and until their successors are elected
and qualified.
NAME FOR
---- ---
Andrew A. Boemi 10,578,053
Michael A. Cavataio 10,578,053
Bradley E. Cooper 10,576,628
Fred Lick, Jr. 10,560,236
Peter W. Nauert 10,579,053
John F. Novatney, Jr. 10,573,065
Richard M. Osborne 10,577,053
Robert A. Spass 10,576,853
Mark H. Tabak 10,577,355
2. With respect to the proposal which provided, among other things,
for the change of the Company's state of incorporation from Ohio to
Delaware through a merger of the Company into Ceres Group, Inc., a Delaware
corporation and a wholly-owned subsidiary of the Company, and for the
change of the Company's name to "Ceres Group, Inc." in the merger, and for
related changes to the Company's organizational documents.
For 9,745,472
Against 24,117
Withheld 49,293
The total number of shares of the Company's Common Shares, no par
value, outstanding as of the November 2, 1998 record date for the Special
Meeting was 11,495,172.
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EXECUTIVE OFFICERS OF THE COMPANY
Pursuant to Instruction 3 to Item 401(b) of Regulation S-K, the current
executive officers of the Company are as follows:
NAME AGE POSITION
---- --- --------
Fred Lick, Jr. 67 Chairman of the Board and Director
Peter W. Nauert 55 President, Chief Executive Officer and
Director
Glen A. Laffoon 59 Executive Vice President and
Assistant Secretary
Val Rajic 39 Executive Vice President and Treasurer
Charles E. Miller, Jr. 48 Executive Vice President and
Chief Financial Officer
The current one year terms of office of the executive officers listed above
began December 7, 1998, with their election to office by the Board of Directors
at its meeting following the special meeting of shareholders held on such date.
There are no arrangements or understandings known to the Company between any
executive officer and any other person pursuant to which any officer was elected
to office. There is no family relationship between any director or executive
officer and any other director or executive officer of the Company.
MR. LICK has served as an officer since 1974 and a director since 1976. He
is currently the Chairman of the Company and Chairman of Central. Prior to July
3, 1998, Mr. Lick was also President and Chief Executive Officer of the Company
and of Central.
MR. NAUERT has served as President and Chief Executive Officer of the
Company since July 3, 1998. Mr. Nauert is also the principal investor in
Strategic Partners and is Principal of Geneva Consolidated, Inc., a company
providing consulting services to small group and life insurance companies. Mr.
Nauert served as President of Pioneer Financial Services from 1982 to 1988 and
1991 to 1995, and served as Chairman from 1988 to 1997. Mr. Nauert had been
employed in an executive capacity by one or more of the insurance subsidiaries
of Pioneer Financial Services from 1968 to 1997.
MR. LAFFOON has served as an officer of the Company since 1991 and an
officer of Central since 1974 and has held various positions in both companies.
Since July 1998, he has served as Executive Vice President of the Company, since
December 1998, he has also served as Assistant Secretary of the Company, and
since June 1998, has served as President and Chief Executive Officer of Central.
MR. RAJIC has served as an officer of the Company since December 1997 and
was a director and acting Chief Operating Officer of the Company from December
1997 to June 1998. Since June 1998, he has held the position of Executive Vice
President of the Company, and since December 1998, he has also served as
Treasurer of the Company. Mr. Rajic has served as President of Strategic
Partners since 1997. From 1993 to 1997, Mr. Rajic held various positions,
including Senior Vice President, at Pioneer Financial Services. Prior to 1993,
Mr. Rajic held various positions at American National Bank and Trust Company of
Chicago, a leading, middle-market business, bank.
MR. MILLER has served as an officer of the Company since October 1998. He
holds the positions of Executive Vice President and Chief Financial Officer of
the Company. From 1996 to 1998, Mr. Miller served as a principal and President
of Wellington Partners, Inc., an insurance acquisition company. Mr. Miller was
also a consultant to IP Delaware. Prior to 1996, Mr. Miller was Executive Vice
President, Chief Financial Officer and a director of Harcourt General Insurance
Companies.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
(a) The Company's Common Shares are traded on the Nasdaq National Market
tier of The Nasdaq Stock Market(SM) under the symbol CERG since December 1998
and under the symbol CRLC prior to that. The following table shows the
representative high and low closing prices of the Common Shares for the calendar
quarters indicated. These prices were taken from the Nasdaq Monthly Statistical
Reports.
HIGH LOW DIVIDENDS
---- --- ---------
1997
First Quarter................... $ 8 1/4 $ 4 1/8 $ -0-
Second Quarter.................. 7 5/8 3 7/8 -0-
Third Quarter................... 7 1/8 5 1/2 -0-
Fourth Quarter.................. 7 4 1/2 -0-
1998
First Quarter................... $ 8 1/2 $ 4 13/16 $ -0-
Second Quarter.................. 8 1/8 6 3/8 -0-
Third Quarter................... 9 5 13/16 -0-
Fourth Quarter.................. 11 3/8 6 3/4 -0-
(b) As of March 22, 1999, there were 1,730 record holders of the Common
Shares.
(c) No cash dividends were paid by the Company in the past two years as
indicated in the table above. In 1998, the Company's primary source of income,
other than a nominal amount of investment income, was rent from Central. Central
is subject to certain restrictions which are contained in the Insurance Holding
Company statute (Ohio Revised Code 3901.34) which prevent Central from paying
the Company, without the approval of the Ohio Superintendent of Insurance, any
dividend from other than earned surplus (as defined in the statute) or any
dividend whose value, together with the value of other dividends paid or
distributions made within the preceding 12 months, exceeds the greater of (i)
10% of Central's surplus as regards policyholders as of December 31 next
preceding the dividend payment, or (ii) the net income of Central for the
12-month period ended the December 31 next preceding the dividend payment. At
December 31, 1998, Central had $30,418,544 of statutory capital and surplus, and
earned surplus of $1,056,434. PALHIC and CGIC are also subject to certain
similar restrictions which will effect the Company in 1999 and future years. In
addition, the Company's Credit Agreement with The Chase Manhattan Bank, dated
February 17, 1999, contains financial and other covenants with respect to the
Company that, among other matters, prohibits the payment of cash dividends on
the Common Shares, except upon compliance with certain conditions.
(d) On June 26, 1998, the shareholders of the Company approved an equity
financing transaction pursuant to which 7,300,000 Common Shares were issued and
Equity Warrants to acquire up to 3,650,000 Common Shares at an exercise price of
$5.50 per share, for an aggregate consideration of $40.2 million to a group of
credited investors.
The transaction closed on July 3, 1998 and the proceeds were used to pay
off the Bridge Loan, plus interest, pay related transaction expenses, such as
legal, printing, accounting and investment banking fees, and make a $5 million
contribution to the surplus of Central. The remaining $13.0 million was used for
working capital at the Company.
The Common Shares and Equity Warrants were exempt from registration in
accordance with Section 4(2) of the Securities Act of 1933, as amended, and
exemptions available under applicable state securities laws.
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ITEM 6. SELECTED FINANCIAL DATA
1998 1997 1996 1995 1994
------------ ------------ ------------ ------------ ------------
FOR THE YEAR:
Premiums (net of
reinsurance)................ $160,784,897 $258,859,307 $258,175,337 $233,168,529 $223,679,071
Net Investment Income......... 7,454,180 6,527,537 6,700,741 6,454,038 6,515,927
Net realized gains (losses)... 210,857 146,478 9,517 149,527 (23,024)
Other Income.................. 1,096,690 -- -- 37,000 29,237
Amortization of deferred
reinsurance gain............ 600,000 -- -- -- --
------------ ------------ ------------ ------------ ------------
Total Revenues................ $170,146,624 $265,533,322 $264,885,595 $239,809,094 $230,201,211
============ ============ ============ ============ ============
Income (Loss) before Federal
Income Taxes................ $ (2,768,771) $(21,088,887) $(12,133,950) $ 5,947,225 $ 6,872,989
Federal Income Tax Expense
(Benefit)................... 1,066,888 (132,531) (2,845,585) 1,442,618 2,059,228
------------ ------------ ------------ ------------ ------------
Net Income (Loss)............. $ (3,835,659) $(20,956,356) $ (9,288,365) $ 4,504,607 $ 4,813,761
============ ============ ============ ============ ============
Basic earnings (loss) per
share....................... $ (.49) $ (5.01) $ (2.29) $ 1.12 $ 1.20
Diluted earnings (loss) per
share....................... $ (.49)(1) $ (5.01)(1) $ (2.29)(1) $ 1.07 $ 1.14
Cash dividends per share...... -- -- $ .52 $ .48 $ .44
AT YEAR END:
Investments................... $ 89,826,188 $ 79,956,724 $ 79,613,508 $ 81,933,496 $ 80,979,411
Total Assets.................. $180,233,135 $135,803,577 $119,388,697 $117,329,039 $107,944,158
Mortgage Note Payable......... $ 8,283,884 $ 8,399,028 $ 8,503,776 $ 8,599,067 $ 8,685,754
Note Payable.................. -- $ 20,000,000 -- -- --
Future Policy Benefits and
Claims Payable.............. $ 97,113,067 $ 81,090,299 $ 76,650,884 $ 65,317,522 $ 62,716,877
Retained Earnings (Accumulated
Deficit).................... $ (9,154,986) $ (5,319,327) $ 15,637,029 $ 27,030,102 $ 24,463,447
Shareholders' Equity.......... $ 35,835,714 $ 1,511,842 $ 21,467,797 $ 33,300,980 $ 24,530,732
Equity Per Share:
After accumulated other
comprehensive income
(loss).................... $3.12 $ .36 $5.18 $8.25 $6.08
Before accumulated other
comprehensive income
(loss).................... $3.02 $ .21 $5.24 $8.06 $7.42
- ---------------
(1) No incremental shares related to options/warrants are included due to the
loss for the year.
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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 may contain forward-looking statements that
are provided to assist in the understanding of anticipated future financial
performance. However, such 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."
GENERAL
The Company is a holding company, which through its subsidiaries,
specializes in meeting the accident and health insurance needs of individuals
and small to mid-sized businesses and the health and life insurance needs of
Americans age 65 and older. In 1998, 1997 and 1996 the Company's business was
conducted primarily through its then principal operating subsidiary, Central.
In 1996 and 1997, Central experienced substantial losses incurred in
connection with newly-issued health plans, greater utilization than anticipated,
new state and federal mandates such as guaranteed issue and preventative
benefits and overall reductions in profitability arising out of industry-wide
pricing competition. In June 1997, in order to address the continued decline in
Central's surplus, the Company borrowed $5.2 million from Huntington National
Bank, $5 million of which was contributed to the surplus of Central.
In December 1997, Central entered into a reinsurance treaty with Hannover
in which Central transferred to Hannover $24.6 million of reserve liability. In
return for Hannover's assumption of this liability, Central transferred $14.6
million in assets to Hannover. The reinsurance treaty, which is on a 50/50
quota-share basis, provided Central with a $10 million initial ceding allowance,
which increased Central's statutory surplus. The combination of the $14.0
million Surplus Note which was invested in connection with the Bridge Loan and
the $10 million ceding allowance provided an additional $24 million to the
statutory capital and surplus of Central, increasing statutory levels in excess
of regulatory risk-based capital requirements and alleviating the regulatory
concerns that were created in 1996 and continued in 1997.
Since January 1, 1998, the Company (1) began a new business plan designed
to increase premium rates, reduce costs and emphasize acquisitions; (2)
completed the July Equity Financing, in which the Company issued and sold
7,300,000 Common Shares at $5.50 per share and Equity Warrants to purchase an
additional 3,650,000 Common Shares at an exercise price of $5.50 per share for
an aggregate purchase price of approximately $40.2 million; (3) entered into an
agreement with UBL in August 1998 to reinsure 100% of the major medical policies
of UBL, covering approximately 100,000 lives with estimated annual premiums of
$100 million; (4) acquired PALHIC from PAMCO on December 31, 1998 for $5.5
million in cash; (5) acquired CGIC, from Western and Southern Life Insurance
Company of Cincinnati, Ohio, on February 17, 1999 for $84.5 million in cash; (6)
completed the February 1999 Financing; and (7) announced, on March 18, 1999, the
execution of an agreement with United Benefit to purchase all of the outstanding
shares of its subsidiary, UBL, subject to board of directors' approval and
approval by the shareholders of United Benefit, and to Central's due diligence,
as well as other customary terms and conditions.
Because of the implementation of the Company's new business plan, the July
Equity Financing, the February 1999 Financing, the reinsurance agreement with
UBL and the acquisitions of PALHIC and CGIC, the Company has undergone numerous
changes since January 1, 1998. The acquisitions of PALHIC and CGIC had no impact
on the Company's results of operations in 1998, and are therefore not reflected
in the "Results of Operations" discussion below. The Company believes that these
acquisitions will have a material positive impact on the Company's results in
1999.
RESULTS OF OPERATIONS
1998 compared to 1997
Premiums, before reinsurance, in 1998 increased 1% to $264,868,186 from
$262,161,343 in 1997. The group life and health segment accounted for 99% of the
premiums in 1998 and 1997. The group certificates in
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force decreased slightly to 103,994 at the end of 1998 compared to 104,687 at
the end of 1997. Certificates issued for new group policies were 35,178 in 1998,
up 16% from 30,377 in 1997. Total lapses (net of additions/ decreases) in 1998
were 35,871, down 15% from 41,994 in 1997. The increase in new certificates
issued in 1998 was related to the infusion of capital into Central, improving
the Risk-Based Capital levels above regulatory actions levels in 1997, making
Central's marketing position stronger. The larger number of lapses in 1997 was
primarily due to a conversion program of older products into newer products, in
several states, along with rate increases for all renewal policies.
Reinsurance assumed represents Central's 100% portion of a block of group
health business under a reinsurance agreement entered into in August of 1998
with UBL. The reinsurance ceded amount represents 80% of the above-mentioned
block (Central's final retention is 20%) plus 50% of Central's group health
business in force at December 31, 1997.
Net investment income increased to $7,454,180, or 14%, in 1998 from
$6,527,537 in 1997. The primary reason for the increase was the interest earned
on funds received from the July Equity Financing.
Other income for 1998 was $1,096,690, which consisted of fees for Central
servicing the reinsurance assumed. The amortization of deferred reinsurance gain
represents Central's portion of the $20 million ceding commission paid by
Hannover for the UBL block of group health policies in August 1998.
The benefits, claims, losses and settlement expenses of $116,058,675 for
1998 is 72% of net premiums compared to $210,776,366, or 81%, for 1997. The
decrease in 1998 was due to the Central reinsurance agreements. The lower loss
ratio of 72% is a combination of reinsurance ceded, rate renewal actions, and
managed care programs and benefits changes.
Underwriting, acquisition and insurance expenses, in total, were lower in
1998 compared to 1997 because of the reinsurance allowances as indicated in Note
I to the consolidated financial statements. Before reinsurance expenses and
allowances, commissions were $36,853,066, up 4% from $35,525,925 in 1997
primarily due to an increase in new business and commission rates; salaries and
benefits in 1998 were $15,717,718, down 13% from $18,112,730 in 1997 due to the
reduction in staff during the first half of the year and the discontinuance of
Central's contribution to the pension plan. Other operating expense increased to
$22,450,200, up 52% from $14,758,817 in 1997. The major reason for the increase
was the cost of outsourcing the Company's computer operations for approximately
$5.0 million, including Year 2000 costs, a provision of approximately $1.5
million taken in connection with a UBL note receivable, and a $1.5 million
expense related to a fraud committed in connection with claims administration at
the UBL facility.
The $647,271 amortization of deferred acquisition costs in 1998 is
primarily the amortization of Central's portion of the ceding commission paid
for the UBL block of group health policies.
Interest expense and financing costs increased to $1,841,334, or 71%, from
$1,078,198 in 1997. The increase was due primarily to the increase in interest
from the $20 million Bridge Loan incurred in December 1997. The Bridge Loan was
paid in full in July 1998 from the July Equity Financing.
The net loss for 1998 was $3,835,659, or $.49 per share, compared to a net
loss of $20,956,356, or $5.01 per share, for 1997. The Company's revenues,
before reinsurance, increased approximately $5,000,000. Although benefits,
losses and expenses were reduced as a result of the reinsurance agreements,
Central implemented certain policy benefit and managed care changes along with
premium rate increases.
Although the Company reported a loss for 1998, a provision for federal
income taxes of $1,066,888 was required principally due to the tax treatment
related to the reinsurance transactions effective in 1998. For further
information concerning the provision for income taxes, as well as information
regarding differences between effective tax rates and statutory tax rates, see
Note G of the Notes to Consolidated Financial Statements.
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RESULTS OF OPERATIONS:
1997 compared to 1996
In 1997 premiums, before reinsurance, increased slightly to $262,161,343
from $260,076,097. The group life and health segment accounted for 99% of the
premiums in 1997. The group certificates in force decreased about 10% to 104,687
in 1997 compared to 116,304 at the end of 1996. Certificates issued for new
group policies were 30,377 in 1997, down 17% from 36,574 in 1996. Total lapses
(net of additions/decreases) in 1997 were 41,994, up 24% from 33,990 in 1996.
Overall the major reason for the flat growth in premiums, decrease in
certificates and increase in lapses can be attributed to the financial condition
of Central in 1997 and 1996. The large losses and related decrease in statutory
surplus discouraged new business and required large rate increases. Although
unprofitable business did terminate, it terminated faster than new profitable
business was being issued. The lowering of Central's A.M. Best rating, to B from
B+, also had a negative effect on the sale of ordinary life and annuity policies
during 1997.
Net investment income decreased about 2% to $6,527,537 in 1997 from
$6,700,741 in 1996. A decrease in invested assets and a negative cash flow in
1997 were the primary reasons for the decrease.
Benefits and claims incurred expenses increased 3% in 1997 to $210,776,366
in 1997 from $203,677,232 in 1996. The incurred loss ratio was 81.4% for 1997
compared to 78.9% for 1996. The major reasons for the increase in the claims
loss ratio and the level of claims incurred were (a) the continued effect of an
underpriced product sold heavily in 1995, (b) a larger number of unexpected and
unanticipated prior year claims (1996) paid in 1997, resulting in a 1996 reserve
deficiency of approximately $7 million, (c) larger number of annuity policies
lapsed than anticipated, (d) a run off in claims due to rate renewal actions and
(e) a reserve strengthening in the fourth quarter of 1997.
Commissions remained fairly level in 1997, $35,525,295 compared to
$35,654,815 in 1996, primarily due to premiums remaining flat.
Operating expenses increased 6% to $39,242,350, or 15.2%, of premiums in
1997 compared to $36,874,665, or 14.3%, of premiums in 1996. Although salaries,
benefits and premium taxes remained the largest portions of the total operating
expenses, other operating expenses increased due to the costs incurred relative
to seeking additional funds for capital and surplus during 1997 for Central.
Interest expense increased 33% to $1,078,198 from $812,833 in 1996. The
increase was due to the $5.2 million loan in June 1997 and the $20 million loan
in December 1997. The $5.2 million loan was paid off in December 1997.
The net loss for 1997 was $20,956,356, or $5.01 per share, compared to
$9,288,365, or $2.25 per share, in 1996. The Company's revenues increased
approximately $647,000, however claims and expenses increased over $7 million,
the majority being in claims. Central's group accident and health business
represented 98% of the revenues and a higher loss ratio from this segment has a
negative effect on earnings. The statutory loss ratio for the group accident and
health segment increased to 81.7% in 1997 compared to 77.9% in 1996. Although
the losses were higher in 1997, Central received $14 million from the Company
and issued a surplus note for the $14 million and received a $10 million ceding
allowance from a reinsurance treaty, both of which increased Central's statutory
capital and surplus. At December 31, 1997, Central's statutory capital and
surplus was $24,650,804, which was above any regulatory action levels.
For information concerning the provision for income taxes, as well
information regarding differences between effective tax rates and statutory tax
rates, see Note G of the Notes to Consolidated Financial Statements.
OPERATING SEGMENT INFORMATION
The Company has identified three distinct operating segments based upon
product types, as follows: group life and health, life insurance and annuities,
and corporate and other.
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Products included in the group life and health segment include short-term
major medical insurance products and comprehensive major medical plans. Group
life policies are included in this segment because such policies are issued only
in conjunction with health insurance policies, and the costs of administering
those policies are incidental to the administration of the related health
policies.
Products included in the life and annuity segment include term insurance,
single premium deferred annuities, flexible premium deferred annuities, and
single premium immediate annuities. These products are not marketed aggressively
by the Company, and are underwritten as an accommodation product. Such products
are segregated from the group life and health segment based upon significant
differences in the sales and administration of such policies, including the
underwriting and claims adjudication processes.
The corporate and other segment encompasses all other activities of the
organization, including interest income and expense of the parent company.
The group life and health segment had net revenues of $168,000,000 for
1998, compared to $263,000,000 for 1997. The primary reason for the decrease in
net revenue is due to the quota share reinsurance treaties with Hannover and
UBL, which reduced net premium by $101,000,000 ($147,000,000 in ceded premium,
offset by an increase in assumed premium of $46,000,000). The remaining
differences were related to an increase in direct premium of $2,700,000, an
increase in other income of approximately $1,700,000, and an increase in
investment income of approximately $700,000.
Total expenses for the group life and health segment in 1998 were
$167,000,000 compared to $283,000,000 for 1997. The decrease in expenses in 1998
is also primarily related to the reinsurance agreements. Claims and losses ceded
plus commission and expense allowances account for approximately $141,000,000 of
the decrease. This decrease was offset by reinsurance commissions and expenses
paid of approximately $14,000,000, an approximate $4,000,000 increase in new
claims and $5,000,000 in costs for outsourcing the computer operations.
The life and annuity segment had revenues of $1,900,000 in 1998, compared
to $2,100,000 in 1997. The decrease was due to a reduction in life premiums
earned in 1998 and investment income due to a decrease in investments. Expenses
were $2,200,000 in 1998, compared to $2,400,000 in 1997. The primary reason for
the decrease was due to a release of reserves applicable to annuities that were
surrendered for cash.
Revenues for the corporate and other segment were $500,000 in 1998,
compared to $200,000 in 1997. The increase in revenue is related to interest
income earned on proceeds received from the July Equity Financing. Expenses
increased to $3,700,000 in 1998, from $1,700,000 in 1997. The increase in
expense is related to (1) interest expense incurred in 1998 on the Bridge Loan,
which was outstanding from December 1997 through July 1998, (2) $850,000 in
stock based compensation expenses incurred related to 1998 employment agreements
with key employees, and (3) an increase in legal and consulting expenses of
approximately $300,000, which resulted from various business strengthening
projects initiated by new management.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is the ability of an enterprise to generate adequate amounts of
cash to meet its financial commitments. The major needs for cash are to enable
Central to pay claims and expenses as they come due. Central's primary sources
of cash are premiums and investment income. Central's payments consist of
current claim payments to insureds, managed care expenses, operating expenses
such as salaries, employee benefits, commissions, taxes, and shareholder
dividends payable to the Company. The Company has, in the past, relied on the
dividend from Central to enable it to pay dividends to shareholders. Central and
the Company discontinued paying dividends at the end of 1996. By statute, the
state regulatory authorities set minimum liquidity standards to protect both
policyholders and shareholders and limit the dividends payable by Central to the
Company.
The majority of the Company's assets are in investments, which were
$89,826,188 after a net unrealized holding gain (before taxes of $564,528) of
$1,660,376, or 50% of the total assets at December 31, 1998. Fixed maturities
are the primary investment of the Company and were $89,731,756 or 99% of total
investments at December 31, 1998. Other investments consist of policy loans. The
Company is carrying fixed maturities of
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21
$8,899,659 at amortized cost (held to maturity) and fixed maturities of
$80,832,097 at estimated fair value (available for sale) at December 31, 1998.
The Company does not hold any so-called "junk" bonds or what are generally
considered high-yield type securities, and 100% of the bonds are of investment
grade quality. In addition to the fixed maturities, the Company also had
$15,031,058 in cash and cash equivalents at December 31, 1998 and a $15 million
line of credit with a major bank. There was no amount outstanding on the line of
credit at December 31, 1998. Effective February 17, 1999, this line of credit
was replaced with a $10 million line of credit as described below.
Assets increased 33% to $180,233,135 at December 31, 1998 from $135,803,577
at December 31, 1997. The increase was primarily due to the July Equity
Financing and reinsurance transactions in 1998.
The total policy liabilities and accruals increased to $97,113,067 at
December 31, 1998, or approximately 20%, from $81,090,299 at December 31, 1997.
The increase was primarily due to an increase in reserves for the UBL block of
policies reinsured in the third quarter of 1998. The Company's shareholders'
equity was $35,835,714 at December 31, 1998 compared to $1,511,842 at December
31, 1997. The increase was primarily due to the July Equity Financing.
To provide funds for the acquisition of CGIC, the Company incurred a debt
of $40 million under a Credit Agreement. Under the terms of the Credit
Agreement, dated as of February 17, 1999, among the Company, various lending
institutions and The Chase Manhattan Bank ("Chase"), as Administrative Agent
(the "Credit Agreement"), the first principal payment of $3.0 million is due
February 17, 2000. Quarterly payments are due thereafter starting with $1.0
million through February 17, 2001; $1.5 million thereafter through February 17,
2002; and $2.25 million every three months thereafter to February 17, 2005.
Interest on the outstanding balance will be determined based on whether the
Company selects a "Base Rate Loan" or a "Eurodollar Loan." Under the Base Rate
Loan, the interest rate will be 2.5% per annum plus the higher of(x) the rate
which is 1/2 of 1% in excess of a federal funds rate and (y) Chase's prime rate
as in effect from time to time. Under the Eurodollar Loan, the interest rate
will be 3.5% per annum plus a Eurodollar rate, which is the arithmetic average
of the offered quotation to first-class banks in the interbank Eurodollar market
by Chase, adjusted for certain reserve requirements. The Credit Agreement also
provides for a $10 million line of credit which bears interest at the same rate
as the $40 million loan. There is currently no amount outstanding under the line
of credit.
The Credit Agreement contains financial and other covenants with respect to
the Company that, among other matters: (1) prohibit the payment of cash
dividends on the Shares, except upon compliance with certain conditions; (2)
restrict the creation of liens and sales of assets; and (3) require that the
Company maintain (a) a leverage ratio (consolidated debt to consolidated total
capital) of 0.50 to 1.00 through December 31, 1999, 0.45 to 1.00 thereafter
through December 31, 2000, 0.40 to 1.00 thereafter through December 31, 2001,
and 0.35 to 1.00 thereafter, (b) an interest coverage ratio (consolidated EBITDA
to consolidated interest expense) of 2.0 to 1 through December 31, 1999, 2.5 to
1 through December 31, 2000, and 3.0 to 1 thereafter, (c) a minimum risk-based
capital ratio for any regulated insurance company subsidiary of the Company of
not less than 125%, and (d) a minimum consolidated net worth of $35.0 million
through December 31,1999, $40.0 million thereafter through December 31, 2000,
$50.0 million thereafter through December 31, 2001, $60.0 million thereafter
through December 31, 2002, and $70.0 million thereafter. In addition, the
Company has pledged the common stock of Continental General Corporation, the
parent of CGIC, Central and other insignificant subsidiaries as security for the
Credit Agreement.
The Company believes that cash flow from operating activities will be
sufficient to meet its currently anticipated operating and capital expenditure
requirements. If additional funds are required for long-term growth, the Company
believes that these funds could be obtained through equity or debt offerings as
market conditions permit or dictate. There is no assurance that the Company will
be able to obtain such financing on terms that are favorable to the Company.
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MARKET RISK AND MANAGEMENT POLICIES
The following is a description of certain risks facing life and accident
and health insurers and how Central mitigates those risks:
Legal/Regulatory Risk is the risk that changes in the legal or regulatory
environment in which an insurer operate will create additional expenses not
anticipated by the insurer in pricing its products. That is, regulatory
initiatives designed to reduce insurer profits or otherwise affecting the
industry in which the insurer operates, new legal theories or insurance company
insolvencies through guaranty fund assessments, may create costs for the insurer
beyond those recorded in the financial statements. Central attempts to mitigate
this risk by offering a wide range of products and by operating in 36 states,
thus reducing its exposure to any single product of non-Federal jurisdiction,
and also by employing underwriting practices which identify and minimize the
adverse impact of this risk.
Inadequate Pricing Risk is the risk that the premium charged for insurance
and insurance related products is insufficient to cover the costs associated
with the distribution of such products which include: benefits, claims and
losses, settlement expenses, acquisition expenses and other corporate expenses.
Central utilizes a variety of actuarial and/or qualitative methods to set such
pricing levels.
Credit Risk is the risk that issuers of securities owned by Central will
default or that other parties, including reinsurers that have obligations to
Central, will not pay or perform. Central attempts to minimize this risk by
adhering to a conservative investment strategy and by maintaining sound
reinsurance and credit and collection policies.
Interest Rate Risk is the risk that interests rates will change and cause a
decrease in the value of an insurer's investments. This change in rates may
cause certain interest-sensitive products to become uncompetitive or may cause
disintermediation Central attempts to mitigate this risk by charging fees for
non-conformance with certain policy provisions and/or by attempting to match the
maturity schedule of its assets with the expected payouts of its liabilities To
the extent that liabilities come due more quickly than assets mature, an insurer
would have to sell assets prior to maturity and recognize a gain or loss.
IMPACT OF YEAR 2000
The Company is devoting significant resources throughout its business
operations to minimize the risk of potential disruption from the Year 2000
("Y2K") issue. This issue is a result of computer programs having been written
using two digits (rather than four) to define the applicable year. Any
information technology ("IT") systems that have time-sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000, which
could result in miscalculations and system failures. The issue also extends to
many "non-IT" systems, such as operating and control systems that rely on
embedded computer chips. In addition, like every other business enterprise, the
Company is at risk from Y2K failures on the part of its major business
counterparts, including suppliers, distributors, licensees and manufacturers, as
well as potential failures in public and private infrastructure services,
including electricity, water, gas, transportation and communications.
System failures resulting from the Y2K issue could adversely affect
operations and financial results in all of the Company's business segments.
Failures may affect such routine but important operations as billing and
collection, payroll operations and daily administration of policyholder claims.
The Company also has business relationships with agents and health providers,
such as hospitals and physicians across the nation. These agents and businesses
are themselves reliant on IT and embedded computer chips to conduct their
operations.
The Company has undertaken a plan to resolve the Y2K issue which involves
the following phases: assessment, strategy, implementation and
testing/certification.
Phase 1 -- Assessment. The Company has fully completed its assessment of
all systems that could be significantly affected by Y2K. The completed
assessment indicated that most of Central's significant IT systems could be
affected. Based on the recent assessments, the Company determined that it will
be required
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to modify or replace significant portions of Central's hardware and software so
that those systems will properly utilize dates beyond December 31, 1999.
The Company in conjunction with an outside vendor has performed an
assessment of the IT applications critical to the processing of the UBL block of
business. The Company has developed a detailed plan relative to transition of
these policies and processing to the systems and anticipates such transition
will be completed in the second and third quarter of 1999.
The Company has performed an assessment of the IT strategy relative to its
recent acquisitions of PALHIC and CGIC. Critical systems processing the business
applications of PALHIC are processed on systems with an independent outside
vendor. A review of the independent outside vendor's Y2K plan has been performed
and the review indicated the plan is underway and many of the Y2K issues have
been resolved. The remaining Y2K issues are scheduled to be completed and
compliance achieved by June 1999.
CGIC has developed a plan for Y2K compliance and as of December 31, 1998,
all operating systems and applications were Y2K compliant. Other systems such as
those controlling payroll, elevators, telephone system and other building
systems are scheduled to be completed and Y2K compliant by June 1999.
Phase 2 -- Strategy. This phase involves the development of appropriate
strategies for both IT and non-IT systems. The selection of an appropriate
strategy is based upon such factors as the assessments made in Phase 1, the type
of system, the availability of a Y2K-compliant replacement and cost. The
strategy phase has been completed for all IT systems. The Company outsourced IT
systems to an outside vendor as of March 31, 1998 for Central and transitioned
processing of certain critical business applications to the outside vendor later
in 1998. The vendor has represented that the IT systems utilized for processing
certain transactions of Central are Y2K compliant as of December 31, 1998.
Central, in conjunction with the outside vendor, has identified other business
application software that is critical to Central's operations and is in the
process of executing remediation plans relative to such applications. For those
applications the Company and the outside vendor anticipate the systems will be
Y2K compliant by July 31, 1999.
Phase 3 -- Implementation. The implementation phase involves creating
detailed project plans, marshaling necessary resources and executing the
strategies chosen. Central's business application software was sent off-site for
Y2K conversion, which has been completed. Other Central software and hardware
are in the stage of being upgraded or replaced. All upgrades are scheduled for
completion by July 31, 1999.
At Central's headquarters, a new telephone and voice mail systems were
installed in the fourth quarter of 1998. Both systems (hardware and software)
are Y2K compliant. The building security/access systems and employee time
tracking system are being replaced and should be completed by the third quarter
of 1999. Elevator and other building facility systems are being reviewed and
will be upgraded as needed by August 1, 1999.
Phase 4 -- Testing and Certification. This phase includes establishing a
test environment, performing system testing and certifying the results. All
mid-range and mainframe applications are being tested using data from production
systems. The Company cannot estimate precisely when the testing phase will be
completed due to the Company's reliance on the use of an outside vendor for
these systems. However, the Company estimates that all testing should be
completed by July 31, 1999 and certified by September 30, 1999.
The Company will utilize both internal and external resources to reprogram
or replace, test and implement the software and operating equipment for Y2K
modifications.
As indicated in Phase 1, above, the strategy, implementation and testing
and certification phases for PALHIC and CGIC have started and are on schedule
for completion in 1999.
Contingency Plans -- As a precautionary measure, the Company is currently
developing contingency plans for all systems by department and business function
which are expected to be in place by the end of the third quarter of 1999. These
plans include information systems recovery, remote site processing and manual
procedures to ensure that critical business functions continue without effecting
customers and business partners. The Company's subsidiaries can process business
on other systems within the group. A special team will create a plan that will
document how business may be transferred between the companies for processing.
21
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The outside vendor is also developing a contingency plan to support the
customers of the back office functions. PALHIC and CGIC have developed
contingency plans to support their systems and customers.
Cost -- The total cost of the Y2K project is estimated at $5.5 million of
which approximately 50% consists of costs related to employees of the Company
and is being funded through operating cash flows. To date, the Company has
incurred approximately $2.6 million related to all phases of the Y2K project.
The estimated additional costs are currently expected to be $2.9 million, which
includes PALHIC and CGIC.
Based upon its efforts to date, the Company believes that the vast majority
of both its IT and its non-IT systems, including all critical and important
systems will remain up and running after January 1, 2000. Accordingly, the
Company does not currently anticipate that internal systems failures will result
in any material adverse effect to its operations or financial condition. During
1999, the Company will also continue and expand its efforts to ensure that major
third-party businesses and public and private providers of infrastructure
services, such as utilities, communications services and transportation, will
also be prepared for Y2K, and to develop contingency plans to address any
failures on their part to become Y2K compliant. At this time, the Company
believes that the most likely "worst-case" scenario involves potential
disruptions in areas in which the Company's operations must rely on the outside
vendor. While such failures could affect important operations of the Company and
its subsidiaries, either directly or indirectly, in a significant manner, the
Company cannot at present estimate either the likelihood or the potential cost
of such failures.
The nature and focus of the Company's efforts to address the Y2K problem
may be revised periodically as interim goals are achieved or new issues are
identified. In addition, it is important to note that the description of the
Company's efforts necessarily involves estimates and projections with respect to
activities required in the future. These estimates and projections are subject
to change as work continues, and such changes may be substantial.
IMPACT OF INFLATION:
Inflation rates impact the Company's financial condition and operating
results in several areas. Changes in inflation rates impact the market value of
the investment portfolio and yields on new investments.
Inflation has had an impact on claim costs and overall operating costs and
although it has been lower in the last few years, hospital and medical costs
have still increased at a higher rate than general inflation, especially in
prescription drug costs. New, more-expensive and wider use of pharmaceuticals is
inflating health care costs. The Office of Personnel Management reported the
costs of prescription drugs increased by 22% in 1998. While to a certain extent
these increased costs are offset by interest rates (investment income), hospital
charges increased, while the rate of income from investments has not increased
proportionately. The Company will continue to establish premium rates in
accordance with trends in hospital and medical costs along with concentrating on
various cost containment programs. However, there can be no assurance that these
efforts by the Company will fully offset the impact of inflation or that
premiums will equal or exceed increasing health care costs.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS:
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities,
which is required to be adopted in years beginning after June 15, 1999. The
Statement permits early adoption as of the beginning of any fiscal quarter after
its issuance. The Company expects to adopt the new Statement effective January
1, 2000. The Statement will require the Company to recognize all derivatives on
the balance sheet at fair value. Derivatives that are not hedges must be
adjusted to fair value through income. If a derivative is a hedge, depending on
the nature of the hedge, changes in the fair value of the derivative will either
be offset against the change in fair value of the hedged asset, liability, or
firm commitment through earnings, or recognized in other comprehensive income
until the hedged item is recognized in earnings. The ineffective portion of a
derivative's change in fair value will be immediately recognized in earnings.
The Company does not anticipate that the adoption of this Statement will have a
significant effect on its results of operations or financial position.
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In December 1997, the AICPA issued SOP 97-3, Accounting by Insurance and
Other Enterprises for Insurance-Related Assessments, which provides guidance for
determining when an insurance or other enterprise should recognize a liability
for guaranty-fund and other insurance-related assessments and guidance for
measuring the liability. This statement is effective for the Company's 1999
financial statements with early adoption permitted. The Company does not expect
adoption of this statement to have a material effect on its financial position
or results of operations.
FORWARD-LOOKING STATEMENTS:
This report on Form 10-K contains both historical and forward-looking
statements. Forward-looking statements are statements other than historical
information or statements of current condition. The forward-looking statements
relate to the plans and objectives of the Company for future operations. In
light of the risks and uncertainties inherent in all future projections, the
inclusion of the forward-looking statements should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved. Many factors could cause the Company's actual
results to differ materially from those in the forward-looking statements,
including the following:
- the failure to successfully integrate the businesses of PALHIC, CGIC or
UBL into the Company, including the failure to achieve cost
consolidations;
- rising health care costs;
- business conditions and competition in the health care industry;
- developments in health care reform and other regulatory issues;
- changes in laws and regulations affecting the Company's business;
- adverse changes in interest rates;
- unforeseen losses with respect to loss and settlement expense reserves
for unreported and reported claims;
- the Company's ability to develop, distribute and administer competitive
products and services in a timely cost-effective manner;
- the Company's visibility in the market place and its financial and claims
paying ratings;
- the costs of defending litigation and the risk of unanticipated material
adverse outcomes in such litigation, including the litigation with the
Internal Revenue Service;
- the performance of others on whom the Company relies for reinsurance;
- the risk that issuers of securities owned by the Company will default or
that other parties will not pay or perform;
- changes in accounting and reporting practices;
- the failure to complete the Y2K conversion, including the success of the
outside vendor of Central in being Y2K compliant; and
- the effect of any future acquisitions.
The foregoing review of important factors should not be construed as
exhaustive and should be read in conjunction with other cautionary statements
that are included in this report, including the risks detailed under "Market
Risk and Management Policies." The Company undertakes no obligation to update
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Market Risk and Management Policies" section under Item
7. -- Management's Discussion and Analysis of Financial Condition and Results of
Operation.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
CERES GROUP, INC.
INDEX
PAGE
----
Independent Auditors' Reports............................... 25
Consolidated Balance Sheets as of December 31, 1998 and
1997...................................................... 27
Consolidated Statements of Operations for the years ended
December 31, 1998, 1997 and 1996.......................... 28
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 1998, 1997 and 1996.............. 29
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996.......................... 30
Notes to Consolidated Financial Statements for the years
ended December 31, 1998, 1997 and 1996.................... 31
Schedule II -- Condensed Financial Information of
Registrant -- Ceres Group, Inc. (Parent Only)............. 50
Schedule III -- Supplementary Insurance Information......... 53
Schedule IV -- Reinsurance.................................. 54
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REPORT OF INDEPENDENT AUDITORS
Shareholders and Board of Directors Ceres Group, Inc.
We have audited the consolidated balance sheet of Ceres Group, Inc. and
subsidiaries (formerly Central Reserve Life Corporation) as of December 31,
1998, and the related consolidated statements of operations, shareholders'
equity, and cash flows for the year then ended. We have also audited the
information presented in the supplemental schedules as of and for the year ended
December 31, 1998. These consolidated financial statements and supplemental
schedules are the responsibility of the Company's management. Our responsibility
is to express an opinion on these consolidated financial statements and
supplemental schedules based on our audit. The consolidated balance sheet of
Ceres Group, Inc. and subsidiaries for the year ended December 31, 1997, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the two years ended December 31, 1997, and the information
presented in the supplemental schedules for those years were audited by other
auditors, whose report dated February 20, 1998, except for Notes B and C, as to
which the date was March 30, 1998, expressed an unqualified opinion on those
statements and supplemental schedules and included an explanatory paragraph that
expressed substantial doubt about the Company's ability to continue as a going
concern, as discussed in Note C to these financial statements.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit and the report of other auditors provide a reasonable
basis for our opinion.
In our opinion, based on our audit and the report of other auditors, the
financial statements referred to above present fairly, in all material respects,
the financial position of Ceres Group, Inc. and subsidiaries, at December 31,
1998 and 1997, and the results of its operations and cash flows for each of the
three years ended December 31, 1998, in conformity with generally accepted
accounting principles. Also in our opinion, the related supplemental schedules,
when considered in relation to the basic consolidated financial statements taken
as a whole, present fairly, in all material respects, the information set forth
therein.
Ernst & Young LLP
Cleveland, Ohio
March 17, 1999
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INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
Central Reserve Life Corporation:
We have audited the consolidated financial statements of Central Reserve
Life Corporation and subsidiaries as of and for each of the years in the
two-year period ended December 31, 1997 as listed in the accompanying index. In
connection with our audits of the consolidated financial statements, we also
have audited the financial statement schedules as of and for each of the years
in the two-year period ended December 31, 1997 as listed in the accompanying
index. These consolidated financial statements and financial statement schedules
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements and financial
statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimate made by
management, as well as evaluating the overall financial statement presentation.
We believe that out audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Central
Reserve Life Corporation and subsidiaries as of December 31, 1997, and the
results of their operations and their cash flows for each of the years in the
two-year period ended December 31, 1997, in conformity with generally accepted
accounting principles. Also in our opinion, the related financial statement
schedules, when considered in relation to the basic consolidated financial
statements taken as a whole, present fairly, in all material respects, the
information set forth therein.
The accompanying consolidated financial statements and financial statement
schedules have been prepared assuming that the Company will continue as a going
concern. As discussed in Note C to the consolidated financial statements, the
Company has suffered substantial losses from operations in 1997 and 1996 that
resulted in a significantly reduced net capital position. The Company has
entered into an Amended and Restated Stock Purchase Agreement to issue and sell
7,300,000 Common Shares and warrants to purchase an additional 3,650,000 Common
Shares at an exercise price of $5.50 per share for an aggregate purchase price
of $40,150,000. The closing of the Amended and Restated Stock Purchase Agreement
in subject to shareholder approval and regulatory approvals. In December 1997,
the Company obtained an interim loan of $20 million and that loan is due June
30, 1998. Should the Amended and Restated Stock Purchase Agreement not be
completed before June 30, 1998, and due to regulatory limitations on the
Company's ability to receive dividends from its insurance subsidiary, the
Company, absent some alternative capital resource, will not have the ability to
repay the interim loan. These matters raise substantial doubt about the ability
of the Company to continue as a going concern. Management's plans in regard to
these matters are also described in Note C to the consolidated financial
statements. The accompanying consolidated financial statements do not include
any adjustments that might result from the outcome of this uncertainty.
Columbus, Ohio KPMG LLP
February 20, 1998, except for Notes B and C,
as to which the date is March 30, 1998.
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CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
1998 1997
------------ ------------
ASSETS
Investments
Fixed maturities--Note E:
Held-to-maturity, at amortized cost.................... $ 8,899,659 $ 11,898,627
Available-for-sale, at fair value...................... 80,832,097 67,961,886
------------ ------------
Total fixed maturities............................ 89,731,756 79,860,513
Policy loans.............................................. 94,432 96,211
------------ ------------
Total investments................................. 89,826,188 79,956,724
Cash and cash equivalents................................... 15,031,058 7,602,865
Cash--restricted--Note E.................................... 4,345,322 3,930,956
Accrued investment income................................... 1,343,297 1,123,693
Premiums receivable......................................... 2,203,690 2,098,243
Note receivable--Note I..................................... 7,367,556 --
Reinsurance receivable--Note I.............................. 41,417,031 26,215,765
Property and equipment, net................................. 10,061,688 10,966,512
Deferred federal income taxes--Note G....................... 1,409,479 1,356,000
Deferred acquisition costs.................................. 3,809,737 325,572
Other assets................................................ 3,418,089 2,227,247
------------ ------------
Total assets...................................... $180,233,135 $135,803,577
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Policy liabilities and accruals:
Future policy benefits, losses and claims................. $ 22,717,862 $ 24,903,497
Other policy claims and benefits payable--Note H.......... 74,395,205 56,186,802
------------ ------------
97,113,067 81,090,299
Deferred reinsurance gain--Note I........................... 13,400,000 10,000,000
Other policyholders' funds.................................. 8,845,829 7,565,341
Federal income taxes payable--Note G........................ 1,105,834 385,834
Note payable--Note B........................................ -- 20,000,000
Mortgage note payable--Note J............................... 8,283,884 8,399,028
Reinsurance payable......................................... 2,993,400 --
Commissions payable......................................... 2,978,140 2,794,026
Other liabilities........................................... 9,677,267 4,057,207
------------ ------------
Total liabilities................................. 144,397,421 134,291,735
Shareholders' equity:
Non-voting preferred shares, $.001 par value, 2,000,000
shares authorized, none issued--Note L................. -- --
Common shares, 30,000,000 shares authorized, $.001 par
value, 11,495,172 shares issued and outstanding in
1998, and 15,000,000 shares authorized, no par value,
$.50 stated value, 4,195,172 shares issued and
outstanding in 1997--Note B............................ 11,495 2,097,586
Additional paid-in capital................................ 43,883,357 4,122,319
Retained earnings (deficit)............................... (9,154,986) (5,319,327)
Accumulated other comprehensive income.................... 1,095,848 611,264
------------ ------------
Total shareholders' equity........................ 35,835,714 1,511,842
------------ ------------
Total liabilities and shareholders' equity........ $180,233,135 $135,803,577
============ ============
See accompanying notes to consolidated financial statements.
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CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
1998 1997 1996
------------ ------------ ------------
REVENUES
Premiums--Note I:
Direct...................................... $264,868,186 $262,161,343 $260,076,097
Assumed..................................... 45,922,385 -- --
Ceded....................................... (150,005,674) (3,302,036) (1,900,760)
------------ ------------ ------------
160,784,897 258,859,307 258,175,337
Net investment income--Note E.................. 7,454,180 6,527,537 6,700,741
Net realized gains--Note E..................... 210,857 146,478 9,517
Other income................................... 1,096,690 -- --
Amortization of deferred reinsurance gain--Note
I........................................... 600,000 -- --
------------ ------------ ------------
170,146,624 265,533,322 264,885,595
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement
expenses.................................... 116,058,675 210,776,366 203,677,232
Underwriting, acquisition and insurance
expenses--Note I............................ 54,368,115 74,763,640 72,417,673
Amortization of deferred acquisition costs..... 647,271 4,005 111,807
Interest expense and financing costs........... 1,841,334 1,078,198 812,833
------------ ------------ ------------
172,915,395 286,622,209 277,019,545
------------ ------------ ------------
Loss before federal income taxes................. (2,768,771) (21,088,887) (12,133,950)
Federal income tax expense (benefit)--Note G..... 1,066,888 (132,531) (2,845,585)
------------ ------------ ------------
NET LOSS......................................... $ (3,835,659) $(20,956,356) $ (9,288,365)
============ ============ ============
Basic and diluted loss per common share.......... $(.49) $(5.01) $(2.29)
See accompanying notes to consolidated financial statements.
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CERES GROUP, INC. AND SUBSIDIARIES