UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q/A
(AMENDMENT NO. 1)
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended September 30, 2002
OR
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from ______________ to _____________
COMMISSION FILE NUMBER 0-13972
------------------------------------------------
PENN TREATY AMERICAN CORPORATION
3440 Lehigh Street, Allentown, PA 18103
(610) 965-2222
INCORPORATED IN PENNSYLVANIA I.R.S. EMPLOYER ID NO.
23-1664166
-------------------------------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
The number of shares outstanding of the Registrant's common stock, par value
$.10 per share, as of November 13, 2002 was 19,907,737.
****EXPLANATORY NOTE****
------------------------
IN OCTOBER 2002, THE COMPANY FILED A PRELIMINARY PROXY STATEMENT WITH THE
SECURITIES AND EXCHANGE COMMISSION. THE COMMISSION DETERMINED TO REVIEW THE
PRELIMINARY PROXY AND THE REFERENCED ANNUAL REPORT ON FORM 10-K FOR THE
PERIOD ENDED DECEMBER 31, 2001 AND THE QUARTERLY REPORT ON FORM 10-Q FOR THE
PERIOD ENDED JUNE 30, 2002. WE BELIEVE THE REVIEW WAS UNDERTAKEN AS A RESULT
OF THE COMMISSION'S NORMAL REVIEW PROCESS.
AS A RESULT OF THE REVIEW, THE COMMISSION REQUESTED, AND THE COMPANY AGREED,
TO CLARIFY CERTAIN LANGUAGE IN ITS FILINGS. IN RESPONSE, THE COMPANY HAS
FILED THE ATTACHED FORM 10-Q/A FOR THE PERIOD ENDED SEPTEMBER 30, 2002, WHICH
IS ITS MOST RECENT INTERIM REPORT.
NO CHANGES TO NET INCOME HAVE OCCURRED AS A RESULT OF THE REVIEW OR THIS
FILING.
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Penn Treaty American Corporation is one of the leading providers of long-term
nursing home and home health care insurance. Our Unaudited Consolidated Balance
Sheets, Statements of Operations and Comprehensive Income and Statements of Cash
Flows and Notes thereto required under this item are contained on pages 3
through 15 of this report. Our financial statements represent the consolidation
of our operations and those of our subsidiaries: Penn Treaty Network America
Insurance Company ("PTNA"), American Network Insurance Company ("American
Network"), American Independent Network Insurance Company of New York ("American
Independent") and Penn Treaty (Bermuda) Ltd. ("Penn Treaty (Bermuda)")
(collectively, the "Insurers") and United Insurance Group Agency, Inc. ("UIG"),
Network Insurance Senior Health Division ("NISHD") and Senior Financial
Consultants (collectively, the "Agencies"), which are underwriters and marketers
of long-term care insurance, disability and other senior-market products. PTNA
is also an underwriter of life insurance products.
2
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(amounts in thousands)
September 30, December 31,
2002 2001
------------- ------------
(unaudited)
ASSETS
Investments:
Bonds, available for sale at market (cost of $25,776 and $463,618, respectively) $ 27,506 $ 478,608
Equity securities at market value (cost of $0 and $8,760, respectively) -- 9,802
Policy loans 237 181
----------- ----------
Total investments 27,743 488,591
Cash and cash equivalents 23,703 114,600
Property and equipment, at cost, less accumulated depreciation of
$7,868 and $6,594, respectively 12,959 12,783
Unamortized deferred policy acquisition costs 172,198 180,052
Receivables from agents, less allowance for uncollectable amounts of $199 1,411 2,190
Accrued investment income 431 7,907
Federal income tax recoverable 5,477 4,406
Goodwill 20,620 25,771
Present value of future profits acquired 894 1,937
Receivable from reinsurers 25,164 25,594
Corporate owned life insurance 57,054 54,478
Experience account due from reinsurer 686,122 --
Other assets 20,154 22,058
----------- ----------
Total assets $ 1,053,930 $ 940,367
=========== ==========
LIABILITIES
Policy reserves:
Accident and health $ 446,005 $ 382,660
Life 13,279 13,386
Policy and contract claims 324,646 214,466
Accounts payable and other liabilities 17,903 19,422
Long-term debt 76,266 79,190
Deferred income taxes 21,583 38,447
3
----------- ----------
Total liabilities 899,682 747,571
----------- ----------
Commitments and contingencies -- --
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding -- --
Common stock, par value $.10; 40,000 shares authorized, 20,321 and 19,749
shares issued 2,032 1,975
Additional paid-in capital 96,992 94,802
Accumulated other comprehensive income 1,119 10,583
Retained earnings 60,810 92,141
----------- ----------
160,953 199,501
Less 915 common shares held in treasury, at cost (6,705) (6,705)
----------- ----------
154,248 192,796
----------- ----------
Total liabilities and shareholders' equity $ 1,053,930 $ 940,367
=========== ==========
4
See accompanying notes to consolidated financial statements.
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations and Comprehensive Income
(unaudited)
(amounts in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- ----------------------
2002 2001 2002 2001
--------- ----------- ---------- ----------
Revenues:
Premium revenue $ 83,635 $ 80,588 $ 251,777 $ 266,646
Net investment income 10,122 8,571 29,829 22,481
Net realized capital gains (losses) 85 (314) 14,649 (1,168)
Trading account loss -- (1,506) -- (2,830)
Market gain on experience account 62,747 -- 56,745 --
Other income 4,361 2,548 9,523 7,313
--------- --------- ---------- ----------
160,950 89,887 362,523 292,442
--------- --------- ---------- ----------
Benefits and expenses:
Benefits to policyholders 164,170 47,220 306,872 179,592
Commissions 11,527 16,920 36,034 62,744
Net policy acquisition costs amortized 3,403 7,255 7,854 3,608
General and administrative expense 13,344 11,079 34,929 36,670
Expense and risk charges on reinsurance 3,577 -- 10,731 --
Claim litigation costs -- -- -- (250)
Excise tax expense 812 -- 2,185 --
Interest expense 1,195 1,238 3,585 3,760
--------- --------- ---------- ----------
198,028 83,712 402,190 286,124
--------- --------- ---------- ----------
(Loss) gain before federal income taxes and cumulative
effect of accounting change (37,078) 6,175 (39,667) 6,318
Federal income tax (benefit) provision (12,607) 2,100 (13,487) 2,148
--------- --------- ---------- ----------
Net (loss) income before cumulative effect of
accounting change (24,471) 4,075 (26,180) 4,170
5
Cumulative effect of change in accounting principle -- -- (5,151) --
--------- --------- ---------- ----------
Net (loss) income (24,471) 4,075 (31,331) 4,170
--------- --------- ---------- ----------
Other comprehensive income:
Unrealized holding gain arising during period 890 14,341 347 15,519
Income tax provision from unrealized holdings (302) (5,019) (118) (5,432)
Reclassification of (gain) loss included in net loss (85) 1,820 (14,649) 3,998
Income tax benefit from reclassification adjustment 28 (637) 4,981 (1,400)
--------- --------- ---------- ----------
Comprehensive (loss) income $(23,940) $ 14,580 $ (40,770) $ 16,855
========= --------- ---------- ----------
Basic earnings per share from net (loss) income before
cumulative effect of accounting change $ (1.26) $ 0.22 $ (1.36) $ 0.33
Basic earnings per share from net (loss) income $ (1.26) $ 0.22 $ (1.63) $ 0.33
Diluted earnings per share from net (loss) income before
cumulative effect of accounting change $ (1.26) $ 0.22 $ (1.36) $ 0.33
Diluted earnings per share from net (loss) income before $ (1.26) $ 0.22 $ (1.63) $ 0.33
Weighted average number of shares outstanding 19,376 18,836 19,194 12,703
Weighted average number of shares outstanding (diluted) 19,376 18,836 19,194 12,826
6
See accompanying notes to consolidated financial statements.
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Nine Months Ended September 30,
(unaudited)
(amounts in thousands)
2002 2001
---------- ----------
Cash flow from operating activities:
Net (loss) income $ (31,331) $ 4,170
Adjustments to reconcile net (loss) income to cash
provided by operations:
Amortization of intangible assets 1,313 1,516
Cumulative effect of accounting change 5,151 -
Amortization of gain on assumption reinsurance 1,980 -
Policy acquisition costs, net 7,854 3,608
Deferred income taxes (11,988) 583
Depreciation expense 1,274 1,165
Net realized capital (gains) losses (14,649) 1,168
Trading account loss - 2,830
Net proceeds from purchase and sales of trading securities - (1,172)
Increase (decrease) due to change in:
Receivables from agents 779 1,156
Receivable from reinsurers 430 3,938
Experience account due from reinsurer (79,429) -
Policy and contract claims 110,180 38,807
Policy reserves 63,238 16,899
Accounts payable and other liabilities (1,519) 9,331
Federal income taxes recoverable (1,071) 1,579
Accrued investment income 7,476 (1,345)
Other, net (523) (1,077)
--------- ---------
Cash provided by operations 59,165 83,156
Cash flow from investing activities:
Proceeds from sales of bonds 473,554 70,780
Proceeds from sales of equity securities 9,547 8,395
Proceeds from maturities of bonds 3,672 12,402
Purchase of bonds (25,523) (234,412)
Purchase of equity securities (20) (12,670)
Increase in corporate owned life insurance (2,576) -
Deposits to experience account due from reinsurer (606,693) -
Acquisition of property and equipment (1,450) (1,579)
--------- ---------
Cash used in investing (149,489) (157,084)
Cash flow from financing activities:
Proceeds from exercise of stock options - 12
Proceeds from stock offering 2,351 25,726
Repayments of long-term debt (2,924) (2,758)
--------- ---------
Cash (used in) provided by financing (573) 22,980
--------- ---------
Decrease in cash and cash equivalents (90,897) (50,948)
Cash balances:
Beginning of period 114,600 116,596
--------- ---------
End of period $ 23,703 $ 65,648
========= =========
7
See accompanying notes to consolidated financial statements.
PENN TREATY AMERICAN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2002 (unaudited) (amounts in thousands, except per share data)
The Consolidated Financial Statements should be read in conjunction with these
notes and with the Notes to Consolidated Financial Statements included in the
Annual Report on Form 10-K/A for the year ended December 31, 2001 of Penn Treaty
American Corporation (the "Company").
In the opinion of management, the summarized financial information reflects all
adjustments (consisting only of normal recurring adjustments) that are necessary
for a fair presentation of the financial position and results of operations,
comprehensive income and cash flows for the interim periods.
1. Regulatory Developments:
The Company's insurance subsidiaries are required to hold statutory surplus that
is, at a minimum, above a calculated authorized control level at which the
Pennsylvania Insurance Department (the "Department") may place its insurance
subsidiaries under regulatory control, leading to rehabilitation or liquidation.
Insurers are obligated to hold additional statutory surplus above the authorized
control level. At December 31, 2000, Penn Treaty, the Company's primary
insurance subsidiary, representing 94% of our direct premium, had Total Adjusted
Capital at the Regulatory Action level. As a result, it was required to file a
Corrective Action Plan (the "Plan") with the insurance commissioner.
On February 12, 2002, the Department approved the Plan. It requires the
Company's Pennsylvania insurance subsidiaries to comply with certain agreements
at the direction of the Department, including, but not limited to:
o The entrance into the reinsurance agreement for substantially all of its
existing business at December 31, 2001. (See Note 2)
o New investments are limited to those rated by the National Association of
Insurance Commissioners ("NAIC") as 1 or 2.
o Affiliated transactions are limited and require Department approval.
o An agreement to increase statutory reserves by an additional $125,000, of
which $50,000 remains to be increased throughout 2002-2004, such that the
Insurers' policy reserves will be based on new, current claims assumptions
and will not include any rate increases. These claim assumptions are
applied to all policies, regardless of issue year and are assumed to have
been present since the policy was first issued. The reinsurance agreement
has provided the capacity to accommodate this increase.
As a result of their statutory capital positions and pending the formulation and
approval of the Plan, the Company's Pennsylvania insurance subsidiaries ceased
new sales during 2001. Upon the approval by the Department of the Plan, the
Company recommenced new sales in 23 states, including Pennsylvania. The Company
has since recommenced sales in eight additional states, including its announced
addition of Florida in August 2002, which has historically represented
approximately 25% of the Company's new business sales (See Note 10). In August
2002, the Company also recommenced sales in Texas, which has historically
represented approximately 5% of the Company's sales. However, the Company has
not yet commenced new business sales in California, Virginia or Illinois, which
together have traditionally represented approximately 27% of new sales.
2. Reinsurance Agreements:
As a primary component of the Plan, effective December 31, 2001, the Company
entered into a reinsurance transaction to reinsure, on a quota share basis,
substantially all of its respective long-term care insurance policies then
in-force. The agreement was entered with Centre Solutions (Bermuda) Limited. The
agreement is subject to certain coverage limitations, including an aggregate
limit of liability that is a function of certain factors and that may be reduced
in the event that rate increases are not obtained.
The initial premium of the reinsurance treaty resulted in the transfer of
approximately $563,000 in cash and marketable securities during February 2002,
and $56,000 as funds held due to the reinsurer. The initial and future premium
of the reinsured policies, less claims payments, ceding commissions and risk
charges, is credited to a notional experience account, which is held for the
Company's benefit in the event of commutation and recapture following December
31, 2007. The reinsurer provides the Company with an experience account
investment credit equal to the total return of a series of benchmark indices and
hedges, which are designed to closely match the duration of the Company's claims
liabilities.
The notional experience account represents a hybrid instrument, containing both
a fixed debt host contract and an embedded derivative, and therefore is being
accounted for in accordance with SFAS 133. The economic characteristics and
risks of the
8
embedded derivative instrument are not clearly and closely related to the
economic characteristics and risks of the fixed debt host contract.
1. The fixed debt host yields a fixed return based on the yield to maturity of
the underlying benchmark indices. The return on the fixed debt host is
reported as investment income in the Statement of Operations.
2. The change in fair value of the embedded derivative represents the
percentage change in the underlying indices applied to the notional
experience account, similar to that of an unrealized gain/loss on a bond.
The change in the fair value of the embedded derivative is reported as
market gain on experience account in the Statement of Operations.
As a result, the Company's financial statements are subject to significant
volatility. The benchmark indices are comprised of US treasury strips, agencies
and investment grade corporate bonds, with weightings of approximately 25%, 15%
and 60%, respectively, and have a duration of approximately 11 years. During the
nine-month period ending September 30, 2002, the Company recorded $28,391 in net
investment income from the debt host and a market gain of $56,745.
The reinsurance agreement contains commutation provisions and allows the Company
to recapture the reserve liabilities and the current experience account balance
as of December 31, 2007, or on December 31 of any year thereafter. The Company
intends, but is not required to commute the agreement on December 31, 2007 and
would incur significant penalties for not commuting. In the event the Company
does not commute the agreement on December 31, 2007, it will be subject to
escalating risk charges, which require the Company to owe annual amounts to the
Reinsurer in excess of $10,000. The risk charges increase to approximately
$13,000 per year if the Company does not commute the agreement before January 1,
2008. Additionally, the reinsurance provisions contain covenants and conditions
that, if breached, may result in the immediate commutation of the agreement and
the payment of $2,500 per quarter from the period of the breach through December
31, 2007. These covenants include, but are not limited to, covenants relating to
material breaches and insolvency.
This agreement does not qualify for reinsurance treatment in accordance with
FASB No. 113 because, based on the Company's analysis, the agreement does not
result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to a number of factors related to the agreement,
including experience refund provisions, expense and risk charges due to the
reinsurer and the aggregate limit of liability. As a result, the Company is
using deposit accounting for this agreement. This agreement meets the
requirements to qualify for reinsurance treatment under statutory accounting
rules.
As part of the agreement, the reinsurer was granted four tranches of warrants to
purchase shares of non-voting convertible preferred stock. The first three
tranches of warrants are exercisable through December 31, 2007 at common stock
equivalent prices ranging from $4.00 to $12.00 per share, if converted. The
reinsurer, at its sole discretion, may execute a cash exercise or a cashless
exercise. If exercised for cash, at the reinsurer's option, the warrants could
yield additional capital and liquidity of approximately $20,000 and, if
converted, the convertible preferred stock would represent approximately 15% of
the then outstanding shares of our common stock. If the agreement is not
commuted following December 31, 2007, the reinsurer may exercise the fourth
tranche of warrants to purchase convertible preferred stock purchase warrants at
a common stock equivalent price of $2.00 per share. If converted, the
convertible preferred stock would potentially generate additional capital of
$12,000 and would represent an additional 20% of the then outstanding common
stock. The reinsurer is under no obligation to exercise any of the warrants.
The warrants are part of the consideration for the reinsurance contract and are
recognized as premium expense over the anticipated life of the contract, which
is six years. The warrants were valued at the issuance date using a
Black-Scholes model with the following assumptions: 6.0 years expected life,
volatility of 70.9% and a risk free rate of 4.74%. The $15,855 value of the
warrants was recorded as a deferred premium as of December 31, 2001. $1,980 of
the deferred premium was amortized to expense during the nine months ended
September 30, 2002.
The agreement also granted the reinsurer the option to participate in reinsuring
new business sales up to 50% on a quota share basis. In August 2002, the
reinsurer exercised its option to reinsure a portion of future sales. Subsequent
to September 30, 2002, the Company submitted a preliminary draft of the proposed
reinsurance agreement to the Pennsylvania Insurance Department for review.
Because the proposed reinsurance agreement has not yet been agreed upon by the
entering parties or the Pennsylvania Insurance Department, no impact has been
reflected in the Company's statements of operations.
3. Contingencies:
The Company and certain of its key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by shareholders of the
Company, on their own behalf and on behalf of a putative class of similarly
situated shareholders who purchased shares of the Company's common stock from
July 23, 2000 through and including March 29, 2001. The consolidated amended
class action complaint seeks damages in an unspecified amount for losses
allegedly incurred as a result of misstatements and omissions allegedly
contained in the Company's periodic reports filed with the SEC, certain press
releases issued by the Company, and in other statements made by its
9
officials. The alleged misstatements and omissions relate, among other matters,
to the statutory capital and surplus position of the Company's largest
subsidiary, PTNA. We believe that the complaint is without merit, and we will
continue to vigorously defend the matter. The Company does not believe that the
eventual outcome will have a material effect on the financial condition or
results of operations.
In June of 2000, the Company instituted an action against a vendor for breach of
contract, seeking a refund of license fees paid for computer software and for
the recovery of its attorneys' fees. The purchase of the software was on a trial
basis, and, at the end of the evaluation period, the Company had the right to
return the software for a refund of $371 in license fees paid, less an
administrative fee of $25. A final payment of $123 was due if the Company
decided to keep the software. The Company returned the software to the vendor,
in February 2000 and requested a refund of the license fees paid. The vendor
refused to refund the license fees to the Company, and filed a counter-claim
against the Company, seeking the final payment of $123 plus its attorneys' fees.
After trial held subsequent to September 30, 2002, the Court found in favor of
the vendor, and ordered that the Company be liable for damages in the amount of
$123, pre-judgment and post-judgment interest, and attorneys' fees in the amount
of $90. The parties are awaiting a final judgment to be entered by the Court.
Once the final judgment has been entered, the Company will have an opportunity
to determine its options for appeal of this matter. For the period ended
September 30, 2002, the Company recorded an expense of approximately $650 for
this judgement.
4. Investments:
Management has categorized all of its investment securities as available for
sale because they may be sold in response to changes in interest rates,
prepayments and similar factors. Investments in this category are reported at
their current market value with net unrealized gains and losses, net of the
applicable deferred income tax effect, being added to or deducted from the
Company's total shareholders' equity on the balance sheet. As of September 30,
2002, shareholders' equity was increased by $1,125 due to unrealized gains of
$1,730 in the investment portfolio. As of December 31, 2001, shareholders'
equity was increased by $10,581 due to unrealized gains of $16,032 in the
investment portfolio. The amortized cost and estimated market value of the
Company's available for sale investment portfolio as of September 30, 2002 and
December 31, 2001 are as follows:
10
September 30, 2002 December 31, 2001
-------------------------- --------------------------
Amortized Estimated Amortized Estimated
Cost Market Value Cost Market Value
----------- ------------ ------------ ------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 14,532 $ 15,767 $ 164,712 $ 172,063
Obligations of states and
political sub-divisions -- -- 572 612
Mortgage backed securities 1,824 1,899 42,587 43,331
Debt securities issued by
foreign governments 206 217 11,954 12,089
Corporate securities 9,214 9,623 243,793 250,513
Equities -- -- 8,760 9,802
Policy Loans 237 237 181 181
--------- ---------- ---------- -----------
Total Investments $ 26,013 $ 27,743 $ 472,559 $ 488,591
========== ========== ========== ===========
Net unrealized gain 1,730 16,032
---------- ----------
$ 27,743 $ 488,591
========== ==========
The majority of the Company's investment portfolio was transferred to the
reinsurer as part of the initial premium paid for the Company's December 31,
2001 reinsurance transaction. The reinsurer maintains a notional experience
account for the Company's benefit in the event of future commutation of the
reinsurance agreement. The Company receives an investment credit equal to the
total return of a series of benchmark indices and hedges. The experience account
balance at September 30, 2002 was $686,122.
Pursuant to certain statutory licensing requirements, as of September 30, 2002,
the Company had on deposit bonds aggregating $8,923 in Insurance Department
special deposit accounts. The Company is not permitted to remove the bonds from
these accounts without approval of the regulatory authority.
11
5. Reconciliation of Earnings Per Share:
A reconciliation of the numerator and denominator of the basic earnings per
share computation to the numerator and denominator of the diluted earnings per
share computation follows. Basic earnings per share excludes dilution and is
computed by dividing income available to common shareholders by the weighted
average number of common shares outstanding for the period. Diluted earnings per
share reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
Anti-dilutive effects are not included.
12
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- ----------------------
2002 2001 2002 2001
--------- ----------- ---------- ----------
Net (loss) income before cumulative effect of accounting change $ (24,471) $ 4,075 $ (26,180) $ 4,170
Weighted average common shares outstanding 19,376 18,836 19,194 12,703
---------- ---------- ---------- --------
Basic earnings per share from net income before
cumulative effect of accounting change $ (1.26) $ 0.22 $ (1.36) $ 0.33
========== ========== ========== ========
Net (loss) income before cumulative effect of
accounting change $ (24,471) $ 4,075 $ (26,180) $ 4,170
Cumulative effect of accounting change -- -- (5,151) --
---------- ---------- ---------- --------
Net (loss) income $ (24,471) $ 4,075 $ (31,331) $ 4,170
========== ========== ========== ========
Basic earnings per share from net income $ (1.26) $ 0.22 $ (1.63) $ 0.33
========== ========== ========== ========
Adjustments net of tax:
Interest expense on convertible debt $ -- $ -- $ -- $ --
Amortization of debt offering costs -- -- -- --
---------- ---------- ---------- --------
Diluted net (loss) income before cumulative effect of
accounting change $ (24,471) $ 4,075 $ (26,180) $ 4,170
========== ========== ========== ========
Diluted net (loss) income $ (24,471) $ 4,075 $ (31,331) $ 4,170
========== ========== ========== ========
========
Weighted average common shares outstanding 19,376 18,836 19,194 12,703
Common stock equivalents due to dilutive
effect of stock options/warrants -- -- -- 123
Shares converted from convertible debt -- -- -- --
---------- ---------- ---------- --------
Total outstanding shares for diluted earnings
per share computation 19,376 18,836 19,194 12,826
---------- ---------- ---------- --------
Diluted earnings per share from net income before
cumulative effect of accounting change $ (1.26) $ 0.22 $ (1.36) $ 0.33
13
========== ========== ========== ========
Diluted earnings per share $ (1.26) $ 0.22 $ (1.63) $ 0.33
========== ========== ========== =========
14
Securities that could potentially dilute basic earnings per share in the future
that were not included in the computation of diluted earnings per share because
to do so would have been antidilutive for the three months and nine months ended
September 30, 2002 are 2,786 and 2,980, respectively and 2,628 and 2,627 for the
three months and nine months ended September 30, 2001, respectively.
6. Policy and Contract Claims:
The Company establishes reserves for the future payment of all currently
incurred claims. The amount of reserves relating to reported and unreported
claims incurred is determined by periodically evaluating historical claims
experience and statistical information with respect to the probable number and
nature of such claims. Claim reserves reflect actual experience through the most
recent time period. Claim reserves include current assumptions as to type and
duration of care, remaining policy benefits, and interest rates. The Company
compares actual experience with estimates and adjusts its reserves on the basis
of such comparisons.
To estimate reserves for future claims payments more precisely, the Company has
refined its assumptions and process for developing these reserves. The Company
has recently completed an analysis of the adverse deviation recognized in the
past development of its reserves for current claims. As a result of this
analysis, the Company's actuarial modeling suggests that future claim payments
will likely exceed its past assumptions, which, if unaddressed, could continue
to cause future adverse deviation.
As a result, the Company has made two modifications to its process for
developing claims reserves:
a) Redefinition of Claims:
In the past 10 years, more policies have been sold offering benefits for both
nursing facility and in-home health care coverage. The Company has recorded
claims that begin in one type of care and later move to another type of care as
two separate claims. Defining claims in this manner has projected a greater
number of expected claims from certain types of policies. However, the Company
believes that it has also underestimated the expected length of individual
claims. The Company has now determined to define this as one claim, using the
earliest date of service as the incurral date. This redefinition of claims
results in fewer expected future claims, but anticipates that each claim will
last longer.
b) Continuance Assumptions:
Once a claim occurs, the Company develops claim reserves by using continuance
tables, which measure the likelihood of a claim continuing in the future.
Historically, the Company has applied every claim to a set of uniform
continuance tables. The Company's actuarial modeling suggests that this method
no longer reflects the increasing number of claims from policies with longer
benefit periods or increased benefit amounts. The Company has developed an
improved methodology by creating separate continuance patterns for facility,
home health and comprehensive care, as well as for tax qualified and
non-qualified plans. In addition, the Company has established separate
continuance tables for claims caused by cognitive impairment. As a result, the
Company believes that the duration of its existing claims will be longer than
was previously expected and has adopted this assumption and process change.
As a result of its redefinition of claims and employment of new continuance
tables for separate types of claims, the Company has strengthened its policy and
contract reserves by $83,000 in the third quarter, 2002, which is primarily
attributable to claims incurred prior to January 1, 2002.
In addition, the Company reduced its assumed discount rate from 6.5% to 5.7%
based upon recent investment yields. This change resulted in an increase to
reserves of approximately $5,000.
7. Policy Reserves and Deferred Policy Acquisition Costs:
The Company also maintains reserves for policies that are not currently on claim
based upon actuarial expectations that a policy may go on claim in the future.
Benefit reserves are determined by evaluating future claims less premium
payments to determine the present value of our anticipated future liability.
These reserves are calculated based on factors that include estimates for
mortality, morbidity, interest rates, premium rate increases and persistency.
Factor components generally include assumptions that are consistent with both
our experience and industry practices.
In connection with the sale of its insurance policies, the Company defers and
amortizes a portion of the policy acquisition costs over the related premium
paying periods of the life of the policy. These costs include all expenses that
are directly related to, and vary with, the acquisition of the policy, including
commissions, underwriting and other policy issue expenses. The amortization of
deferred policy acquisition costs ("DAC") is determined using the same projected
actuarial assumptions used in computing policy reserves. DAC can be affected by
unanticipated terminations of policies because, upon such terminations, the
Company is required to expense fully the DAC associated with the terminated
policies.
15
At September 30, 2002, the Company reviewed the appropriateness and
recoverability of its existing DAC. From this review, it determined to recognize
a DAC impairment loss of $1,100 during the third quarter of 2002 primarily as a
result of the incorporation of certain assumptions related to the future
profitability of its current business in force. These assumptions included the
use of a lower discount rate, which reflects the current interest rate
environment, higher anticipated claims costs due to newly estimated claim
duration and expected future premium rate increases on policies for which the
Company has already filed or anticipates filing. Also, these new assumptions are
utilized in the determination of the Company's policy reserves. In the event
that premium rate increases cannot be obtained as needed, the Company's DAC
could be further impaired and the Company would incur an expense in the amount
of the impairment.
8. New Accounting Principles:
In June 2001, the Financial Accounting Standards Board ("FASB") issued two
Statements of Financial Accounting Standards ("SFAS"). SFAS No. 141, "Business
Combinations," requires usage of the purchase method for all business
combinations initiated after June 30, 2001, and prohibits the usage of the
pooling of interests method of accounting for business combinations. The
provisions of SFAS No. 141 relating to the application of the purchase method
are generally effective for business combinations completed after June 30, 2001.
Such provisions include guidance on the identification of the acquiring entity,
the recognition of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition provisions
of SFAS No. 141 require an analysis of goodwill acquired in purchase business
combinations prior to July 1, 2001 to identify and reclassify separately
identifiable intangible assets currently recorded as goodwill.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily addresses the
accounting for goodwill and intangible assets subsequent to their acquisition.
The Company adopted SFAS No. 142 on January 1, 2002 and ceased amortizing
goodwill at that time. During the second quarter 2002, the Company completed an
impairment analysis of goodwill, in accordance with FASB No. 142. The Company's
goodwill was recorded as a result of the purchase of its agencies and its
insurance subsidiaries. As part of its evaluation, the Company completed
numerous steps in determining the recoverability of its goodwill. The first
required step was the measurement of total enterprise fair value versus book
value. Because the Company's fair market value, as measured by its stock price,
was below book value at January 1, 2002, goodwill was next evaluated at a
reporting unit level, which comprised its insurance agencies and insurance
subsidiaries.
Upon completion of its evaluation, the Company determined that the goodwill
associated with the agency purchases was fully recoverable. The deficiency of
current market value to book value was assigned to the insurance subsidiary
values. As a result, the Company determined that the goodwill associated with
its insurance subsidiaries was impaired and recognized an impairment loss of
$5,151 from its transitional impairment test of goodwill, which it recorded as a
cumulative effect of change in accounting principle. The impairment has been
recorded effective January 1, 2002. Management has completed an assessment of
other intangible assets and has determined to continue to amortize these assets
so as to closely match the future profit emergence from these assets.
No goodwill was amortized for the nine months ended September 30, 2002. For the
nine months ended September 30, 2001, the Company amortized $970 of goodwill.
For comparative purposes, the following table adjusts net income and basic and
diluted earnings per share for the third quarter and nine months ended September
30, 2001, as if goodwill amortization had ceased at the beginning of 2001 and no
cumulative effect of accounting change had occurred.
16
Three Months Ended September 30, Nine Months Ended September 30,
------------------------------- ------------------------------
2002 2001 2002 2001
---- ---- ---- ----
Reported net (loss) income $ (24,471) $ 4,075 $ (26,180) $ 4,170
Adjustment for goodwill amortization, net of tax -- 213 -- 640
--------- ------- --------- -------
Adjusted net (loss) income $ (24,471) $ 4,288 $ (26,180) $ 4,810
========== ======= ========== =======
Reported basic earnings per share $ (1.26) $ 0.22 $ (1.36) $ 0.33
Adjustment for goodwill amortization, net of tax -- 0.01 -- 0.05
--------- ------- --------- -------
Adjusted basic earnings per share $ (1.26) $ 0.23 $ (1.36) $ 0.38
========== ======= ========== =======
Reported diluted earnings per share $ (1.26) $ 0.22 $ (1.36) $ 0.33
Adjustment for goodwill amortization, net of tax -- 0.01 -- 0.05
--------- ------- --------- -------
Adjusted diluted earnings per share $ (1.26) $ 0.23 $ (1.36) $ 0.38
========== ======= ========== =======
17
9. Equity Placement:
In March 2002, the Company completed a private placement of 510 shares of common
stock for net proceeds of $2,352. The common stock was sold to several current
and new institutional investors, at $4.65 per share. The offering price was a 10
percent discount to the 30-day average price of our common stock prior to the
issuance of the new shares. Pursuant to registration rights granted in the
private placement, the Company filed a registration statement registering the
shares granted in the private placement for resale. The Securities and Exchange
Commission declared the registration statement effective on June 20, 2002. The
proceeds of the private placement provided additional liquidity to the parent
company to meet its current year debt service obligations. The proceeds,
together with currently available cash sources, are sufficient to meet the
Company's cash requirements through March 31, 2003 but may not be sufficient to
meet interest requirements on the Company's debt for April and June 2003, and
will not be sufficient to meet its October and December 2003 interest
requirement or to retire a portion of its outstanding subordinated debt upon
maturity in December 2003.
In June 2002, the Company completed a private placement of 60 shares of common
stock as compensation to its financial advisor in conjunction with the private
placement of 510 shares and as consideration for future services. 30 of these
shares were included in the resale registration statement, which was declared
effective by the Securities and Exchange Commission on June 20, 2002. The
Company recorded $325 as an expense in 2002 related to this item.
10. Subsequent Events:
In September 2002, the Company, having made all necessary filings with the
Securities and Exchange Commission, commenced an offer of up to $74,750 in
aggregate principal amount of 6-1/4% Convertible Subordinated Notes due 2008 in
exchange for up to all of its outstanding 6-1/4% Convertible Subordinated Notes
due 2003. Under the terms of the exchange, the new notes would have terms
similar to the former notes but mature in October 2008 and would be convertible
into shares of the Company's common stock at a conversion price of $5.31. Prior
to the termination of the exchange offer, the Company reduced its offered
conversion price to $4.50. In addition, beginning in October 2004, the new notes
are mandatorily convertible if, at any time, the 15-day average closing price of
the Company's common stock exceeds 110% of the conversion price. On October 24,
2002, the Company's exchange offer expired and the Company exchanged $59,703 of
the old notes due 2003 for new notes due 2008. The remaining old notes mature in
December 2003 and are convertible into shares of the Company's common stock at a
conversion price of $28.44. Subsequent to the expiration of the exchange offer,
we exchanged an additional $3,640 upon the request of certain holders of the
2003 Notes.
In October 2002, the Company announced that it intends to raise additional
equity capital prior to March 31, 2003 in order to support future sales growth,
provide additional parent company liquidity and continue to meet statutory
requirements. The Company's primary insurance subsidiary is required to raise
approximately $25,000 of additional equity capital prior to December 31, 2002 in
order to remain in compliance with its Consent Order entered with the Florida
Insurance Department upon the recommencement of sales in July 2002. The Consent
Order includes, among other requirements with which the Company's subsidiary is
currently in compliance, a requirement to raise sufficient equity capital to
meet Florida requirements for gross premium to surplus ratios. If the Company
(on behalf of its subsidiary) is unsuccessful in its efforts to raise additional
capital and is unable to report December 31, 2002 statutory capital sufficient
to meet the required Florida gross premium to surplus ratio, the Company could
be required to cease new sales in Florida and its certificate of authority could
be suspended by the Florida Insurance Department until sufficient capital could
be raised. The intended equity capital raise does not contemplate future
liquidity requirements of the parent company.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Overview (amounts in thousands)
Our principal products are individual, defined benefit accident and health
insurance policies that consist of nursing home care, home health care, Medicare
supplement, life and long-term disability insurance. We experienced significant
reductions in new premium sales during 2001 due to the cessation of new business
generation in all states and as a result of market concerns regarding our
insurance subsidiaries' statutory surplus. Under our Plan which was approved by
the Department in February 2002, we recommenced sales in certain states, but
intend to limit new business growth to levels that will allow us to maintain
sufficient statutory surplus. Our underwriting practices rely upon the base of
experience that we have developed in over 30 years of providing nursing home
care insurance, as well as upon available industry and actuarial information. As
the home health care market has developed, we have encouraged our customers to
purchase both nursing home and home health care coverage, thus providing our
policyholders with enhanced protection and broadening our policy base.
Our insurance subsidiaries are subject to the insurance laws and regulations of
the states in which they are licensed to write insurance. These laws and
regulations govern matters such as payment of dividends, settlement of claims
and loss ratios. State regulatory authorities must approve premiums charged for
insurance products. In addition, our insurance subsidiaries are required to
establish and maintain reserves with respect to reported and incurred but not
reported losses, as well as estimated future
18
benefits payable under our insurance policies. These reserves must, at a
minimum, comply with mandated standards. Our reserves are certified annually by
our consulting actuary as to standards required by the insurance departments for
our domiciliary state and for the other states in which we conduct business. We
believe we maintained adequate reserves as mandated by each state in which we
are currently writing business at September 30, 2002. For a description of
current regulatory matters affecting our insurance subsidiaries, see "Liquidity
and Capital Resources" and "Subsidiary Operations."
Our results of operations are affected significantly by the following other
factors:
Level of required reserves for policies in-force. Our insurance policies are
accounted for as SFAS 60 long duration contracts. As a result, there are two
components of policyholder liabilities. The first is a policy reserve liability
as required by SFAS 60 for future policyholder benefits, represented by the
present value of future benefits less future premium collection. These reserves
are calculated based on assumptions that include estimates for mortality,
morbidity, interest rates, premium rate increases and policy persistency. The
assumptions are consistent with industry experience and historical results, as
modified for our own experience.
The second is a reserve for incurred, either reported or not yet reported,
policy and contract claims, which represents the benefits for current claims.
The amount of reserves relating to reported and unreported claims incurred is
determined by periodically evaluating statistical information with respect to
the number and nature of historical claims. We compare actual experience with
estimates and adjust our reserves on the basis of such comparisons to the extent
that our analysis suggests that adverse development is likely to continue or
occur in future periods.
Additions to, or reductions in, reserves are recognized in our current
consolidated statements of operations and comprehensive income as expense or
income, respectively, through benefits to policyholders and are a material
component of our net income or loss. A portion of premium collected in each
period is set aside to establish reserves for future policy benefits.
Establishing reserves is based upon current assumptions and we cannot assure
you that actual claims expense will not differ materially from the claims
expense anticipated by the assumptions used in the establishment of reserves.
Any variance from these assumptions could affect our profitability in
future periods.
Policy premium levels. We attempt to set premium levels to maximize
profitability. Premium levels on new products, as well as rate increases on
existing products, are subject to government review and regulation.
Deferred policy acquisition costs. In connection with the sale of our insurance
policies, we defer and amortize a portion of the policy acquisition costs over
the related premium paying periods of the life of the policy. These costs
include all expenses that are directly related to, and vary with, the
acquisition of the policy, including commissions, underwriting and other policy
issue expenses. The amortization of deferred policy acquisition costs ("DAC") is
determined using the same projected actuarial assumptions used in computing
policy reserves. DAC can be affected by unanticipated terminations of policies
because, upon such terminations, we are required to expense fully the DAC
associated with the terminated policies. In addition, the assumptions underlying
DAC and our policy benefit reserves are periodically reviewed and updated to
reflect current assumptions. Whenever we determine that our DAC is not fully
recoverable, we impair the carrying value of our DAC through an expense to our
consolidated statement of operations and comprehensive income. See "Results of
Operations - Deferred Policy Acquisition Costs."
Investment income and experience account. Our investment portfolio, excluding
our experience account, consists primarily of investment grade fixed income
securities. Income generated from this portfolio is largely dependent upon
prevailing levels of interest rates. Due to the duration of our investments
(approximately 5.0 years), investment income does not immediately reflect
changes in market interest rates.
In connection with our reinsurance agreement with Centre, we transferred
substantially all of our investment portfolio to the reinsurer as the initial
premium payment. The initial and future premium for the reinsured policies, less
claims payments, ceding commissions and risk charges is credited to a notional
experience account, the balance of which also receives an investment credit. The
notional experience account balance represents an amount to be paid to us in the
event of commutation of the agreement. Based on our analysis of SFAS 133, we
believe that the experience account represents a hybrid instrument, containing
both a fixed debt host contract and an embedded derivative.
1. The fixed debt host yields a fixed return based upon the yield to maturity
of the underlying benchmark indices. The return on the fixed debt host is
reported as investment income in the Statement of Operations.
2. The change in fair value of the embedded derivative represents the
percentage change in the underlying indices applied to the notional
experience account, similar to that of an unrealized gain/loss on a bond.
The change in the fair value of the embedded derivative is reported a
market gain on experience account in the Statement of Operations.
As a result, our results of operations are subject to significant volatility.
Recorded market value gains or losses, although recognized in current earnings,
are expected to be offset in future periods as a result of our receipt of the
most recent market rates, and, therefore, have no anticipated long-term effect
on shareholder value. The benchmark indices are comprised of US
19
Treasury strips, agencies and investment grade corporate bonds, with weightings
of approximately 25%, 15% and 60%, respectively, and have a duration of
approximately 11 years.
Lapsation and persistency. Factors that affect our results of operations include
lapsation and persistency, both of which relate to the renewal of insurance
policies. Lapsation is the termination of a policy by non-renewal. Lapsation is
automatic if and when premiums become more than 31 days overdue although, in
some cases, a lapsed policy may be reinstated within six months. Persistency
represents the percentage of premiums renewed, which we calculate by dividing
the total annual premiums at the end of each year (less first year premiums for
that year) by the total annual premiums in-force for the prior year. For
purposes of this calculation, a decrease in total annual premiums in-force at
the end of any year would be the result of non-renewal of policies, including
policies that have terminated by reason of death, lapsed due to nonpayment of
premiums and/or been converted to other policies we offered. First year premiums
are premiums covering the first twelve months a policy is in-force. Renewal
premiums are premiums covering all subsequent periods.
Policies renew or lapse for a variety of reasons, both internal and external. We
believe that our efforts to address policyholder concerns or questions help to
ensure policy renewals. We work closely with our licensed agents, who play an
integral role in policy persistency and policyholder communication.
Economic cycles can influence a policyholder's ability to continue the payment
of insurance premiums when due. We believe that publicity regarding newly
enacted Federal and state tax legislation allowing medical deductions for
certain long-term care insurance premiums has raised public awareness of the
escalating costs of long-term care and the value provided to the consumer of
long-term care insurance. The ratings assigned to our insurance subsidiaries by
independent rating agencies also influence consumer decisions.
Lapsation and persistency can both positively and adversely affect future
earnings. Reduced lapsation and higher persistency generally result in higher
renewal premiums and lower amortization of deferred acquisition costs, but may
lead to increased claims in future periods. Higher lapsation can result in
reduced premium collection, a greater percentage of higher-risk policyholders,
and accelerated expensing of deferred acquisition costs. However, higher
lapsation may also lead to decreased claims in future periods.
Results of Operations
Three Months Ended September 30, 2002 and 2001 (amounts in thousands)
Premiums. Total premium revenue earned in the three month period ended September
30, 2002 (the "2002 quarter"), including long-term care, disability, life and
Medicare supplement, increased 3.8% to $83,635, compared to $80,588 in the same
period in 2001 (the "2001 quarter"). Premium in the 2001 quarter was reduced
$10,009 as a result of the accounting treatment for the reinsurance of our
disability business to an unaffiliated insurer.
Total first year premiums earned in the 2002 quarter decreased 82.0% to $1,279,
compared to $7,118 in the 2001 quarter. First year long-term care premiums
earned in the 2002 quarter decreased 84.2% to $1,046, compared to $6,629 in the
2001 quarter. We experienced significant reductions in new premium sales due to
the cessation of new business generation in all states and due to continued
market concerns regarding our insurance subsidiaries' statutory surplus. Under
our Corrective Action Plan (the "Plan"), which was approved by the Pennsylvania
Insurance Department (the "Department") in the first quarter of 2002, we
recommenced sales in certain states, but intend to limit new business growth to
levels that will allow us to maintain sufficient statutory surplus. See
"Liquidity and Capital Resources."
Effective September 10, 2001, we determined to discontinue the sale nationally
of all new long-term care insurance policies until the Plan was completed and
approved by the Department. This decision resulted from our concern about
further depletion of statutory surplus from new policy sales prior to the
completion and approval of the Plan and from increasing concern with respect to
the status of the Plan expressed by many states in which the Company is
licensed to conduct business. Upon the approval by the Department of the Plan
in February 2002, we recommenced new policy sales in 23 states, including
Pennsylvania. We have since recommenced new policy sales in nine additional
states, including Florida and Texas (See "Liquidity and Capital Resources"),
which have historically represented approximately 25% and 5%, respectively of
our new policy sales. However, we have not yet commenced new policy sales in
California, Virginia or Illinois, which together have traditionally represented
approximately 27% of sales, or in 15 other states. We are actively working with
the remaining states to recommence sales in all jurisdictions.
Total renewal premiums earned in the 2002 quarter decreased 1.3% to $82,356,
compared to $83,479 in the 2001 quarter. Renewal long-term care premiums earned
in the 2002 quarter decreased .8% to $79,575, compared to $80,215 in the 2001
quarter. We may continue to experience reduced renewal premiums in the future,
especially given our recent premium rate increases, which are anticipated to
cause additional policy lapses. Current declines in first year premiums, as
discussed above, will negatively impact future renewal premium growth.
20
Net investment income. Net investment income earned for the 2002 quarter
increased 18.1% to $10,122, from $8,571 for the 2001 quarter.
As a result of our new reinsurance agreement, substantially all of our
investable assets from business written prior to December 31, 2001, were
transferred to the reinsurer. The reinsurer maintains a notional experience
account on our behalf in the event that the reinsurance agreement is later
commuted. As discussed above in "Overview," the notional experience account
is credited with an investment credit equal to the most recent yield to
maturity on a series of benchmark indices and hedges, which are designed to
closely match the duration of our liabilities. See "Liquidity and Capital
Resources."
Our average yield on invested assets at cost, including cash and cash
equivalents, was 6.1% in both the 2002 and 2001 quarters. Although market
interest rates have declined, the yield in the 2002 quarter resulted from having
investments only in higher yielding bonds (including the makeup of the
underlying experience account indices, which have a duration of approximately 11
years), rather than in bonds and common stocks, as were present in the 2001
quarter. The investment income component of our notional experience account
investment credit generated $9,798 in the 2002 quarter.
Net realized capital gains and trading account activity. During the 2002
quarter, we recognized capital gains of $85, compared to capital losses of $314
in the 2001 quarter. The results in the 2002 and 2001 quarters were recorded as
a result of our normal investment management operations.
During 2001, we classified our convertible bond portfolio as trading account
investments. Changes in trading account investment market values were recorded
in our statement of operations during the period in which the change occurred,
rather than as an unrealized gain or loss recorded directly through equity. As a
result, we recorded a trading account loss in the 2001 quarter of $1,506, which
reflected the unrealized and realized loss of our convertible portfolio that
arose during that quarter. No investments were classified as trading during the
2002 quarter.
Market gain (loss) on notional experience account. We recorded a market gain on
our notional experience account balance of $62,747 in the 2002 quarter.
As discussed in "Overview" and "Net Investment Income" above, the reinsurer of
our new reinsurance agreement maintains a notional experience account for our
benefit in the event of future recapture. The notional experience account
receives an investment credit based upon the total return of a series of
benchmark indices and derivative hedges, which are designed to closely match the
duration of our reserve liabilities. Periodic changes in the market values of
the benchmark indices and derivative hedges are recorded in our financial
statements as a realized gain or loss in the period in which they occur. As a
result, our future financial statements are subject to significant volatility.
Other income. We recorded $4,361 in other income during the 2002 quarter, up
from $2,548 in the 2001 quarter. The increase is attributable primarily to a
recognition of a deferred gain from the sale of our disability business in the
2001 quarter. The sale was done as a 100% quota share agreement, in
contemplation of a subsequent assumption of the business, where actual ownership
of the policies would change. In the 2002 quarter, approximately 50% of the
policies were assumed and we recorded the corresponding portion of the deferred
gain as a gain to other income.
Benefits to policyholders. Total benefits to policyholders in the 2002 quarter
increased 248% to $164,170, compared to $47,220 in the 2001 quarter. Our loss
ratio, or policyholder benefits to premiums, was 196.3% in the 2002 quarter,
compared to 58.6% in the 2001 quarter.
As discussed in "Overview" above, we establish reserves for current claims based
upon current and historical experience of our policyholder benefits, including
an expectation of claims incidence and duration, as well as the establishment of
a reserve for claims that have been incurred but are not yet reported. We
continuously monitor our experience to determine the best estimate of reserves
to be held for future payments of these claims. As a result, we periodically
refine our process to incorporate the most recent known information in
establishing these reserves.
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. When we
experience deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During the third
quarter 2001, we filed for premium rate increases on the majority of our policy
forms. These rate increases were necessary because we expect higher loss ratios
as a result of higher claims expectations than existed at the time of the
original form filings. We have currently received approval for more than 90% of
the rate increases requested as measured by premiums. We have been generally
successful in the past in obtaining state insurance department approvals for
increases. If we are unsuccessful in obtaining future rate increases when
deemed necessary, or if we do not pursue rate increases when actual claims
experience exceeds our expectations, we would suffer a financial loss.
21
Our benefit reserves, which are held for policyholders not currently on claim,
are highly dependent upon policyholder persistency. As a result of our recently
implemented premium rate increases, we experienced a decline in persistency, or
"shock lapse," because certain policyholders elected not to pay the higher
premium amounts. During the 2002 quarter, although lapses were within the bounds
of our expectations, we believe that a greater portion of lapses occurred in
policies with shorter benefit periods than was expected. The resultant mix of
policies for which we hold reserves is comprised of a greater percentage of
policies with longer benefit periods. As a result, our benefit reserves in the
2002 quarter were approximately $5,000 higher than anticipated.
The amount of reserves relating to reported and unreported claims incurred is
determined by periodically evaluating historical claims experience and
statistical information with respect to the probable number and nature of such
claims. Claim reserves reflect actual experience through the most recent time
period. Claim reserves include current assumptions as to type and duration of
care, remaining policy benefits and interest rates. We compare actual experience
with estimates and adjust our reserves on the basis of such comparisons.
To estimate reserves for future claims payments more precisely, we have refined
our assumptions and processes for developing these reserves. We have recently
completed an analysis of the adverse deviation recognized in the past
development of our reserves for current claims. As a result of this analysis,
our actuarial modeling suggests that future claim payments will likely exceed
our past assumptions, which, if unaddressed, could continue to cause future
adverse deviation.
As a result, we have made two modifications to our process for developing claims
reserves:
a) Redefinition of Claims :
Over the past 10 years, our percentage of policies-in-force offering benefits
for both nursing facility and in-home health care coverage has increased. We
have recorded claims that begin in one type of care and later move to another
type of care as two separate claims. Defining claims in this manner has
projected a greater number of expected claims from certain types of policies.
However, we believe that we have also underestimated the expected length of
individual claims. We have now determined to define this as one claim, using
the earliest date of service as the incurral date. This redefinition of claims
results in fewer expected future claims, but anticipates that each claim will
last longer.
b) Continuance Assumptions:
Once a claim occurs, we develop claim reserves by using continuance tables,
which measure the likelihood of a claim continuing in the future. Historically,
we have applied every claim to a set of uniform continuance tables. Our
actuarial modeling suggests that this method no longer reflects the increasing
number of claims from policies with longer benefit periods or increased benefit
amounts. We have developed improved assumptions and processes by creating
separate continuance patterns for facility, home health and comprehensive care,
as well as for tax qualified and non-qualified plans. In addition, we have
established separate continuance tables for claims caused by cognitive
impairment. As a result, we believe that the duration of existing claims will be
longer than was previously expected and have adopted this assumption and process
change.
By redefining these `multiple' claims as a single claim and by employing new
assumptions and processes for predicting the continuance of claims, we believe
that we can predict future claims development with a much higher degree of
precision than was true in the past. By retrospectively applying these findings
to earlier periods in multiple tests, we would have seen substantially less
adverse deviation from expected results in the development of claims reserves.
We further believe that the new assumptions will serve to reduce future reserve
volatility by more closely predicting future claims development.
As a result of this redefinition of claims and employment of new continuance
tables for separate types of claims, we increased our policy and contract
claims reserves by $83,000 in the 2002 quarter, which is primarily attributable
to claims incurred prior to January 1, 2002.
Further, by employing a lower discount rate of 5.7% in the 2002 quarter, rather
than the 6.5% that had been used prior to the current quarter, we increased our
claims reserves by approximately $5,000. We believe that, as a result of lower
market interest rates, the lower discount rate more closely matches our
currently anticipated return from the investment of assets supporting these
reserves.
Commissions. Commissions to agents decreased 31.9% to $11,527 in the 2002
quarter, compared to $16,920 in the 2001 quarter.
First year commissions on accident and health business in the 2002 quarter
decreased 88.4% to $579, compared to $4,968 in the 2001 quarter, due to the
decrease in first year accident and health premiums. The ratio of first year
accident and health commissions to first year accident and health premiums was
45.3% in the 2002 quarter and 71.2% in the 2001 quarter. We believe that the
decrease in the first year commission ratio is primarily attributable to the
increased sale of our Secured Risk and Medicare Supplement Policy as a
percentage of total sales. These policies pay a lower commission. Our Secured
Risk policy
22
provides limited benefits to higher risk policyholders at a substantially
increased premium rate. We believe that we are likely to experience an increase
in the sale of these policies as a percentage of new sales when we reenter sales
in many states as a result of our lower financial ratings with A.M. Best and
Standard and Poor's rating services.
Renewal commissions on accident and health business in the 2002 quarter
decreased 17.6% to $10,282, compared to $12,476 in the 2001 quarter, due to the
decrease in renewal premiums discussed above. The ratio of renewal accident and
health commissions to renewal accident and health premiums was 12.6% in the 2002
quarter and 15.2% in the 2001 quarter. We began the implementation of premium
rate increases of approximately 20% on our existing policy premium in the 2001
quarter, for which we do not pay commissions. As a result, commission ratios are
reduced.
During the 2002 quarter, we reduced commission expense, as an intercompany
elimination, by netting $625 from override commissions affiliated insurers paid
to our agency subsidiaries. During the 2001 quarter, we reduced commissions by
$892.
Net policy acquisition costs amortized. The net policy acquisition costs
amortized in the 2002 quarter decreased to $3,403, compared to $7,255 in
the 2001 quarter.
Deferred costs are typically all costs that are directly related to, and vary
with, the acquisition of new premiums. The deferred costs include the variable
portion of commissions, which are defined as the first year commissions less
ultimate renewal commissions, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based on actuarial assumptions, including persistency of
policies in-force. In the event a policy lapses prematurely due to death or
termination of coverage, the remaining unamortized portion of the deferred
amount is immediately recognized as expense in the current period.
The net amortization of deferred policy acquisition costs is affected by new
business generation, imputed interest on prior reserves and policy persistency.
During the 2002 quarter, higher policyholder lapses (as noted under "Premiums"),
resulted in increased amortization of deferred policy acquisition costs.
However, the amortization of deferred costs is generally offset largely by the
deferral of costs associated with new premium generation. Lower new premium
sales during the 2002 and 2001 quarters produced significantly less expense
deferral to offset amortized costs. In addition, at December 31, 2001, the
Company impaired its deferred acquisition cost asset by approximately $61,800,
which resulted in reduced future periodic amortization expense including that
for the third quarter of 2002.
At September 30, 2002, we reviewed the appropriateness and recoverability of
DAC. From this review, we determined to recognize a DAC impairment charge of
$1,100 during the third quarter of 2002 primarily as a result of the
incorporation of certain assumptions related to the future profitability of our
current business in force. These assumptions included the use of a lower
discount rate, which reflects the current interest rate environment, higher
anticipated claims costs due to newly estimated claim duration and reasonably
expected future premium rate increases on policies for which we have already
filed or anticipate filing. In the event that premium rate increases cannot be
obtained as needed, our DAC could be further impaired and we would incur an
expense in the amount of the impairment. Also, these new assumptions are now
utilized in the determination of our policy reserves. At September 30, 2002
unamortized DAC was $172,198.
General and administrative expenses. General and administrative expenses in the
2002 quarter increased 20.4% to $13,344, compared to $11,079 in the 2001
quarter. The 2002 and 2001 quarters include $1,462 and $1,625, respectively of
general and administrative expenses related to United Insurance Group expense.
The ratio of total general and administrative expenses to premium revenues,
excluding United Insurance Group, was 14.2% in the 2002 quarter, compared to
11.7% in the 2001 quarter.
Although certain expenses have declined as a result of reduced new policy
sales, related underwriting and policy issuance expenses and management
initiatives to reduce operating expenses, the 2002 quarter includes the
following additional expenses that are not related to policy issuance: 1)
we expensed approximately $600 related to consulting costs in the development
of our system replacement project, 2) we expensed $650 related to our losing a
lawsuit that we had filed against an unaffiliated party, 3) we expensed
approximately $650 related to the warrants issued as part of the reinsurance
agreement entered on December 31, 2001, which represents a recurring quarterly
amount through 2007, and 4) we expensed approximately $200 for legal and
printing costs related to the exchange of our convertible debt.
We believe that if we remain unable to write new business in certain states
where we have ceased new production, or if we are unable to use our existing
staff and infrastructure capacity to generate additional premiums, we will need
to decrease production expenses, which could result in decisions to reduce our
staff or other operating functions.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance
agreement provides the reinsurer with annual expense and risk charges, which are
charged against our notional experience account in the event of future
commutation of the agreement. The annual charge consists of a fixed cost and
a variable component based upon reserve and capital levels needed to support
the reinsured business. In the 2002 quarter, we incurred an expense of $3,577
for this charge. In addition, we are subject to an excise tax for premium
payments made to a foreign reinsurer. We recorded $812 for excise tax expenses
in the 2002 quarter as a result.
23
Provision for Federal income taxes. Due to the loss we recognized in the 2002
quarter, our provision for Federal income taxes for the 2002 quarter decreased
700% to a tax benefit of $12,607, compared to an income tax provision of $2,100
for the 2001 quarter. The effective tax rate of 34% in the 2002 and 2001
quarters is below the normal Federal corporate income tax rate as a result of
anticipated credits from our investments in corporate owned life insurance.
Comprehensive income. During the 2002 quarter, our investment portfolio
generated pre-tax unrealized gains of $890, compared to unrealized gains of
$14,341 in the 2001 quarter. The reduced unrealized gain at September 30, 2002,
is primarily attributable to the sale of the majority of our investment
portfolio in conjunction with the initial premium payment for our reinsurance
agreement. After accounting for deferred taxes from these gains, shareholders'
equity decreased by $24,471 from comprehensive losses during the 2002 quarter,
compared to gains of $14,850 in the 2001 quarter.
Nine Months Ended September 30, 2002 and 2001 (amounts in thousands)
Premiums. Total premium revenue earned in the nine month period ended September
30, 2002 (the "2002 period"), including long-term care, disability, life and
Medicare supplement, decreased 5.6% to $251,777, compared to $266,646 in the
same period in 2001 (the "2001 period").
Total first year premiums earned in the 2002 period decreased 87.9% to $4,830,
compared to $39,934 in the 2001 period. First year long-term care premiums
earned in the 2002 period decreased 89.2% to $4,123, compared to $38,153 in the
2001 period. We experienced significant reductions in new premium sales due to
the cessation of new business generation in all states and due to continued
market concerns regarding our insurance subsidiaries' statutory surplus. Under
our Plan, which was approved by the Department in the first quarter 2002, we
recommenced sales in certain states, but intend to limit new business growth to
levels that will allow us to maintain sufficient statutory surplus. See
"Liquidity and Capital Resources."
Effective September 10, 2001, we determined to discontinue the sale nationally
of all new long-term care insurance policies until the Plan was completed and
approved by the Department. This decision resulted from our concern about
further depletion of statutory surplus from new policy sales prior to the
completion and approval of the Plan and from increasing concern with respect to
the status of the Plan expressed by many states in which the Company is
licensed to conduct business. Upon the approval by the Department of the Plan
in February 2002, we recommenced new policy sales in 23 states, including
Pennsylvania. We have since recommenced new policy sales in nine additional
states, including Florida and Texas (See "Liquidity and Capital Resources"),
which have historically represented approximately 25% and 5%, respectively of
our new policy sales. However, we have not yet commenced new policy
sales in California, Virginia or Illinois, which together have traditionally
represented approximately 27% of new sales, or in 15 other states. We are
actively working with the remaining states, in order to recommence sales in
all jurisdictions.
Total renewal premiums earned in the 2002 period increased 4.3% to $246,947,
compared to $236,721 in the 2001 period. Renewal long-term care premiums earned
in the 2002 period increased 5.8% to $238,825, compared to $225,715 in the 2001
period. This increase reflects renewals of a larger base of in-force policies.
We may experience reduced renewal premiums if policies lapse, especially given
our recent premium rate increases, which are anticipated to cause additional
policy lapses. Current declines in first year premiums, as discussed above, will
negatively impact future renewal premium growth.
Net investment income. Net investment income earned for the 2002 period
increased 32.7% to $29,829, from $22,481 for the 2001 period.
As a result of our new reinsurance agreement, substantially all of our
investable assets from business written prior to December 31, 2001, were
transferred to the reinsurer. The reinsurer maintains a notional experience
account on our behalf in the event that the reinsurance agreement is later
commuted. As discussed above in "Overview," the notional experience account is
credited with an investment credit equal to the most recent yield to maturity of
a series of benchmark indices and hedges, which are designed to closely match
the duration of our liabilities. See "Liquidity and Capital Resources."
Our average yield on invested assets at cost, including cash and cash
equivalents, was 6.3% and 5.7%, respectively, in the 2002 and 2001 periods.
Although market rates have declined, the higher yield in the 2002 period
resulted from having investments only in higher yielding bonds (including the
makeup of the underlying experience account indices, which have a duration of
approximately 11 years), rather than in bonds and common stocks as were present
in the 2001 period. The investment income component of our experience account
investment credit generated $28,391 in the 2002 period.
Net realized capital gains and trading account activity. During the 2002 period,
we recognized capital gains of $14,649, compared to capital losses of $1,168 in
the 2001 period. We accounted for the transfer of the securities portion of the
initial premium payment for our new reinsurance agreement as a sale of these
assets. Substantially all of the recognized capital gains in the 2002 period
resulted from the transfer of the initial premium of approximately $563,000 to
the reinsurer. The results in the 2001 period were recorded as a result of our
normal investment management operations.
24
During the 2001 period, we classified our convertible bond portfolio as trading
account investments. Changes in trading account investment market values were
recorded in our statement of operations during the period in which the change
occurred, rather than as an unrealized gain or loss recorded directly through
equity. As a result, we recorded a trading account loss in the 2001 period of
$2,830, which reflected the unrealized and realized loss of our convertible
portfolio that arose during that period. No investments were classified as
trading during the 2002 period.
Market gain (loss) on experience account. We recorded a market gain on our
experience account balance of $56,745 in the 2002 period.
As discussed in "Overview" and "Net Investment Income" above, the reinsurer of
our new reinsurance agreement maintains a notional experience account for our
benefit in the event of future recapture. The notional experience account
receives an investment credit based upon the total return of a series of
benchmark indices and derivative hedges, which are designed to closely match the
duration of our reserve liabilities. Periodic changes in the market values of
the benchmark indices and derivative hedges are recorded in our financial
statements as a realized gain or loss in the period in which they occur. As a
result, our future financial statements are subject to significant volatility.
Other income. We recorded $9,523 in other income during the 2002 period, up from
$7,313 in the 2001 period. The increase is attributable primarily to an increase
in commissions earned by United Insurance Group on sales of insurance products
underwritten by unaffiliated insurers, to income generated from our ownership of
corporate owned life insurance policies, and to a recognition of deferred gain
from the sale of our disability business in the 2001 period. The sale was done
as a 100% quota share agreement, in contemplation of a subsequent assumption of
the business, where actual ownership of the policies would change. In the 2002
period, approximately 50% of the policies were assumed and we recorded the
corresponding portion of the deferred gain as a gain to other income.
Benefits to policyholders. Total benefits to policyholders in the 2002 period
increased 70.9% to $306,872 compared to $179,592 in the 2001 period. Our loss
ratio, or policyholder benefits to premiums, was 121.9% in the 2002 period,
compared to 67.4% in the 2001 period.
As discussed in "Overview" above, we establish reserves for current claims
based upon current and historical experience of our policyholder benefits,
including an expectation of claims incidence and duration, as well as the
establishment of a reserve for claims that have been incurred but are not yet
reported ("IBNR"). We continuously monitor our experience to determine the best
estimate of reserves to be held for future payments of these claims. As a
result, we periodically refine our process to incorporate the most recent known
information in establishing these reserves.
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. When we
experience deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During the third
quarter 2001, we filed for premium rate increases on the majority of our policy
forms. These rate increases were sought as a result of increased loss ratios
resulting from higher claims expectations than existed at the time of the
original form filings. The assumptions used in requesting and supporting the
premium rate increase filings are consistent with those incorporated in our
newest policy form offerings. We have currently received approval for more than
90% of the rate increases requested. We have been generally successful in the
past in obtaining state insurance department approvals for increases. If we are
unsuccessful in obtaining future rate increases when deemed necessary, or if we
do not pursue rate increases when actual claims experience exceeds our
expectations, we would suffer a financial loss.
The amount of reserves relating to reported and unreported claims incurred is
determined by periodically evaluating historical claims experience and
statistical information with respect to the probable number and nature of such
claims. Claim reserves reflect actual experience through the most recent time
period. Claim reserves include current assumptions as to type and duration of
care, remaining policy benefits, and interest rates. We compare actual
experience with estimates and adjust reserves on the basis of such comparisons.
To estimate reserves for future claims payments more precisely, we have refined
our assumptions and processes for developing these reserves. We have recently
completed an analysis of the adverse deviation recognized in the past
development of our reserves for current claims. As a result of this analysis,
our actuarial modeling suggests that future claim payments will likely exceed
our past assumptions, which, if unaddressed, could continue to cause future
adverse deviation.
As a result, we have made two modifications to our process for developing claims
reserves:
a) Redefinition of Claims:
Over the past 10 years, our percentage of policies-in-force offering benefits
for both nursing facility and in-home health care coverage has increased. We
have recorded claims that begin in one type of care and later move to another
type of care as two separate claims. Defining claims in this manner has
projected a greater number of expected claims from certain types of policies.
However, we believe that
25
we have also underestimated the expected length of individual claims. We have
now determined to define this as one claim, using the earliest date of service
as the incurral date. This redefinition of claims results in fewer expected
future claims, but anticipates that each claim will last longer.
b) Continuance Assumptions:
Once a claim occurs, we develop claim reserves by using continuance tables,
which measure the likelihood of a claim continuing in the future. Historically,
we have applied every claim to a set of uniform continuance tables. Our
actuarial modeling suggests that this assumption and process method no longer
reflects the increasing number of claims from policies with longer benefit
periods or increased benefit amounts. We have developed improved assumptions and
processes by creating separate continuance patterns for facility, home health
and comprehensive care, as well as for tax qualified and non-qualified plans. In
addition, we have established separate continuance tables for claims caused by
cognitive impairment. As a result, we believe that the duration of existing
claims will be longer than was previously expected and have adopted this
assumption and process change.
By redefining these `multiple' claims as a single claim and by employing new
assumptions and processes for predicting the continuance of claims, we are
confident that we can predict future claims development with a much higher
degree of precision. By retrospectively applying these findings to earlier
periods in multiple tests, we would have seen substantially less adverse
deviation from expected results in the development of claims reserves. We
believe that the new assumptions will serve to reduce future reserve volatility
by more closely predicting future claims development.
As a result of this redefinition of claims and employment of new continuance
tables for separate types of claims, we have increased our policy and contract
claims by $83,000 in the 2002 period, which is primarily attributable to claims
incurred prior to January 1, 2002.
Further, by employing a lower discount rate of 5.7% at September 30, 2002,
rather than the 6.5% that had been used prior to the current quarter, we
increased our claims reserves by approximately $5,000. We believe that, as a
result of lower market interest rates, the lower discount rate more closely
matches our currently anticipated return from the investment of assets
supporting these reserves.
During the 2002 period, we experienced a change in the composition of our
aggregate policyholder base. The resultant composition included more policies
with inflation protection, shorter elimination periods and type of care
protection than we had previously seen. As a result, during the 2002 period, we
are holding higher reserves per policy than in the 2001 period. This change in
composition has caused us to hold approximately $21,500 in additional benefit
reserves.
Commissions. Commissions to agents decreased 42.6% to $36,034 in the 2002
period, compared to $62,744 in the 2001 period.
First year commissions on accident and health business in the 2002 period
decreased 89.6% to $2,754, compared to $26,528 in the 2001 period, due to the
decrease in first year accident and health premiums. The ratio of first year
accident and health commissions to first year accident and health premiums was
57.0% in the 2002 period and 67.5% in the 2001 period. We believe that the
decrease in the first year commission ratio is primarily attributable to the
increased sale of our Secured Risk and Medicare Supplement policies as a
percentage of total sales. These policies pay a lower commission. Our Secured
Risk policy provides limited benefits to higher risk policyholders at a
substantially increased premium rate. We believe that we are likely to
experience an increase in the sale of these policies as a percentage of new
sales when we reenter sales in many states as a result of our lower financial
ratings with A.M. Best and Standard and Poor's rating services.
Renewal commissions on accident and health business in the 2002 period decreased
9.2% to $34,264, compared to $37,744 in the 2001 period, due to the decrease in
renewal premiums discussed above. The ratio of renewal accident and health
commissions to renewal accident and health premiums was 14.0% in the 2002 period
and 16.4% in the 2001 period. We began the implementation of premium rate
increases of approximately 20% at the end of the 2001 period, for which we do
not pay commissions. As a result, commission ratios are reduced.
During the 2002 period, we reduced commission expense by netting, as an
intercompany elimination, $2,051 from override commissions affiliated insurers
paid to our agency subsidiaries. During the 2001 period, we reduced commissions
by $2,973.
Net policy acquisition costs amortized (deferred). The net deferred policy
acquisition costs in the 2002 period increased to a net amortization of costs of
$7,854, compared to $3,608 in the 2001 period.
Deferred costs are typically all costs that are directly related to, and vary
with, the acquisition of new premiums. These costs include the variable portion
of commissions, which are defined as the first year commission rate less
ultimate renewal commission rates, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based upon actuarial assumptions, including persistency of
policies in-force. In the event that a policy
26
lapses prematurely due to death or termination of coverage, the remaining
unamortized portion of the deferred amount is immediately recognized as expense
in the current period.
The amortization of deferred costs is generally offset largely by the deferral
of costs associated with new premium generation. Lower new premium sales during
the 2002 period produced significantly less expense deferral to offset amortized
costs.
General and administrative expenses. General and administrative expenses in the
2002 period decreased 4.7% to $34,929, compared to $36,670 in the 2001 period.
The 2002 and 2001 periods include $4,526 and $4,995, respectively, of general
and administrative expenses related to United Insurance Group expense. The ratio
of total general and administrative expenses to premium revenues, excluding
United Insurance Group, was 12.1% in the 2002 period, compared to 11.9% in the
2001 period.
Certain expenses have declined as a result of reduced new premium sales, related
underwriting and policy issuance expenses and management initiatives to reduce
operating expenses. However, we believe that if we remain unable to write new
business in certain states where we have ceased new production, or if we are
unable to utilize our existing staff and infrastructure capacity to generate
additional premiums, we will need to decrease production expenses further.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance
agreement provides the reinsurer with annual expense and risk charges, which are
charged against our experience account in the event of future commutation of the
agreement. The annual charge consists of a fixed cost and a variable component
based upon reserve and capital levels needed to support the reinsured business.
In the 2002 period, we incurred an expense of $10,731 for this charge. In
addition, we are subject to an excise tax for premium payments made to a foreign
reinsurer. We recorded $2,185 for excise tax expenses in the 2002 period.
Provision for Federal income taxes. As a result of current losses, our provision
for Federal income taxes for the 2002 period decreased 728% to an income tax
benefit of $13,487, compared to an income tax provision of $2,148 for the 2001
period. The effective tax rate of 34% in the 2002 and 2001 periods is below the
normal Federal corporate income tax rate as a result of anticipated credits from
our investments in corporate owned life insurance and the Cumulative effect of
accounting change. We recognized an impairment loss of $5,151 in the 2002 period
as a result of our transitional impairment test of goodwill. See "New Accounting
Principles."
Comprehensive income. During the 2002 period, our investment portfolio generated
pre-tax unrealized gains of $347, compared to unrealized gains of $15,519 in the
2001 period. The reduced unrealized gain at September 30, 2002 is primarily
attributable to the sale of the majority of our investment portfolio in
conjunction with the initial premium payment for our reinsurance agreement.
After accounting for deferred taxes from these gains, shareholders' equity
decreased by $40,770 from comprehensive losses during the 2002 period, compared
to comprehensive income of $16,855 in the 2001 period.
Liquidity and Capital Resources (amounts in thousands)
Our consolidated liquidity requirements have historically been met from the
operations of our insurance subsidiaries, from our agency subsidiaries and from
funds raised in the capital markets. Our primary sources of cash are premiums,
investment income and maturities of investments. We have obtained, and may in
the future obtain, cash through public and private offerings of our common
stock, the exercise of stock options and warrants, other capital markets
activities or debt instruments. Our primary uses of cash are policy acquisition
costs (principally commissions), payments to policyholders, investment purchases
and general and administrative expenses.
In the 2002 period, our cash flows were attributable to cash provided by
operations, cash used in investing and cash provided by financing. Our cash
decreased $90,897 in the 2002 period primarily due to payments made to our
reinsurer and the purchase of $25,543 in bonds and equity securities. Cash was
provided primarily from the maturity and sale of $486,773 in bonds and equity
securities. These sources of funds were supplemented by $59,165 from operations.
The major source of cash from operations was premium and investment income
received.
Our cash decreased $50,948 in the 2001 period primarily due to the purchase of
$247,082 in bonds and equity securities. Cash was provided primarily from the
maturity and sale of $91,577 in bonds and equity securities. These sources of
funds were supplemented by $83,156 from operations. The major provider of cash
from operations was premium revenue used to fund reserve additions of $55,706.
We invest in securities and other investments authorized by applicable state
laws and regulations and follow an investment policy designed to maximize yield
to the extent consistent with liquidity requirements and preservation of assets.
As of September 30, 2002, shareholders' equity was increased by $1,125 due to
unrealized gains of $1,730 in the investment portfolio. As of December 31, 2001,
shareholders' equity was increased by $10,581 due to unrealized gains of $16,032
in the investment portfolio.
27
-- Subsidiary Operations
Our insurance subsidiaries are regulated by various state insurance departments.
In its ongoing effort to improve solvency regulation, the National Association
of Insurance Commissioners ("NAIC") has adopted Risk-Based Capital ("RBC")
requirements for insurance companies to evaluate the adequacy of statutory
capital and surplus in relation to investment and insurance risks, such as asset
quality, mortality and morbidity, asset and liability matching, benefit and loss
reserve adequacy, and other business factors. The RBC formula is used by state
insurance regulators as an early warning tool to identify, for the purpose of
initiating regulatory action, insurance companies that potentially are
inadequately capitalized. In addition, the formula defines minimum capital
standards that an insurer must maintain. Regulatory compliance is determined by
a ratio of the enterprise's regulatory Total Adjusted Capital, to its Authorized
Control Level RBC, as defined by the NAIC. Companies below specific trigger
points or ratios are classified within certain levels, each of which may require
specific corrective action depending upon the insurer's state of domicile.
Our insurance subsidiaries, Penn Treaty, American Network, and American
Independent (representing approximately 92%, 6% and 2% of our in-force premium,
respectively) are each required to hold statutory surplus that is, above a
certain required level. If the statutory surplus of any of our subsidiaries
falls below such level, the Department would be required to place such
subsidiary under regulatory control, leading to rehabilitation or liquidation.
At December 31, 2000, Penn Treaty had Total Adjusted Capital at the Regulatory
Action level. As a result, it was required to file a Corrective Action Plan (the
"Plan") with the insurance commissioner.
On February 12, 2002, the Department approved the Plan. As a primary component
of the Plan, effective December 31, 2001, Penn Treaty and American Network
entered a reinsurance transaction to reinsure, on a quota share basis,
substantially all of our long-term care insurance policies then in-force. The
agreement is subject to certain coverage limitations, including an aggregate
limit of liability that is a function of certain factors and that may be reduced
in the event that the rate increases that the reinsurance agreement may require
are not obtained. We intend, but are not required to commute the agreement on
December 31, 2007 and would incur undesirable penalties for not commuting, such
as additional vested warrants provided to the reinsurer and escalating risk
charges, which require us to owe annual amounts to the Reinsurer in excess of
$10,000. The risk charges increase to approximately $13,000 annually if we do
not commute before January 1, 2008. This agreement meets the requirements to
qualify for reinsurance treatment under statutory accounting rules. However,
this agreement does not qualify for reinsurance treatment in accordance with
FASB No. 113 because, based on our analysis, the agreement does not result in
the reasonable possibility that the reinsurer may realize a significant loss.
This is due to a number of factors related to the agreement, including
experience refund provisions, expense and risk charges due to the reinsurer and
the aggregate limit of liability.
The initial premium of the treaties was approximately $619,000, comprised of
$563,000 of cash and qualified securities transferred in February 2002, and
$56,000 as funds held due to the reinsurer. The initial premium and future cash
flows from the reinsured policies, less claims payments, ceding commissions and
risk charges, is credited to a notional experience account, which is held for
our benefit in the event of commutation and recapture on or after December 31,
2007. The notional experience account balance receives an investment credit
based upon the total return from a series of benchmark indices and derivative
hedges that are intended to match the duration of our reserve liability.
The reinsurance agreement contains commutation provisions and allows us to
recapture the statutory reserve liabilities and the notional experience account
balance as of December 31, 2007, or on December 31 of any year thereafter. We
intend, but are not required, to commute the agreement on December 31, 2007. Our
intention to commute the agreement on December 31, 2007 is predicated upon our
actuarial modeling, which suggested that, by that time, Penn Treaty would have
sufficient statutory surplus to support the reinsured business under regulatory
requirements. In the event we determine, due to future revisions of our
actuarial projections, that our planned commutation is likely to occur after
December 31, 2007, we would record annual expense and risk charges that
incorporate future escalation provisions through the newly determined
commutation date, as well as extend the period of time over which the initial
costs are amortized. We would also evaluate and potentially record an impairment
of our DAC asset due to any additional expense and risk charges.
As a result of our intention to commute, we assessed only the expense and risk
charges anticipated prior to the commutation date in our most recent DAC
recoverability analyses completed at December 31, 2001 and are not recording the
potential of future escalating charges in our current financial statements. In
addition, we are recognizing the up front costs of entering the agreement, such
as the fair value of the warrants granted to the reinsurer, over the period of
time to the expected commutation date
The agreement also granted the reinsurer an option to participate in reinsuring
new business sales up to 50% on a quota share basis. In August 2002, the
reinsurer exercised its option to reinsure a portion of future sales. Subsequent
to September 30, 2002, we submitted a preliminary draft of the proposed
reinsurance agreement to the Department for review. Because the proposed
reinsurance agreement has not yet been agreed upon by the entering parties or
the Pennsylvania Insurance Department, no impact has been reflected in our
statements of operations.
28
The Plan requires Penn Treaty to comply with certain other agreements at the
direction of the Department, including, but not limited to:
o New investments are limited to NAIC 1 or 2 rated securities.
o Affiliated transactions are limited and require Department approval.
o An agreement to increase statutory reserves by an additional $50,000
throughout 2002-2004, such that our subsidiaries' policy reserves will be based
on new, current claims assumptions and will not include any rate increases.
These claim assumptions are applied to all policies, regardless of issue year
and are assumed to have been present since the policy was first issued. The
reinsurance agreement has provided the capacity to accommodate this increase.
Effective September 10, 2001, we determined to discontinue the sale nationally
of all new long-term care insurance policies until the Plan was approved by the
Department. The decision resulted from our concern about further depletion of
statutory surplus from new policy sales prior to the completion and approval of
the Plan and from increasing concern regarding our status by many states in
which we are licensed to conduct business. The form of our cessation varied by
state, ranging from no action to certificate suspensions.
Upon the approval by the Department of the Plan in February 2002, we recommenced
new policy sales in 23 states, including Pennsylvania. We have since recommenced
sales in nine additional states, including Florida and Texas, which have
historically represented approximately 25% and 5%, respectively of our new
policy sales (See "-- Parent Company Operations"). However, we have not yet
commenced new business sales in California, Virginia or Illinois, which together
have traditionally represented approximately 27% of new policy sales. We are
actively working with the remaining states, in order to recommence sales in all
jurisdictions.
The majority of our insurance subsidiaries' cash flow results from our existing
long-term care policies, which will be ceded to the reinsurer under this
agreement. Our subsidiaries' ability to meet additional liquidity needs and
fixed expenses in the future is highly dependent upon our ability to issue new
policies and to control expense growth.
Our future growth is dependent upon our ability to continue to expand our
historical markets, retain and expand our network of agents and effectively
market our products and our ability to fund our marketing and expansion while
maintaining minimum statutory levels of capital and surplus required to support
such growth. Under the insurance laws of Pennsylvania and New York, where our
insurance subsidiaries are domiciled, insurance companies can pay ordinary
dividends only out of earned surplus. In addition, under Pennsylvania law, our
Pennsylvania insurance subsidiaries (including our primary insurance subsidiary)
must give the Department at least 30 days' advance notice of any proposed
"extraordinary dividend" and cannot pay such a dividend if the Department
disapproves the payment during that 30-day period. For purposes of that
provision, an extraordinary dividend is a dividend that, together with all other
dividends paid during the preceding twelve months, exceeds the greater of 10% of
the insurance company's surplus as shown on the company's last annual statement
filed with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to the immediate or
accelerated recognition of all costs associated with premium growth and benefit
reserves. Additionally, the Plan requires the Department to approve all dividend
requests made by Penn Treaty, regardless of normal statutory requirement for
allowable dividends. We believe that the Department is unlikely to consider any
dividend request in the foreseeable future, as a result of Penn Treaty's current
statutory surplus position. Although not stipulated in the Plan, this
requirement is likely to continue until such time as Penn Treaty meets normal
statutory allowances, including reported net income and positive cumulative
earned surplus.
Under New York law, our New York insurance subsidiary (American Independent)
must give the New York Insurance Department 30 days' advance notice of any
proposed dividend and cannot pay any dividend if the regulator disapproves the
payment during that 30-day period. In addition, our New York insurance company
must obtain the prior approval of the New York Insurance Department before
paying any dividend that, together with all other dividends paid during the
preceding twelve months, exceeds the lesser of 10% of the insurance company's
surplus as of the preceding December 31 or its adjusted net investment income
for the year ended the preceding December 31.
Penn Treaty and American Network have not paid any dividends to the parent
company for the past three years and are unlikely in the foreseeable future to
be able to make dividend payments due to insufficient statutory surplus and
anticipated earnings. However, our New York subsidiary is not subject to the
Plan and was permitted by New York statute to make a dividend payment following
December 31, 2001. During the 2002 period, we received a dividend from our New
York subsidiary of $651.
Our subsidiaries' debt currently consists primarily of a mortgage note in the
amount of $1,516 that was issued by a former subsidiary and assumed by us when
that subsidiary was sold. The mortgage note is currently amortized over 15
years, and has a balloon payment due on the remaining outstanding balance in
December 2003. Although the note carries a variable interest rate,
29
we have entered into an amortizing swap agreement with the same bank with a
nominal amount equal to the outstanding debt, which has the effect of converting
the note to a fixed rate of interest of 6.85%.
-- Parent Company Operations
Our parent company is a non-insurer that directly controls 100% of the voting
stock of our insurance subsidiaries. If we are unable to meet our financial
obligations, become insolvent or discontinue operations, the financial condition
and results of operations of our insurance subsidiaries could be materially
affected.
On April 27, 2001, we distributed rights to our shareholders and holders of our
6.25% convertible subordinated notes due 2003 ("Rights Offering") for the
purpose of raising new equity capital. Pursuant to the Rights Offering, holders
of our common stock and holders of our convertible subordinated notes received
rights to purchase 11,547 newly issued shares of common stock at a set price of
$2.40 per share. The Rights Offering was completed on May 25, 2001 and generated
net proceeds of $25,726 in additional equity capital. We contributed $18,000 of
the net proceeds to the statutory capital of our subsidiaries.
In March 2002, we completed a private placement of 510 shares of common stock
for net proceeds of $2,352. The common stock was sold to several current and new
institutional investors, at $4.65 per share. The offering price was a 10 percent
discount to the 30-day average price of our common stock prior to the issuance
of the new shares. Our common stock is listed on the New York Stock Exchange. We
filed a registration statement with the Securities and Exchange Commission on
June 5, 2002 to register these shares for resale. However, the proceeds of the
private placement provided sufficient additional liquidity to the parent company
to meet our debt obligations prior to the maturity of the remaining convertible
debt in 2003. The proceeds, together with currently available cash sources, will
not be sufficient to meet the December 2003 final interest requirement of the
convertible debt or to retire the debt upon maturity.
In June 2002, we completed a private placement of 60 shares of common stock as
compensation to our financial advisor. We filed a registration statement for 30
of these additional shares with the Securities and Exchange Commission on
June 5, 2002.
In October 2002, we announced our intention to raise additional equity capital
prior to March 31, 2003 in order to support future sales growth, provide
additional parent company liquidity and to continue to meet statutory
requirements. We are required to raise approximately $25,000 of additional
equity capital prior to December 31, 2002 in order for Penn Treaty to remain in
compliance with its Consent Order entered with the Florida Insurance Department
upon the recommencement of sales in July 2002. The Consent Order includes, among
other requirements for which our subsidiary is currently in compliance, a
requirement to raise sufficient equity capital to meet Florida requirements for
gross premium to surplus ratios. If we are unsuccessful in our efforts to raise
additional capital and are unable to report December 31, 2002 statutory capital
sufficient to meet the required Florida gross premium to surplus ratio, our
subsidiary could be required to cease new sales in Florida and its certificate
of authority could be suspended by the Florida Insurance Department until
sufficient capital could be raised.
Parent company debt currently consists of $15,047 of 6.25% convertible
subordinated notes due 2003 ("the 2003 Notes") and $59,703 of 6.25% senior
convertible subordinated notes due 2008 ("the 2008 Notes").
The 2003 Notes, issued in November 1996, are convertible into common stock at
$28.44 per share until maturity in December 2003. At maturity, to the extent
that any portion has not been converted into common stock, we will have to repay
their entire principal amount in cash. The 2003 Notes carry a fixed interest
coupon of 6.25%, payable semi-annually. Because we do not have sufficient cash
flow to retire the debt upon maturity, and the conversion price of $28.44 per
share is not likely to be met, we expect that we will need to refinance the
remaining 2003 Notes on or before maturity in 2003.
In September 2002, having made all necessary filings with the Securities and
Exchange Commission, we commenced an offer of up to $74,750 in aggregate
principal amount of 2008 Notes in exchange for up to all of our then outstanding
2003 Notes. Under the terms of the exchange offer, the new notes would have
terms similar to the former notes but mature in October 2008 and would be
convertible into shares of our common stock at a conversion price of $5.31.
Prior to the termination of the exchange offer, we reduced our offered
conversion price to $4.50. In addition, beginning in October 2004, the 2008
Notes are mandatorily convertible if, at any time, the 15-day average closing
price of our common stock exceeds 110% of the conversion price. Subsequent
to September 30, 2002, we exchanged approximately $63,343 of the 2003
Notes for the 2008 Notes.
On January 1, 1999, we purchased all of the common stock of United Insurance
Group, a Michigan based consortium of long-term care insurance agencies, for
$18,192. As part of the purchase, we issued a note payable for $8,078, which was
in the form of a three-year zero-coupon installment note. The installment note,
after discounting for imputed interest, was recorded as a note payable of
$7,167, and had an outstanding balance of $2,858 at December 31, 2001. The
remainder of the purchase price was paid in cash. The total outstanding balance
of the note was repaid in January 2002.
30
At September 30, 2002, our total debt and financing obligations through
2006 were as follows:
Lease
Debt Obligations Total
---- ----------- -----
2002 $ - $ 245 $ 245
2003 12,923 344 13,267
2004 - 252 252
2005 - 18 18
2006 - 18 18
-------- ----- --------
Total $ 12,923 $ 877 $ 13,800
==========================================
Our 2008 Notes in the amount of $63,343, which were exchanged for 2003 Notes due
in December 2003 subsequent to September 30, 2002, are due, if not converted, in
October 2008. The table reflects the exchange of the notes on a proforma basis.
Other amounts due after 2006 are immaterial.
In December 1999, we contributed $1,000 to initially capitalize another
subsidiary, which concurrently lent us $750 in exchange for a demand note, which
is still outstanding.
As part of our reinsurance agreement, effective December 31, 2001, the reinsurer
was granted four tranches of warrants to purchase shares of non-voting
convertible preferred stock. The first three tranches of warrants are
exercisable through December 31, 2007 at common stock equivalent prices ranging
from $4.00 to $12.00 per share. If exercised for cash, at the reinsurer's
option, the warrants could yield additional capital and liquidity of
approximately $20,000 and the convertible preferred stock would represent, if
converted, approximately 15% of the then outstanding shares of our common stock.
If the agreement is not commuted on or after December 31, 2007, the reinsurer
may exercise the fourth tranche of convertible preferred stock purchase warrants
at a common stock equivalent price of $2.00 per share, potentially generating
additional capital of $12,000 and, if converted, the convertible preferred stock
would represent an additional 20% of the then outstanding common stock. No
assurance can be given that the reinsurer will exercise any or all of the
warrants granted or that it will pay cash in connection with their exercise.
Cash flow needs of the parent company primarily include interest payments on
outstanding debt and limited operating expenses. The funding is primarily
derived from the operating cash flow of our agency subsidiary operations and
dividends from the insurance subsidiaries. However, as noted above, the dividend
capabilities of the insurance subsidiaries are limited and we may need to rely
upon the dividend capabilities of our agency subsidiaries to meet current
liquidity needs. Our current cash on hand and these sources of funds are
expected to be sufficient to meet our liquidity needs through March 31, 2003,
but may be insufficient to meet our interest payments in April and June 2003,
and will be insufficient to meet our interest payments in October and December
2003, including any remaining repayment of our 2003 Notes upon maturity in
December 2003. We believe that we will need to raise additional equity capital
in order to meet our parent company needs in 2003 and for the foreseeable
future.
New Accounting Principles (amounts in thousands)
In June 2001, the Financial Accounting Standards Board ("FASB") issued two
Statements of Financial Accounting Standards ("SFAS"). SFAS No. 141, "Business
Combinations," requires usage of the purchase method for all business
combinations initiated after June 30, 2001, and prohibits the usage of the
pooling of interests method of accounting for business combinations. The
provisions of SFAS No. 141 relating to the application of the purchase method
are generally effective for business combinations completed after July 1, 2001.
Such provisions include guidance on the identification of the acquiring entity,
the recognition of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition provisions
of SFAS No. 141 require an analysis of goodwill acquired in purchase business
combinations prior to July 1, 2001 to identify and reclassify separately
identifiable intangible assets currently recorded as goodwill.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily addresses the
accounting for goodwill and intangible assets subsequent to their acquisition.
We adopted SFAS No. 142 on January 1, 2002 and ceased amortizing goodwill at
that time. During the second quarter 2002, we completed an impairment analysis
of goodwill, in accordance with FASB No. 142. Our goodwill was recorded as a
result of the purchase of its agencies and its insurance subsidiaries. As part
of our evaluation, we completed numerous steps in determining the revocerability
of its goodwill. The first required step was the measurement of total enterprise
fair value versus book value. Because our fair market value, as measured by our
stock price, was below book value at January 1, 2002, goodwill was next
evaluated at a reporting unit level, which comprised our insurance agencies and
insurance subsidiaries.
31
Upon completion of our evaluation, we determined that the goodwill associated
with the agency purchases was fully recoverable. The deficiency of current
market value to book value was assigned to the insurance subsidiary values. As a
result, we determined that the goodwill associated with our insurance
subsidiaries was impaired and recognized an impairment loss of $5,151 from our
transitional impairment test of goodwill, which we recorded as a cumulative
effect of change in accounting principle. The impairment has been recorded
effective January 1, 2002. Management has completed an assessment of other
intangible assets and has determined to continue to amortize these assets so as
to closely match the future profit emergence from these assets.
Forward Looking Statements
Certain statements made by us may be considered forward - looking within the
meaning of the Private Securities Litigation Reform Act of 1995. Although we
believe that our expectations are based upon reasonable assumptions within the
bounds of our knowledge of our business and operations, there can be no
assurance that actual results of our operations will not differ materially from
our expectations. Factors which could cause actual results to differ from
expectations include, among others, our ability to comply with the Pennsylvania
Corrective Action Plan, the Florida Consent Order, which includes, among others,
a requirement to comply with Florida gross premium to surplus ratios, for which
we are required to raise additional equity capital of approximately $25 million
prior to year end and which, if we are unsuccessful in doing so could lead to
the suspension of our insurance license in Florida, the orders or directives of
other states in which we do business or any special provisions imposed by states
in connection with the resumption of writing business, our ability to commute
our reinsurance agreement and to recapture our reinsured polices and accumulated
experience account balance, whether our Corrective Action Plan will be accepted
and approved by all states, our ability to meet our future risk-based capital
goals, the adverse financial impact of suspending new business sales, our
ability to raise adequate capital to meet regulatory requirements and to support
anticipated growth, our ability to refinance, convert or repay our outstanding
2003 convertible notes and our 2008 convertible notes, the cost associated with
recommencing new business sales, liquidity needs and debt obligations, the
adequacy of our loss reserves and the recoverability of our unamortized deferred
policy acquisition cost asset, our ability to sell insurance products in certain
states, our ability to resume generating new business in all states, our ability
to comply with government regulations and the requirements which may be imposed
by state regulators as a result of our capital and surplus levels, the ability
of senior citizens to purchase our products in light of the increasing costs of
health care, our ability to defend ourself against adverse litigation, and our
ability to recapture, expand and retain our network of productive independent
agents, especially in light of the suspension of new business. For additional
information, please refer to our reports filed with the Securities and Exchange
Commission, which may be viewed at www.sec.gov.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
(amounts in thousands of dollars)
We invest in securities and other investments authorized by applicable state
laws and regulations and follow an investment policy designed to maximize yield
to the extent consistent with liquidity requirements and preservation of assets.
A significant portion of assets and liabilities are financial instruments, which
are subject to the market risk of potential losses from adverse changes in
market rates and prices. Our primary market risk exposures relate to interest
rate risk on fixed rate domestic medium-term instruments and, to a lesser
extent, domestic short-term and long-term instruments. We have established
strategies, asset quality standards, asset allocations and other relevant
criteria for our portfolio to manage our exposure to market risk.
As part of our reinsurance transaction, our reinsurer will maintain a notional
experience account for our benefit that includes the initial premium paid, all
future cash flows from the reinsured business and accumulated investment
earnings. The notional experience account balance will receive an investment
credit based upon the total return of a series of benchmark indices and
derivative hedges, which are designed to closely match the duration of our
reserve liabilities. Periodic changes in the market values of the benchmark
indices and derivative hedges are recorded in our financial statements as
investment gains or losses in the period in which they occur. As a result, our
future financial statements have been and will continue to be subject to
significant volatility.
We currently have an interest rate swap on our mortgage, which is used as a
hedge to convert the mortgage to a fixed interest rate. We believe that, since
the notional amount of the swap is amortized at the same rate as the underlying
mortgage and both financial instruments are with the same bank, no credit or
financial risk is carried with the swap.
Our financial instruments are held for purposes other than trading. Our
portfolio does not contain any significant concentrations in single issuers
(other than U.S. treasury and agency obligations), industry segments or
geographic regions.
We urge caution in evaluating overall market risk from the information below.
Actual results could differ materially because the information was developed
using estimates and assumptions as described below, and because insurance
liabilities and reinsurance receivables are excluded in the hypothetical effects
(insurance liabilities represent 87.8% of total liabilities and reinsurance
32
receivables on unpaid losses represent 67.4% of total assets). Long-term debt,
although not carried at fair value, is included in the hypothetical effect
calculation.
The hypothetical effects of changes in market rates or prices on the fair values
of financial instruments as of September 30, 2002, including the value of our
experience account, but excluding insurance liabilities and other reinsurance
receivables on unpaid losses because such insurance related assets and
liabilities are not carried at fair value, would have been as follows:
If interest rates had increased by 100 basis points, there would have been an
approximate $38,000 decrease in the net fair value of our financial instruments.
The change in fair values was determined by estimating the present value of
future cash flows using models that measure the change in net present values
arising from selected hypothetical changes in market interest rate. A 200 basis
point increase in market rates at September 30, 2002 would have resulted in an
approximate $72,000 decrease in the net fair value. If interest rates had
decreased by 100 and 200 basis points, there would have been an approximate
$43,000 and $91,000 net increase, respectively, in the net fair value of our
financial instruments.
We hold certain mortgage and asset backed securities as part of our investment
portfolio. The fair value of these instruments may react in a convex or
non-linear fashion when subjected to interest rate increases or decreases. The
anticipated cash flows of these instruments may differ from expectations in
changing interest rate environments, resulting in duration drift or a varying
nature of predicted time-weighted present values of cash flows. The result of
unpredicted cash flows from these investments could cause the above hypothetical
estimates to change. However, we believe that the minimal amount we have
invested in these instruments and their broadly defined payment parameters
sufficiently outweigh the cost of computer models necessary to accurately
predict their possible impact to our investment income from the hypothetical
effects of changes in market rates or prices on the fair values of financial
instruments as of September 30, 2002.
Item 4. Internal Controls
The Company carried out an evaluation of the effectiveness of the Company's
disclosure controls and procedures within 90 days prior to the filing date of
this report. This evaluation was carried out under the supervision and with the
participation of the Company's management, including the Company's Chairman and
Chief Executive Officer, the Company's President and Chief Operating Officer and
the Company's Executive Vice President and Chief Financial Officer. Based upon
that evaluation, the Company's Chairman and Chief Executive Officer, the
Company's President and Chief Operating Officer and the Company's Executive Vice
President and Chief Financial Officer concluded that the Company's disclosure
controls and procedures are effective. There have not been any significant
changes in the Company's internal controls, or in other factors which could
significantly affect internal controls subsequent to the date the Company
carried out its evaluation, or any corrective actions with regard to significant
deficiencies and material weaknesses.
33
PART II OTHER INFORMATION
Item 1. Legal Proceedings
Our subsidiaries are parties to various lawsuits generally arising in the normal
course of their business. We do not believe that the eventual outcome of any of
the suits to which we are party will have a material adverse effect on our
financial condition or results of operations. However, the outcome of any single
event could have a material impact upon the quarterly or annual financial
results of the period in which it occurs.
The Company and certain of our key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by our shareholders, on
their own behalf and on behalf of a putative class of similarly situated
shareholders who purchased shares of the Company's common stock between July 23,
2000 through and including March 29, 2001. The consolidated amended class action
complaint seeks damages in an unspecified amount for losses allegedly incurred
as a result of misstatements and omissions allegedly contained in our periodic
reports filed with the SEC, certain press releases issued by us, and in other
statements made by our officials. The alleged misstatements and omissions
relate, among other matters, to the statutory capital and surplus position of
our largest subsidiary, Penn Treaty Network America Insurance Company. On
December 7, 2001, the defendants filed a motion to dismiss the complaint, which
was denied. We believe that the complaint is without merit, and we will continue
to vigorously defend the matter.
In June of 2000, the Company instituted an action against Money Services, Inc.
in the 342nd Judicial District Court of Tarrant County, Texas for breach of
contract, seeking a refund of license fees paid for computer software and for
the recovery of its attorneys' fees. The purchase of the software was on a trial
basis, and, at the end of the evaluation period, the Company had the right to
return the software for a refund of $371,250 in license fees paid, less an
administrative fee of $25,000. A final payment of $123,500 was due if the
Company decided to keep the software. The Company returned the software to Money
Services, Inc., in February 2000 and requested a refund of the license fees
paid. Money Services refused to refund the license fees to the Company. Money
Services filed a counter-claim against the Company, seeking the final payment of
$123,500 plus its attorneys' fees. After trial held on October 21 and 22, 2002,
the Court found in favor of Money Services, Inc., and ordered that the Company
be liable for damages in the amount of $123,500, pre-judgment and post-judgment
interest, and attorneys' fees in the amount of $90,000. The parties are awaiting
a final judgment to be entered by the Court. Once the final judgment has been
entered, the Company will have an opportunity to determine its options for
appeal of this matter.
Item 2. Changes in Securities
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. Other Information
Not Applicable
Item 6. Exhibits and Reports on Form 8-K
Exhibit Number Description
10.1 Reinsurance Agreement with Centre Solutions (Bermuda) Limited.
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.
99.2 Certification of President and Chief Operating Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act.
34
99.3 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act.
99.4 Corrective Order with Pennsylvania Insurance Department.
35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant had duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PENN TREATY AMERICAN CORPORATION
--------------------------------
Registrant
Date: December 24, 2002 /s/ Irving Levit
----------------- -----------------------------------------
Irving Levit
Chairman of the Board and
Chief Executive Officer
Date: December 24, 2002 /s/ Cameron B. Waite
----------------- ----------------------------------------
Cameron B. Waite
Executive Vice President and
Chief Financial Officer
I, Irving Levit, certify that:
1. I have reviewed this quarterly report on Form 10-Q/A of Penn Treaty American
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a)
designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: December 24, 2002 /s/ Irving Levit
----------------- -------------------------------
Irving Levit
Chairman of the Board and
Chief Executive Officer
36
I, William W. Hunt, certify that:
1. I have reviewed this quarterly report on Form 10-Q/A of Penn Treaty American
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a)
designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: December 24, 2002 /s/ William W. Hunt
----------------- ----------------------------
William W. Hunt
President and
Chief Operating Officer
37
I, Cameron B. Waite, certify that:
1. I have reviewed this quarterly report on Form 10-Q/A of Penn Treaty American
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a)
designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: December 24, 2002 /s/ Cameron B. Waite
----------------- --------------------------------
Cameron B. Waite
Executive Vice President and
Chief Financial Officer
38