PROSPECTUS
[PENN TREATY LOGO]
Penn Treaty American Corporation
3440 Lehigh Street
Allentown, PA 18103
(610) 965-2222
PENN TREATY AMERICAN CORPORATION
$14,000,000 6 1/4% CONVERTIBLE SUBORDINATED NOTES DUE 2008 ISSUED ON
FEBRUARY 2, 2004
$2,000,000 6 1/4% CONVERTIBLE SUBORDINATED NOTES DUE 2008 ISSUED ON
FEBRUARY 19, 2004
$10,000,000 6 1/4% CONVERTIBLE SUBORDINATED NOTES DUE 2008 ISSUED ON
NOVEMBER 24, 2004
15,312,469 SHARES OF COMMON STOCK
This prospectus relates to the offering by the selling securityholders
named herein of $14,000,000 6 1/4% Convertible Subordinated Notes due 2008
issued on February 2, 2004 (the "Series 1 Notes"), $2,000,000 6 1/4% Convertible
Subordinated Notes due 2008 issued on February 19, 2004 (the "Series 2 Notes")
and $10,000,000 6 1/4% Convertible Subordinated Notes due 2008 issued on
November 24, 2004 (the "Series 3 Notes" and, together with the Series 1 Notes
and the Series 2 Notes, the "Notes") of Penn Treaty American Corporation. In
addition, this prospectus relates to the offering by the selling securityholders
of up to 15,212,469 shares of our common stock, par value $.10 per share, issued
or issuable upon conversion of the Notes, and up to 100,000 additional shares of
common stock, par value $.10 per share (collectively, the "Common Stock" and,
together with the Notes, the "Securities").
The selling securityholders acquired the Notes directly from us in three
separate private placement transactions completed by us on February 2, 2004,
February 19, 2004 and November 24, 2004 that were each exempt from the
registration requirements of the federal securities laws. The selling
securityholders acquired or will acquire the Common Stock upon conversion of the
Notes or directly from us in two separate private placement transactions
completed by us on May 8, 2003 and May 28, 2004 that were each exempt from the
registration requirements of the federal securities laws.
Interest on the Notes is payable semi-annually on April 15 and October
15 of each year. The Notes are convertible into shares of our common stock, at
any time, at a conversion price of $1.75 per share. The Notes are subordinated
to our senior indebtedness. The Notes will mature on October 15, 2008.
If any Notes are converted prior to October 15, 2005, we will be
required to pay the holders of those Notes an amount equal to the interest that
would have been otherwise earned on those Notes between the date of conversion
and October 15, 2005, discounted from October 15, 2005 to present value using a
rate of 6.25%. We may, in our sole discretion, pay the interest in cash or in
shares of common stock. If we elect to pay the interest in common stock, we will
determine the number of shares to be issued based on a per share value equal to
90% of the average closing prices of the common stock for the five trading days
immediately preceding the conversion date. Up to 355,326 of the shares of common
stock covered by this prospectus have been registered for this purpose.
The Notes are not listed on any national securities exchange or the
Nasdaq Stock Market. Our common stock is traded on the New York Stock Exchange
under the symbol "PTA." On May 10, 2005, the last sale price of the common
stock, as reported on the New York Stock Exchange, was $2.10 per share.
The selling securityholders, directly, through agents designated from
time to time, or through brokers, dealers or underwriters to be designated, may
sell the Securities from time to time at terms to be determined at the time of
sale. The selling securityholders will be responsible for any commissions or
discounts due to brokers or dealers. The amount of those commissions or
discounts cannot be known now because they will be negotiated at the time of the
sales. We will pay all other offering expenses. We will not receive any of the
proceeds from sales of the Securities by the selling securityholders.
SEE "RISK FACTORS" BEGINNING ON PAGE 6 FOR A DISCUSSION OF CERTAIN FACTORS THAT
SHOULD BE CONSIDERED BY PROSPECTIVE INVESTORS IN THE SECURITIES.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF THIS
PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
The date of this prospectus is May 20, 2005.
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You should rely only on the information contained in this prospectus. We
have not authorized anyone to provide you with information that is different
from that contained in this prospectus. The selling securityholders are offering
to sell, and seeking offers to buy, the Notes and the shares of Common Stock
only in jurisdictions where offers and sales are permitted. The information
contained in this prospectus is accurate only as of the date of this prospectus,
regardless of the time of delivery of this prospectus or any sale of the Notes
or the Common Stock. In this prospectus, unless the context requires otherwise,
references to "Penn Treaty," "we," "us" and "our" refer to Penn Treaty American
Corporation, except that in discussions relating to operations and results of
operations, those references include our subsidiaries. The Common Stock is the
common stock of Penn Treaty American Corporation and the obligations under the
Notes are the obligations of Penn Treaty American Corporation.
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TABLE OF CONTENTS
SUMMARY........................................................................1
RISK FACTORS...................................................................6
USE OF PROCEEDS...............................................................15
MARKET PRICE, DIVIDENDS AND RELATED SHAREHOLDER MATTERS.......................15
BUSINESS......................................................................16
SELECTED FINANCIAL DATA.......................................................43
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS......................................................49
MANAGEMENT....................................................................76
DESCRIPTION OF NOTES..........................................................88
DESCRIPTION OF COMMON STOCK..................................................100
CERTAIN FEDERAL INCOME TAX CONSEQUENCES......................................104
ERISA CONSIDERATIONS.........................................................108
SELLING SECURITYHOLDERS......................................................110
PLAN OF DISTRIBUTION.........................................................116
LEGAL MATTERS................................................................118
EXPERTS 118
WHERE YOU CAN FIND MORE INFORMATION..........................................118
FINANCIAL STATEMENTS.........................................................F-1
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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains certain "forward-looking statements" based on
our current expectations, assumptions, estimates and projections about our
business and our industry. These forward-looking statements involve risks and
uncertainties. Words such as "believe," "anticipate," "expect," "intend,"
"plan," "will," "may" and other similar expressions identify forward-looking
statements. In addition, any statements that refer to expectations, projections
or other characterizations of future events or circumstances are forward-looking
statements. Our actual results could differ materially from those anticipated in
such forward-looking statements as a result of several factors more fully
described in "Risk Factors." The forward-looking statements made in this
prospectus relate only to events as of the date on
which the statements are made. We undertake no obligation to update publicly any
forward-looking statements for any reason, even if new information becomes
available or other events occur in the future.
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SUMMARY
THIS SUMMARY HIGHLIGHTS SELECTED INFORMATION FROM THIS PROSPECTUS AND
FROM DOCUMENTS INCORPORATED BY REFERENCE IN THIS PROSPECTUS. THIS SUMMARY IS NOT
COMPLETE AND DOES NOT CONTAIN ALL OF THE INFORMATION YOU SHOULD CONSIDER BEFORE
INVESTING IN THE NOTES OR THE SHARES OF COMMON STOCK. YOU SHOULD CAREFULLY READ
THIS PROSPECTUS AND THE DOCUMENTS INCORPORATED BY REFERENCE HEREIN BEFORE MAKING
A DECISION ABOUT WHETHER TO INVEST IN THE NOTES OR THE SHARES OF COMMON STOCK.
YOU SHOULD PAY PARTICULAR ATTENTION TO "RISK FACTORS" AND OUR FINANCIAL
STATEMENTS AND THE RELATED NOTES INCORPORATED BY REFERENCE HEREIN.
PENN TREATY AMERICAN CORPORATION
We are a leading provider of long-term care insurance in the United
States. Our principal products are individual, defined benefit accident and
health insurance policies covering long-term care services, including
confinement to nursing facilities and assisted living facilities. Our policies
are designed to provide meaningful benefits if and when the insured is no longer
capable of functioning independently. We also own insurance agencies that sell
senior-market insurance products issued by us as well as by other insurers.
We maintain and administer one of the largest individual long-term care
insurance portfolios in the industry. Our sales and marketing efforts through
our independent agency distribution channels were very successful between 1995
and 2000, as total in-force premiums grew at a compound annual rate of
approximately 29% from $102 million to $360 million. Our total in-force premiums
were approximately $326 million at December 31, 2004.
In 2001, we ceased new policy sales nationwide as a result of
insufficient statutory surplus levels until we formulated a Corrective Action
Plan (the "Plan") with the Pennsylvania Insurance Department (the "Department").
Both Penn Treaty Network America Insurance Company ("PTNA") and American Network
Insurance Company ("ANIC"), which represent 91% and 8% of our direct premium
revenue, respectively, are subject to the Plan. Upon the Department's approval
of the Plan in February 2002, we recommenced new policy sales in 23 states,
including Pennsylvania. We have now recommenced new policy sales in 18
additional states, including Florida and California (both subject to corrective
orders). Florida, California and Pennsylvania accounted for approximately 16%,
15% and 12%, respectively, of our direct premium revenue for the year ended
December 31, 2004. We are working with the remaining states to recommence new
policy sales in all jurisdictions.
As part of the Plan, effective December 31, 2001, we entered into a
reinsurance agreement with Centre Solutions (Bermuda) Limited to reinsure, on a
quota share basis, substantially all of our long-term care insurance policies
then in-force. The agreement is subject to certain coverage limitations and an
aggregate limit of liability, which may be reduced if we are unable to obtain
premium rate increases required by the agreement. The agreement meets the
requirements to qualify as reinsurance for statutory accounting, but not for
generally accepted accounting principles. As the agreement is treated for
reinsurance for statutory accounting purposes, it results in the cession (or
removal) of substantially all of PTNA's and ANIC's policy reserve and claim
reserve liabilities for statutory accounting purposes.
CORPORATE INFORMATION
Penn Treaty was incorporated in Pennsylvania in 1965. Our principal
executive offices are located at 3440 Lehigh Street, Allentown, Pennsylvania
18103. Our telephone number is (610) 965-2222.
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TRUSTEE
Wells Fargo Bank, National Association (formerly Wells Fargo Bank
Minnesota, N.A.) is the trustee for the Notes. Its principal executive offices
are located at Sixth Street and Marquette Avenue, Minneapolis, Minnesota 55479.
Its telephone number is (612) 316-4305.
RECENT DEVELOPMENT
On May 16, 2005, we filed a Notification of Late Filing on Form 12b-25,
indicating that we could not file our Quarterly Report on Form 10-Q for the
quarter ended March 31, 2005 by the deadline of May 16, 2005 without
unreasonable effort or expense. In our Form 12b-25, we stated that our net
income is very volatile due to swings in the notional experience account
described in this prospectus and that, as a result, our results of operations
for the first quarter of 2005 are expected to vary significantly from our
results of operations for the first quarter of 2004. In the first quarter of
2004, the notional experience account had a gain of approximately $35.6 million.
In the first quarter of 2005, the notional experience account had a loss of
approximately $.6 million.
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SUMMARY DESCRIPTION OF THE NOTES AND COMMON STOCK
NOTES
Issuer................................ Penn Treaty American Corporation.
Debt Securities Offered............... $14 million aggregate principal amount
of 6 1/4% Convertible Subordinated
Notes due 2008 issued on February 2,
2004 (the "Series 1 Notes") under an
indenture between Penn Treaty and
Wells Fargo Bank Minnesota, N.A., as
trustee.
$2 million aggregate principal amount
of 6 1/4% Convertible Subordinated
Notes due 2008 issued on February 19,
2004 (the "Series 2 Notes") under an
indenture between Penn Treaty and
Wells Fargo Bank Minnesota, N.A., as
trustee.
$10 million aggregate principal amount
of 6 1/4% Convertible Subordinated
Notes due 2008 issued on November 24,
2004 (the "Series 3 Notes" and,
together with the Series 1 Notes and
the Series 2 Notes, the "Notes") under
an indenture between Penn Treaty and
Wells Fargo Bank, National
Association, as trustee.
Maturity Date......................... October 15, 2008
Interest.............................. The Notes accrue interest at the rate
of 6 1/4% per annum, payable
semiannually on April 15 and October
15 of each year.
Conversion............................ The Notes are convertible into shares
of our common stock, at a conversion
price of $1.75 per share, at any time.
If a Note is called for redemption,
the holder is entitled to convert it
at any time before the close of
business on the last business day
prior to the redemption date. If any
Notes are converted prior to October
15, 2005, we will be required to pay
the holders of those Notes an amount
equal to the interest that would have
been otherwise earned on those Notes
between the date of conversion and
October 15, 2005, discounted from
October 15, 2005 to present value
using a rate of 6.25% with simple
interest over a 360-day year. We may,
at our sole discretion, pay the
interest in cash or in shares of
common stock. If we elect to pay the
interest in common stock, we will
determine the number of shares to be
issued based on a per share value
equal to 90% of the average closing
prices of the common stock for the
five trading days immediately
preceding the conversion date.
Mandatory Conversion.................. If the average closing share price of
our common stock for any 15
consecutive trading days beginning on
or after October 15, 2005 is at least
10% greater than the conversion price
of the Notes (i.e., $1.93) and we have
sufficient shares
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of common stock available for
issuance, then holders of the Notes
are required to convert their Notes
into common stock at the conversion
price of $1.75.
Optional Redemption................... The Notes are redeemable, in whole or
in part, at our option, at any time,
after October 15, 2005, at a price
equal to 100% of the principal amount
of the Notes plus accrued and unpaid
interest.
Mandatory Redemption.................. In the event of a Change of Control
(as defined herein) of Penn Treaty, a
holder of the Notes will have the
right, at the holder's option, to
require us to repurchase all or any
part of the holder's Notes, provided
that the principal amount must be
$1,000 or an integral multiple of
$1,000, at a price equal to 101% of
the principal amount of such holder's
Notes plus accrued and unpaid
interest.
Ranking; Subordination................ The Notes are general unsecured
obligations of Penn Treaty, are PARI
PASSU with Penn Treaty's two other
series of 6 1/4% convertible
subordinated notes due 2008 and are
subordinated in right of payment to
all future senior indebtedness of Penn
Treaty. Penn Treaty does not currently
have any senior indebtedness
outstanding. In addition, because our
operations are conducted through
subsidiaries, claims of holders of
indebtedness of such subsidiaries, as
well as claims of regulators and
creditors of such subsidiaries, will
have priority with respect to the
assets and earnings of such
subsidiaries over the claims of
creditors of Penn Treaty, including
the Note holders. The indentures for
the Series 1 Notes, the Series 2 Notes
and the Series 3 Notes do not limit
the amount of additional indebtedness
that Penn Treaty can create, incur,
assume or guarantee, nor do the
indentures for the Series 1 Notes, the
Series 2 Notes and the Series 3 Notes
limit the amount of indebtedness that
any subsidiary can create, incur,
assume or guarantee.
Listing............................... The Notes are not listed for trading
on any national securities exchange or
authorized to be quoted in any inter-
dealer quotation system of any
national securities association and we
do not intend to apply for either
listing or quotation. Several
securities firms, including
Philadelphia Brokerage Corporation,
facilitate purchases and sales of Penn
Treaty's two other series of 6 1/4%
convertible subordinated notes due
2008 that are registered and following
the effectiveness of the registration
statement, we expect such firms to do
so with respect to the Notes as well.
COMMON STOCK
Issuer................................ Penn Treaty American Corporation.
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Equity Securities Offered............. 14,857,143 shares of common stock, par
value $.10 per share, issuable upon
the conversion of the Notes, up to
355,326 additional shares of common
stock issuable at our option as
payment of discounted interest on any
Notes converted prior to October 15,
2005 from the date of conversion to
October 15, 2005 and 100,000
additional shares of common stock that
were issued in two private placements
to individuals affiliated with
Philadelphia Brokerage Corporation,
which has acted as a placement agent
in certain of our private placements
and which we have retained to provide
us with certain professional services.
The number of shares issuable as
payment of discounted interest on
Notes converted prior to October 15,
2005 will vary based on our stock
price and the number of days remaining
until October 15, 2005.
Listing............................... The common stock currently trades on
the New York Stock Exchange under the
symbol "PTA."
Market Price.......................... On May 10, 2005, the closing price per
share of our common stock on the New
York Stock Exchange was $2.10.
Dividends............................. We have never paid any
dividends and have no present
intention to pay any dividends
in the foreseeable future.
RATIO OF EARNINGS TO FIXED CHARGES
(IN THOUSANDS $) TWELVE MONTHS ENDED DECEMBER 31,
-------------------------------------------------------------------
2000 2001(1) 2002(1) 2003(1) 2004
------------ ------------ ------------ ------------ ------------
Fixed charges, as defined:
Interest on long-term debt $ 5,134 $ 4,999 $ 5,733 $ 7,024 $ 8,797
Amortization of debt expense 359 359 303 580 933
Amortization of discount on
long-term debt....... - - - 412 820
Estimated interest component
of operating rentals. 229 187 306 385 387
------------ ------------ ------------ ------------ ------------
Total fixed charges.... $ 5,722 $ 5,545 $ 6,342 $ 8,401 $ 10,937
============ ============ ============ ============ ============
Earnings, as defined:
Net income............. $ 21,811 $ (49,699) $ (31,743) $ (13,170) $ 20,536
Add (Deduct):
Cumulative effect of
accounting change.... - - 5,151 -- -
Income taxes........... 11,214 (16,877) (13,728) (2,992) 15,676
Total fixed charges as above 5,722 5,545 6,342 8,401 10,937
------------ ------------ ------------ ------------ ------------
Total earnings......... $ 38,747 $ (61,031) $ (33,978) $ (7,761) $ 47,149
============ ============ ============ ============ ============
Ratio of earnings to fixed charges 6.8x 4.3x
(1) In 2001, 2002 and 2003, earnings were deficient to cover fixed charges
by $66,576, $40,320 and $16,162, respectively.
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RISK FACTORS
BEFORE DECIDING TO INVEST IN OUR SECURITIES YOU SHOULD CONSIDER
CAREFULLY THE RISKS DESCRIBED BELOW AND THE RISKS SET FORTH IN ANY PROSPECTUS
SUPPLEMENT, AS WELL AS OTHER INFORMATION WE INCLUDE OR INCORPORATE BY REFERENCE
IN THIS PROSPECTUS AND THE ADDITIONAL INFORMATION IN THE REPORTS THAT WE FILE
WITH THE SEC. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES
WE FACE. ADDITIONAL RISKS AND UNCERTAINTIES THAT WE DO NOT PRESENTLY KNOW ABOUT,
THAT WE CURRENTLY BELIEVE ARE IMMATERIAL OR WHICH ARE SIMILAR TO THOSE FACED BY
OTHER COMPANIES IN OUR INDUSTRY OR BUSINESS IN GENERAL, MAY ALSO ADVERSELY
IMPACT OUR BUSINESS. IF ANY OF THE RISKS DESCRIBED ACTUALLY OCCUR, OUR BUSINESS,
FINANCIAL CONDITION OR RESULTS OF FUTURE OPERATIONS COULD BE MATERIALLY AND
ADVERSELY AFFECTED. IN SUCH CASE, THE PRICE OF OUR SECURITIES COULD DECLINE, AND
YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT.
RISKS RELATED TO THE NOTES
THE NOTES ARE SUBORDINATED TO ANY FUTURE SENIOR INDEBTEDNESS.
The Notes are subordinated to any future senior indebtedness, as defined
in the indentures. The Notes rank PARI PASSU with our two other series of 6 1/4%
convertible subordinated notes due 2008. As of the date of this prospectus, WE
have no indebtedness outstanding that will rank senior to the Notes. However,
because our operations are conducted through subsidiaries, claims of holders of
indebtedness of such subsidiaries, as well as claims of regulators and creditors
(including policyholders) of such subsidiaries, will have priority with respect
to the assets and earnings of such subsidiaries over the claims of creditors of
Penn Treaty, including the Note holders.
IF THE MARKET PRICE OF OUR COMMON STOCK IS LOWER THAN THE CONVERSION PRICE OF
THE NOTES, THE CONVERSION OF THE NOTES MAY NOT BE PRACTICABLE OR PROFITABLE.
The conversion price for the Notes is $1.75 per share of common stock.
As of May 10, 2005, the closing price per share for our common stock on the New
York Stock Exchange was $2.10. However, if the market price for our common stock
falls below the conversion price for the Notes, the conversion of the Notes may
not be practicable or profitable because a holder would be paying more for our
shares of common stock by converting the Notes than he or she would have to pay
for the same shares on the open market.
THE CONVERSION OF THE NOTES, THE CONVERSION OF OUR TWO OTHER SERIES OF 6 1/4%
CONVERTIBLE SUBORDINATED NOTES DUE 2008, THE EXERCISE OF OUR OUTSTANDING
WARRANTS AND STOCK OPTIONS AND ANY FUTURE ISSUANCES OF NEW SHARES OF OUR COMMON
STOCK WILL RESULT IN SIGNIFICANT DILUTION TO OUR THEN-EXISTING SHAREHOLDERS.
The conversion of the Notes and our two other series of 6 1/4%
convertible subordinated notes due 2008 would represent significant dilution to
our then-existing shareholders. Also, if holders elect to convert the Notes or
our two other series of 6 1/4% convertible subordinated notes due 2008 into
shares of our common stock prior to October 15, 2005, we may issue additional
shares of common stock as payment of a discounted amount of interest that would
otherwise be payable through that date. In addition, we have granted warrants to
Centre Solutions (Bermuda) Limited, which are exercisable until December 31,
2007 for preferred stock convertible into 15% of our then-outstanding common
stock after conversion on a fully diluted basis and an additional 20% of our
then-outstanding common stock after conversion on a fully diluted basis in the
event that we do not commute (i.e., recapture the statutory reserve liabilities
on the underlying policies) our reinsurance agreement at or prior to December
31, 2007. We anticipate that, to finance the growth of our business adequately,
we may offer and sell notes or other debt obligations convertible into shares of
our common stock or shares of common stock in the future.
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The occurrence of any or all of the foregoing will result in significant
additional dilution to our then-existing shareholders.
THERE IS NO ESTABLISHED MARKET FOR THE NOTES AND THEY MAY BE DIFFICULT TO SELL.
We do not intend to list the Notes for trading on any national
securities exchange or to cause them to be quoted in any inter-dealer quotation
system. Whether a market develops for the Notes and, if so, the liquidity of
Notes within such market, will depend on the number of holders of the Notes, our
financial performance and the market for similar securities. We cannot assure
you that an active trading market for the Notes will develop or, if it does, at
what prices the Notes may trade.
WE COULD BE REQUIRED TO REDUCE CERTAIN TAX ATTRIBUTES (SUCH AS CREDITS, LOSSES,
ETC.) AND THEREBY OWE GREATER FEDERAL INCOME TAXES.
The Internal Revenue Service has established rules that potentially
limit or defer a company's use of prior period net operating loss carryforwards
for tax purposes in the event that a majority of the company's common stock
ownership changes within any consecutive three-year period. Due to the issuance
of additional shares of our common stock since May 2001, we have become subject
to these limitations or deferrals and have established a valuation allowance
against the use of our net operating loss carryforwards. However, if our
interpretation of the rules is incorrect, our valuation allowance is
insufficient, or if we generate future losses that limit our ability to use
these net operating losses further, we could be required to reduce certain of
our tax attributes further and thereby owe greater taxes. The payment of greater
taxes would also adversely affect our statutory surplus. It is not possible for
us to quantify the impact of such a further reduction in tax attributes and we
are not certain that any such reduction would be required. However, such
reduction could have a material impact upon our financial condition and results
of operations.
WE HAVE SIGNIFICANT CONVERTIBLE DEBT AND MAY BE UNABLE TO SERVICE AND REPAY OUR
DEBT OBLIGATIONS, WHICH COULD CAUSE A PAYMENT DEFAULT.
We are an insurance holding company whose assets principally consist of
the capital stock of our operating subsidiaries. Our ability to redeem,
repurchase or make interest payments on our outstanding convertible debt is
dependent upon the ability of our subsidiaries to pay cash dividends or make
other cash payments to us. Our insurance subsidiaries are subject to state laws
and regulations and the Plan with the Department, which restrict their ability
to pay dividends and make other payments to us and could require the parent to
make further capital contributions to their surplus in the future.
Our ability to service our debt obligations is dependent upon our parent
company expenses and liquidity and agency dividend capabilities. If our debt is
not converted into shares of our common stock, if we are unable to generate
sufficient funds through operations or raise additional capital to meet our debt
service obligations in or after October 2006 or if our assumptions about our
ability to service our debt prior to October 2006 are not correct, we may
default on our debt obligations, which could result in our having to cease doing
business.
RISKS RELATED TO PENN TREATY
OUR BUSINESS COULD BE MATERIALLY ADVERSELY AFFECTED IF WE WERE UNABLE TO
CONTINUE SELLING POLICIES OR ARE UNSUCCESSFUL IN RECOMMENCING NEW POLICY SALES
IN A FEW KEY STATES.
Historically, our business has been concentrated in a few key states.
During 2004, approximately 43% of our direct premium revenue came from sales of
policies in California, Florida and Pennsylvania.
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Although, we have recommenced new policy sales in 41 states, including
California, Florida and Pennsylvania, we have not yet recommenced new policy
sales in nine other states. We are working with the remaining states to
recommence sales in all jurisdictions.
We have agreed to conditions for the recommencement of business in
California, Florida, Illinois and Pennsylvania. If we were found not to be in
compliance with these conditions, we could be forced to stop new policy sales.
Each state insurance department may impose its own conditions on our
recommencing or continuing new policy sales in its state. If we are unable to
continue selling new policies in our key states, our financial condition and
results of operations could be materially adversely affected.
WE MAY NOT HAVE ENOUGH STATUTORY CAPITAL AND SURPLUS TO CONTINUE TO WRITE
BUSINESS.
Our continued ability to write business is dependent on maintaining
adequate levels of statutory capital and surplus to support the policies we
write. Our new business writing typically results in net losses on a statutory
basis during the early years of a policy. The resulting reduction in statutory
surplus, or surplus strain, limits our ability to seek new business due to
statutory restrictions on premium to surplus ratios and statutory surplus
requirements. If we cannot generate sufficient statutory surplus to maintain
minimum statutory requirements through increased statutory profitability,
reinsurance or other capital generating alternatives, we will be limited in our
ability to realize additional premium revenue from new business writing, which
could have a material adverse effect on our financial condition and results of
operations or, in the event that our statutory surplus is not sufficient to meet
minimum premium to surplus and risk based capital ratios in any state, we could
be prohibited from writing new policies in such state.
WE COULD SUFFER A LOSS IF OUR PREMIUM RATES ARE NOT ADEQUATE AND WE ARE UNABLE
TO OBTAIN NECESSARY STATE APPROVALS FOR PREMIUM RATE INCREASES.
We set our premiums based on assumptions about numerous variables,
including our estimate of the probability of a policyholder making a claim, the
severity and duration of such claim, the mortality rate of our policyholders,
the persistency or renewal of our policies in-force and the amount of interest
we expect to earn from the investment of premiums. In setting premium rates, we
consider historical claims information, industry statistics and other factors.
Based on our recent studies, we believe that the policies we currently
offer are priced to provide a satisfactory profit margin. However, those studies
also suggest that certain of our older policies are only marginally profitable
and some are unprofitable. As a result, we commenced efforts to obtain premium
rate increases on such polices, which may include some policies that previously
received a premium rate increase. If our actual experience proves to be less
favorable than we assumed, our financial condition and results of operations
could be materially adversely affected.
We generally cannot raise our premium rates in any state unless we first
obtain the approval of the insurance regulator in that state. We cannot assure
you that we will be able to obtain approval for premium rate increases from
existing requests or requests filed in the future. If we are unable to raise our
premium rates because we fail to obtain approval for a premium rate increase in
one or more states, our financial condition and results of operations could be
materially adversely affected.
Premium rate increases could lead to anti-selection, which is the
lapsation of policies held by healthier policyholders. Anti-selection could
cause our actual claims experience to exceed our expectations based on the
higher risk of the remaining policyholders. As a result, our financial condition
and results of operations could be materially adversely affected.
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OUR RESERVES FOR CURRENT AND FUTURE CLAIMS MAY BE INADEQUATE AND ANY INCREASE TO
SUCH RESERVES COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.
We calculate and maintain reserves for current and future claims using
assumptions about numerous variables, including our estimate of the probability
of a policyholder making a claim, the severity and duration of such claim, the
mortality rate of our policyholders, the persistency or renewal of our policies
in-force and the amount of interest we expect to earn from the investment of
premiums. The adequacy of our reserves depends on the accuracy of our
assumptions. We cannot assure you that our actual experience will not differ
from the assumptions used in the establishment of reserves. Any variance from
these assumptions could have a materially adverse effect on our financial
condition and results of operations.
OUR UNAMORTIZED DEFERRED POLICY ACQUISITION COST ASSET MAY NOT BE FULLY
RECOVERABLE, WHICH WOULD RESULT IN AN IMPAIRMENT CHARGE AND COULD MATERIALLY
ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
In connection with the sale of our insurance policies, we defer and
amortize the policy acquisition costs over the related premium paying periods
throughout the life of the policy. These costs include all expenses that are
directly related to, and vary with, the acquisition of the policy, including
commissions, underwriting and other policy issue expenses. The amortization of
deferred policy acquisition costs ("DAC") is determined using the same projected
actuarial assumptions used in computing policy reserves. DAC can be affected by
unanticipated terminations of policies because, upon such terminations, we are
required to expense fully the DAC associated with the terminated policies. In
addition, we review and update the assumptions underlying DAC and our policy
reserves to reflect current experience on a quarterly basis. If, based on that
review we determine that our DAC is not fully recoverable, we would impair the
value of our DAC and would fully expense the impaired amount. As a result, our
financial condition and results of operations could be materially adversely
affected.
DECLINES IN THE VALUE OF, OR THE YIELD ON, OUR NOTIONAL EXPERIENCE ACCOUNT OR
OUR INVESTMENT PORTFOLIO COULD ADVERSELY AFFECT OUR FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
Our reinsurance agreement with Centre Solutions (Bermuda) Limited
reinsures, on a quota share basis, substantially all of our long-term care
insurance policies in-force at December 31, 2001 under statutory accounting
rules. The reinsurer maintains a notional experience account for our benefit in
the event of commutation. The notional experience account reflects the initial
premium paid, subsequent premiums collected net of claims, expenses and
accumulated investment earnings. The notional experience account balance
receives an investment credit based on the total return of a series of benchmark
indices and hedges, which are designed to match closely the duration of our
reserve liabilities. As a result, we have experienced, and may continue to
experience, significant volatility in our financial condition and results of
operations.
Income from our investment portfolio is an element of our overall net
income. We are susceptible to changes in market interest rates when cash flows
from maturing investments are reinvested at prevailing market rates. If our
investments do not perform well, our financial condition and results of
operations could be materially adversely affected.
In addition, in establishing the level of our reserves for future policy
claims and benefits, we make assumptions about the performance of our
investments. If our investment income or the capital gains in our portfolio are
lower than expected, we may have to increase our reserves, which could
materially adversely affect our financial condition and results of operations.
9
OUR REINSURANCE AGREEMENT WITH CENTRE SOLUTIONS (BERMUDA) LIMITED IS SUBJECT TO
AN AGGREGATE LIMIT OF LIABILITY, WHICH, IF EXCEEDED, COULD ADVERSELY AFFECT OUR
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Our reinsurance agreement with Centre Solutions (Bermuda) Limited is
subject to certain coverage limitations and an aggregate limit of liability. The
aggregate limit of liability may be reduced if we are unable to obtain premium
rate increases deemed necessary under the provisions of the agreement or if
certain other events occur. If the aggregate limit of liability is expected to
be exceeded, we would be unable to receive full statutory credit for the cession
of our reserves, resulting in the reduction of our statutory surplus and the
possible breach of this provision of the Plan.
In the event that (1) the reinsurer's limit of liability is reduced or
exceeded, (2) the reinsurance agreement is cancelled, (3) the reinsurer is not
able to satisfy its obligations to us or (4) we breach the Plan, our financial
condition, results of operations and statutory surplus could be materially
adversely affected.
WE MAY HAVE INSUFFICIENT CAPITAL AND SURPLUS TO COMMUTE OUR REINSURANCE
AGREEMENT WITH CENTRE SOLUTIONS (BERMUDA) LIMITED, WHICH COULD ADVERSELY AFFECT
OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND CAUSE SUBSTANTIAL DILUTION
TO SHAREHOLDERS.
We are entitled to commute the our reinsurance agreement with Centre
Solutions (Bermuda) Limited on December 31, 2007 or any December 31 thereafter.
To be able to do so, we would be required to have amounts of statutory capital
and surplus which would support recapturing the statutory liability for such
policies. We do not currently have enough statutory capital and surplus to do
so. While we believe, based upon our most recent projections and modeling, that
it is probable that our business will be sufficiently profitable in the future
such that we will have a sufficient amount of statutory capital and surplus to
do so by December 31, 2007 and that viable alternatives, such as new reinsurance
opportunities or additional capital issuances, are available to enable us to
commute the agreement, there is no assurance that we will be able to commute the
reinsurance agreement.
If we do not commute the agreement on December 31, 2007, the amounts
assessed against our notional experience account to Centre Solutions (Bermuda)
Limited under the reinsurance agreement will be substantially increased. In
addition, in such circumstances, Centre Solutions (Bermuda) Limited would become
entitled to exercise a fourth tranche of warrants. The warrants are exercisable
for convertible preferred stock which, if converted, and when combined with the
potential conversion of preferred stock issuable upon exercise of the first
three tranches of warrants (which would expire on December 31, 2007 if
unexercised), would result in the issuance to Centre Solutions (Bermuda) Limited
of approximately 35% of our common stock outstanding after such issuance on a
fully diluted basis. The issuance of such shares would substantially dilute the
interest of our then-existing shareholders.
POLICIES ISSUED ON OR AFTER AUGUST 1, 2004 ARE NOT REINSURED AND OUR INABILITY
TO FIND A REINSURER COULD LIMIT OUR ABILITY TO ISSUE NEW POLICIES WITHOUT
REDUCING OUR STATUTORY SURPLUS AND MATERIALLY ADVERSELY AFFECT OUR FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
On March 29, 2004, Centre Solutions (Bermuda) Limited notified us that,
for reasons unrelated to us, it would discontinue its quota share reinsurance of
new long-term care insurance policies issued after July 31, 2004. Policies
issued prior to August 1, 2004 will be unaffected by the termination of the
agreement. We have been attempting to obtain alternative reinsurance since March
29, 2004 but have not been successful. In the event that we are unable to obtain
reinsurance from another carrier for policies issued on or after August 1, 2004,
or find other sources of statutory surplus, our ability to issue new
10
business without reducing statutory surplus could be limited and our financial
condition and results of operations could be materially adversely affected.
OUR REINSURERS MAY NOT SATISFY THEIR OBLIGATIONS TO US, WHICH COULD MATERIALLY
ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
We obtain reinsurance from unaffiliated reinsurers, in addition to
Centre Solutions (Bermuda) Limited, on certain of our policies. Although each
reinsurer is liable to us to the extent the risk is transferred to such
reinsurer, reinsurance does not relieve us of liability to our policyholders.
Accordingly, we bear credit risk with respect to all of our reinsurers. We
cannot assure you that our reinsurers will pay all of our reinsurance claims or
that they will pay our reinsurance claims on a timely basis. The failure of our
reinsurers to make such payments could have a material adverse effect on our
financial condition and results of operations.
PTNA is a party to a reinsurance agreement to cede the risk of certain
home health care claims that extend beyond 36 months. Reinsurance recoverables
related to this agreement were approximately $11.2 million at December 31, 2004.
The reinsurer has notified PTNA that it believes that the Company breached this
agreement by entering into the 2001 Centre agreement without the prior written
approval of the reinsurer. The ultimate resolution of this dispute cannot be
determined at this time.
WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY WITH INSURERS THAT HAVE GREATER
FINANCIAL RESOURCES OR BETTER FINANCIAL STRENGTH RATINGS.
We sell our products in highly competitive markets. We compete with
large national insurers, smaller regional insurers and specialty insurers. Many
insurers are larger than we are and many have greater resources and better
financial strength ratings than we do. Most insurers also have not experienced
the regulatory problems we have faced. In addition, we are subject to
competition from insurers with broader product lines. We also may be subject,
from time to time, to new competition resulting from changes in Medicare
benefits, as well as from insurance carriers introducing products similar to
those offered by us.
The financial strength ratings assigned to our insurance company
subsidiaries by A.M. Best Company, Inc. and Standard & Poor's Insurance Rating
Services, two independent insurance industry rating agencies, affect our ability
to expand and to attract new business. A.M. Best's ratings for the industry
range from "A++ (superior)" to "F (in liquidation)." Standard & Poor's ratings
range from "AAA (extremely strong)" to "CC (extremely weak)." A.M. Best and
Standard & Poor's insurance company ratings are based upon factors of concern to
policyholders and insurance agents and are not directed toward the protection of
investors. Our subsidiaries that are rated have A.M. Best ratings of "B- (fair)"
and Standard & Poor's ratings of "B- (weak) with positive outlook."
Certain distributors will not sell our products unless we have a more
favorable financial strength rating. Similarly, certain prospective customers
may decline to purchase new policies because of a perceived risk of non-payment
of policy benefits due to our financial condition. Our inability to achieve
improved ratings could have a material adverse effect on our financial condition
and results of operations.
WE MAY SUFFER REDUCED INCOME IF GOVERNMENTAL AUTHORITIES CHANGE THE REGULATIONS
APPLICABLE TO THE INSURANCE INDUSTRY.
Our insurance subsidiaries are subject to comprehensive regulation by
state insurance regulatory authorities. The laws of the various states establish
insurance departments with broad powers with respect to such things as licensing
companies to transact business, licensing agents, prescribing
11
accounting principles and practices, admitting statutory assets, mandating
certain insurance benefits, regulating premium rates, approving policy forms,
regulating unfair trade, regulating market conduct and claims practices,
establishing statutory reserve requirements and solvency standards, limiting
dividends, restricting certain transactions between affiliates and regulating
the types, amounts and statutory valuation of investments. The primary purpose
of such regulation is to protect policyholders, not shareholders.
State legislatures, state insurance regulators and the National
Association of Insurance Commissioners ("NAIC") continually reexamine existing
laws and regulations, and may impose changes in the future that materially
adversely affect our financial condition and results of operations and could
make it difficult or financially impracticable to continue doing business. Some
states limit premium rate increases on long-term care insurance products and
other states have considered doing so. Because insurance premiums are our
primary source of income, our financial condition and results of operations
could be materially adversely affected by any of these changes.
Certain legislative proposals could, if enacted or further refined,
materially adversely affect our financial condition and results of operations.
These include the implementation of minimum consumer protection standards for
inclusion in all long-term care policies, including: guaranteed premium rates;
protection against inflation; limitations on waiting periods for pre-existing
conditions; setting standards for sales practices for long-term care insurance;
and guaranteed consumer access to information about insurers, including lapse
and replacement rates for policies and the percentage of claims denied. In
addition, recent Federal financial services legislation requires states to adopt
laws for the protection of consumer privacy. Compliance with various existing
and pending privacy requirements also could result in significant additional
costs to us.
WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY IF WE CANNOT RECRUIT AND RETAIN
INSURANCE AGENTS.
We distribute our products principally through independent agents whom
we recruit and train to market and sell our products. We also engage field
marketing organizations from time to time to recruit independent agents and
develop networks of agents in various states. We compete vigorously with other
insurance companies for productive independent agents, primarily on the basis of
our financial position, support services, compensation and product features.
When we ceased new policy sales in 2001, many of our agents began selling more
long-term care insurance products issued by our competitors. We may not be able
to attract (or in the case of agents who have begun writing long-term care
products for our competitors, to re-engage) and retain independent agents to
sell our products, especially if we are unable to obtain permission to
recommence new policy sales in the nine states where we are currently not
permitted to offer new policies. Because our future profitability depends
primarily on new policy sales, our business and ability to compete would suffer
if we are unable to recruit and retain insurance agents or if we lost the
services provided by our field marketing organizations.
LITIGATION MAY RESULT IN FINANCIAL LOSSES OR HARM OUR REPUTATION AND MAY DIVERT
MANAGEMENT RESOURCES.
Current and future litigation may result in financial losses, harm our
reputation and require the dedication of significant management resources. We
are regularly involved in litigation. The litigation naming us as a defendant
ordinarily involves our activities as an insurer. In recent years, many
insurance companies, including us, have been named as defendants in class
actions relating to market conduct or sales practices, and other long-term care
insurance companies have been sued when they sought to implement premium rate
increases. See "Business--Legal Proceedings" for a description of current legal
proceedings.
12
CERTAIN ANTI-TAKEOVER PROVISIONS IN STATE LAW AND OUR ARTICLES OF INCORPORATION
MAY MAKE IT MORE DIFFICULT TO ACQUIRE US AND THUS MAY DEPRESS THE MARKET PRICE
OF OUR COMMON STOCK.
Our Restated and Amended Articles of Incorporation, the Pennsylvania
Business Corporation Law of 1988, as amended, and the insurance laws of states
in which our insurance subsidiaries do business contain certain provisions which
could delay or impede the removal of incumbent directors and could make a
merger, tender offer or proxy contest involving us difficult, or discourage a
third party from attempting to acquire control of us, even if such a transaction
would be beneficial to our shareholders. In particular, the classification and
three-year terms of our directors could have the effect of delaying a change in
control. Insurance laws and regulations of Pennsylvania and New York, our
insurance subsidiaries' states of domicile, prohibit any person from acquiring
control of us, and thus indirect control of our insurance subsidiaries, without
the prior approval of the insurance commissioners of those states.
OUR FAILURE TO ACHIEVE AND MAINTAIN EFFECTIVE DISCLOSURE CONTROLS AND PROCEDURES
AND INTERNAL CONTROL OVER FINANCIAL REPORTING COULD AFFECT OUR ABILITY TO
PRODUCE RELIABLE FINANCIAL REPORTS AND COULD HAVE A MATERIAL ADVERSE EFFECT ON
OUR STOCK PRICE.
The Company carried out an evaluation, under the supervision and with
the participation of the Company's management, including the Company's Chief
Executive Officer and the Company's Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures pursuant to Exchange Act Rule 13a-15 as of December 31, 2004.
Based upon that evaluation, the Chief Executive Officer and the Chief Financial
Officer concluded that the Company's disclosure controls and procedures were not
effective because in March 2005, in conjunction with the preparation of the
financial statements for the year ended December 31, 2004, the Company concluded
that certain policy riders were not reserved for in prior years. The premiums
associated with the policies were properly billed and any claims incurred on
these policies were properly paid. However, the policy riders were not properly
identified in the data utilized to calculate policy reserves. Therefore, the
Company determined that it did not properly account for benefits expense and
policy reserves. As a result of this conclusion, the Company restated its
previously issued financial statements for the years ended December 31, 2003 and
2002 to reflect the inclusion of the policy riders. In determining whether this
control deficiency constitutes a material weakness, the Company referred to
PCAOB Auditing Standard No. 2, "An Audit of Internal Control Over Financial
Reporting Performed in Conjunction with an Audit of Financial Statements" noting
that a material weakness is defined as a significant deficiency that, by itself,
or in a combination with other significant deficiencies, results in more than a
remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. The Company concluded
that the omission of the policy riders from benefits expense and policy reserves
was a material weakness. During the first fiscal quarter of 2005, the Company
implemented a process to identify all policies issued with an inflation rider
and cross-referenced the list of policies identified to the data utilized to
calculate policy reserves to ensure that the policy rider is properly
identified. However, our failure to achieve and maintain effective disclosure
controls and procedures and internal control over financial reporting in the
future could affect our ability to produce reliable financial reports and could
have a material adverse effect on our stock price, especially once we become
subject to Section 404 of the Sarbanes-Oxley Act of 2002, which requires
management to assess and report on the effectiveness of our internal control
over financial reporting and that our independent registered public accounting
firm attest to and report on management's assessment.
FORWARD LOOKING STATEMENTS
Certain statements made by us in this prospectus 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
13
and operations, there can be no assurance that actual results of our operations
will not differ materially from our expectations. An investment in our
securities includes certain risks, which may be specific to us or to the
long-term care insurance industry. Factors which could cause actual results to
differ from expectations include, among others, our ability to comply with the
Corrective Action Plan, the Florida Consent Order, 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 new business, our ability to
commute our reinsurance agreement and to recapture our reinsured policies and
accumulated notional 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 convertible subordinated 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 DAC asset, our
ability to sell insurance products in certain states, our ability to enter into
a reinsurance agreement for policies sold after July 31, 2004, 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 ourselves 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.
14
USE OF PROCEEDS
All sales of the Notes or Common Stock will be by or for the account of
the selling securityholders listed in this prospectus or any prospectus
supplement. We will not receive any proceeds from the sale by any selling
securityholder of the Notes or the Common Stock.
MARKET PRICE, DIVIDENDS AND RELATED SHAREHOLDER MATTERS
Our common stock is traded on the New York Stock Exchange under the
symbol "PTA." As of March 18, 2005, there were 423 record holders of our common
stock. On May 10, 2005, the last sale price of our common stock, as reported on
the New York Stock Exchange, was $2.10 per share. The following table indicates
the high and low sale prices of our common stock as reported on the New York
Stock Exchange during the periods indicated.
HIGH LOW
---------- -------
2004
1st Quarter $ 2.27 $ 1.50
2nd Quarter 2.24 1.85
3rd Quarter 2.19 1.37
4th Quarter 2.11 1.47
2003
1st Quarter $ 2.37 $ 1.25
2nd Quarter 1.95 1.40
3rd Quarter 2.67 1.73
4th Quarter 2.10 1.47
We have never paid any cash dividends on our common stock and do not
intend to do so in the foreseeable future. It is our present intention to retain
any future earnings to support the continued growth of our business. Any future
payment of dividends is subject to the discretion of the board of directors and
is dependent, in part, on any dividends we may receive from our subsidiaries.
The payment of dividends by our subsidiaries is dependent on a number of
factors, including their respective earnings and financial condition, business
needs and capital and surplus requirements, and is also subject to certain
regulatory restrictions and the effect that such payment would have on their
financial strength ratings. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources,"
"Business--Insurance Industry Rating Agencies" and "Business--Government
Regulation."
15
BUSINESS
CERTAIN STATEMENTS MADE BY US IN THIS PROSPECTUS MAY BE CONSIDERED
FORWARD-LOOKING WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM
ACT OF 1995. ALTHOUGH WE BELIEVE THAT OUR EXPECTATIONS ARE BASED ON REASONABLE
ASSUMPTIONS WITHIN THE BOUNDS OF OUR KNOWLEDGE OF OUR BUSINESS AND OPERATIONS,
THERE CAN BE NO ASSURANCE THAT OUR ACTUAL RESULTS OF OPERATIONS WILL NOT DIFFER
MATERIALLY FROM OUR EXPECTATIONS. FACTORS WHICH COULD CAUSE ACTUAL RESULTS TO
DIFFER FROM EXPECTATIONS INCLUDE THOSE DESCRIBED IN "RISK FACTORS" BEGINNING ON
PAGE 6.
THE COMPANY AND THE LONG-TERM CARE INSURANCE INDUSTRY
We are a leading provider of long-term care insurance in the United
States. Our principal products are individual, defined benefit accident and
health insurance policies covering long-term care services, including
confinement to nursing facilities and assisted living facilities, as well as
home health care. Our policies are designed to provide meaningful benefits if
and when the insured is no longer capable of functioning independently. We also
own insurance agencies that sell senior-market insurance products issued by us
as well as other insurers.
We introduced our first long-term nursing home insurance product in 1972
and our first home health care insurance product in 1983. Since then we have
developed several new products designed to meet the changing needs of our
customers that were the first of their kind in the long-term care industry. Our
primary product offerings are:
o The Assisted Living Plus(R) policy, which provides coverage for
all levels of facility care and includes an optional home health
care rider;
o The Personal Freedom(R) policy, which provides comprehensive
coverage for facility and home health care;
o The Independent Living(R) policy, which provides coverage for
home and community-based care furnished by licensed care
providers, as well as unlicensed caregivers;
o The Post Acute Recovery policy, which provides coverage for
short-term recuperative care received in a long-term care
facility, or the policyholder's home;
o The Secured Risk(R) product, which is a limited benefit policy
designed for substandard risks; and
o Simple LTC SolutionSM, which offers a new and simplified
approach to long-term care insurance, and includes innovative
features, such as a policyholder co-payment for covered
services.
Although nursing home and home health care policies accounted for
approximately 95% of our total annualized premiums in-force as of December 31,
2004, we also market and sell Medicare supplement policies.
We maintain and administer one of the largest individual long-term care
insurance portfolios in the industry. Our sales and marketing efforts through
our independent agency distribution channels were very successful between 1995
and 2000 as total in-force premiums grew at a compound annual rate of
approximately 29% from $102 million to $360 million. Our total long-term care
in-force premiums were approximately $326 million at December 31, 2004.
In 2001, we ceased new policy sales nationwide as a result of
insufficient statutory surplus levels until we formulated a Corrective Action
Plan (the "Plan") with the Pennsylvania Insurance Department (the "Department").
Both Penn Treaty Network America Insurance Company ("PTNA") and American Network
Insurance Company ("ANIC"), which represent approximately 91% and 8% of our
direct
16
premium revenue, respectively, are subject to the Plan. Upon the Department's
approval of the Plan in February 2002, we recommenced new policy sales in 23
states, including Pennsylvania. We have now recommenced new policy sales in 18
additional states, including Florida and California (both subject to Corrective
Orders). Florida, California and Pennsylvania accounted for approximately 16%,
15% and 12%, respectively, of our direct premium revenue for the year ended
December 31, 2004. We are working with the remaining states to recommence new
policy sales in all jurisdictions.
As part of the Plan, effective December 31, 2001, we entered into a
reinsurance agreement with Centre Solutions (Bermuda) Limited to reinsure, on a
quota share basis, substantially all of our respective long-term care insurance
policies then in-force. The agreement is subject to certain coverage limitations
and an aggregate limit of liability, which may be reduced if we are unable to
obtain premium rate increases required by the agreement. The agreement meets the
requirements to qualify as reinsurance for statutory accounting, but not for
generally accepted accounting principles ("GAAP"). As the agreement is treated
as reinsurance for statutory accounting purposes, it results in the cession (or
removal) of substantially all of PTNA's and ANIC's policy reserve and claim
reserve liabilities for statutory accounting purposes.
CORPORATE BACKGROUND
Penn Treaty is registered and approved as a holding company under the
Pennsylvania Insurance Code. Penn Treaty was incorporated in Pennsylvania on May
13, 1965 under the name Greater Keystone Investors, Inc. and changed its name to
Penn Treaty American Corporation on March 25, 1987. Our primary business is the
sale of long-term care insurance, which we conduct through the following
subsidiaries:
o Penn Treaty Network America Insurance Company -- a
Pennsylvania-based insurance company;
o American Network Insurance Company -- a Pennsylvania-based
insurance company; and
o American Independent Network Insurance Company of New York -- a
New York-based insurance company.
We also conduct insurance agency operations through the following
subsidiaries:
o Senior Financial Consultants Company--a Pennsylvania-based
insurance agency brokerage;
o United Insurance Group Agency, Inc.--a Michigan-based consortium
of long-term care insurance agencies; and
o Network Insurance Senior Health Division--a Florida-based
insurance agency brokerage.
THE LONG-TERM CARE INSURANCE INDUSTRY
Based on the 2004 Annual Survey by LIMRA International:
o Industry-wide long-term care insurance sales were down by 25% in
2004, on a premium basis, primarily due to premium rate
increases on older polices and higher premium rates on new
policies. Approximately $699 million in new annual policy
premiums were issued in 2004 compared to $935 million in 2003.
o Total in-force premium has grown over the past 10 years. From
1999 to 2004, in-force premium grew at a compound average growth
rate of 12%, compared to a compound average growth rate of 16%
from 1998 to 2003.
17
o The total number of in-force policies at the end of 2004
exceeded four million, with in-force annualized premium reaching
$6.8 billion.
Given the projected demographics of the U.S. population, the rising
costs of home health care and long-term care, the associated challenges faced by
Medicaid, and current and proposed state and federal legislation that support
the purchase of private long-term care insurance coverage, we believe the
potential for future growth remains significant.
According to a 2000 U.S. Census Bureau report, the population of senior
citizens (people age 65 and over) in the United States is projected to grow from
an estimated level of approximately 35 million in 2002 to approximately 70
million by 2030. Furthermore, health and medical technologies are improving life
expectancy and, by extension, increasing the number of people requiring some
form of long-term care. The projected growth of the target population indicates
a substantial growth opportunity for companies providing long-term care
insurance products. We believe that the rising cost of nursing home and home
health care services, along with the increasing strain these services are having
on the state and federally financed Medicaid system (which is the largest payer
of long-term care services) makes long-term care insurance an attractive means
to pay for these services. According to a 2005 report by the Centers for
Medicare and Medicaid Services, the combined cost of home health care and
nursing home care was $20.0 billion in 1980. By 2001, this cost rose to $134.9
billion. These costs are projected to rise to $160.6 billion in 2004 and $170.9
billion in 2005.
OUR STRATEGY
We seek to enhance shareholder value by strengthening our position as a
leading provider of long-term care insurance. Our value proposition incorporates
innovative product development, stratification of underwriting risk, efficient
and effective underwriting and an individualized service culture for agents and
policyholders. We intend to achieve our goal of profitable growth by executing
the following strategies:
RECOMMENCEMENT OF SALES AND MARKETING EFFORTS IN ALL STATES. In 2001, we
ceased new policy sales nationwide as a result of diminished surplus levels. We
have since recommenced new policy sales in 41 states, which represented
approximately 90% of our direct premium revenue in 2004. We are working with the
insurance departments of the remaining states to recommence new policy sales in
all jurisdictions.
The sale of our current policies, which we believe are priced with
appropriate profit margins, is an important component of our earnings per share
growth in the future. Although the in-force business we sold before 2002 remains
marginally profitable, sales of new policies are expected to be a driving force
in generating profits in the future. In 2004, sales of our current generation of
long-term care insurance products totaled approximately $17.3 million on an
annualized premium basis, 35% above the sales level of 2003.
REENGAGEMENT OF OUR EXISTING SALES FORCE AND THE EXPANSION OF
DISTRIBUTION OPPORTUNITIES. In connection with our efforts to recommence sales,
we have also been actively involved in reengaging our network of agents. We
recognize that our ability to generate new policy sales is highly dependent on
agents who understand the needs of our target market. We intend to continue to
recruit agents as we recommence new policy sales throughout the United States.
Besides providing innovative products, competitive commissions and
personalized service, our strategy to reengage our sales force is highly
dependent upon our claims paying ability, ratings from independent rating
agencies, our financial strength and our reputation with agents and
policyholders.
18
We believe that the actions we have taken, which included increasing
statutory capital through the issuance of new convertible debt, will enhance the
likelihood that insurance rating agencies will increase our ratings. In
addition, we plan to continue our focus on agent communication and education by
providing our sales force with periodic updates regarding the progress achieved
in our execution of the Plan.
ENHANCEMENT OF OUR LEADERSHIP TEAM AND FINANCIAL MANAGEMENT CAPABILITY.
Since 2001, we have been strengthening our leadership team through the addition
of individuals with the experience and skills necessary to create value for all
of our stakeholders, which include our investors, policyholders, agents and
employees.
Our directors and senior executives have a wide breadth of financial
services industry experience. In May 2004, Patrick Falconio, a former insurance
company executive, was appointed to the Board of Directors. In 2004, we
realigned our management team by creating a new position, Executive Vice
President of Strategic Operations, which was assumed by the former Chief
Financial Officer. The Chief Accounting Officer advanced to Chief Financial
Officer. In 2005, our leadership team was further enhanced through the addition
of a Senior Vice President of Claims Management and Policyholder Services who
has over 20 years of healthcare and long-term care insurance risk management
experience. The former Senior Vice President in charge of claims management and
policyholder services maintains leadership over our underwriting and compliance
functions and assumed responsibility for all product development efforts.
INCREASE OUR OPERATIONAL EFFICIENCY THROUGH TECHNOLOGICAL IMPROVEMENTS.
In 2002, we embarked on a system replacement project ("SRP"), initiated to
redesign our long-term care administration systems over the subsequent three
years. In 2005, after evaluating the projected timing and expense of completing
our SRP internally, we entered an agreement with an outside vendor to customize
an existing operating system for our own unique needs, while maximizing the use
of our efforts and capitalized costs to date. The revised SRP, which is expected
to be completed over the next 18 months, includes the assessment of each major
task performed in our daily operations and the identification of value and
non-value added functions. As part of the SRP, we are redesigning each major
process within our business model in order to gain operational efficiency
through the redesign and deployment of our resources. The SRP design is specific
to the processing and administration of long-term care insurance.
DEVELOPMENT AND APPROVAL OF NEW PRODUCTS. We have sold long-term care
insurance for over 30 years. As an innovator in nursing home and home health
care insurance products, we have introduced many new policies over the years. We
continually discuss long-term care insurance needs with our agency sales force
and policyholders. As a result, we are able to design new products and offer
what we believe to be the most comprehensive benefit features in the industry.
The development of new products enables us to generate new business and provide
advancements in the benefits we offer. We have developed our next generation of
long-term care insurance products and have filed these products with the
insurance department of each state in which we are currently approved to sell
new policies. These products have been updated to include greater flexibility of
benefit design and to incorporate additional coverage options, including
expanded spousal benefits. We have also recently introduced our Simple LTC
SolutionSM product, which offers a simple approach to long-term care insurance
and incorporates a policyholder co-payment for covered care.
INSURANCE PRODUCTS
Since 1972, we have developed, marketed and sold defined benefit
accident and health insurance policies designed to be responsive to changes in:
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o the characteristics and needs of the senior insurance market;
o governmental regulations and governmental benefits available for
senior citizens; and
o the health care and long-term care delivery systems.
As of December 31, 2004, approximately 95% of our total annualized
premiums in-force were derived from long-term care policies, which include
facility and home health care policies. Our other lines of insurance include
Medicare supplement, life and disability products. We solicit input from both
our independent agents and our policyholders with respect to the changing needs
of the senior market. In addition, our representatives regularly attend
regulatory meetings and seminars to monitor significant trends in the long-term
care industry.
Our focus on long-term care insurance has enabled us to gain expertise
in claims and underwriting which we have applied to product development. Through
the years, we have continued to build on our brand names by offering a series of
differentiated products.
The following table sets forth, at the dates indicated, information
related to our policies in force:
(annualized premiums in $000's)
December 31,
2004 2003 2002
---- ---- ----
Long-term facility, home
and comprehensive coverage:
Annualized premiums $ 326,030 95.3% $ 334,529 95.5% $ 344,771 95.7%
Number of policies 172,324 185,608 204,429
Average premium per policy $ 1,892 $ 1,802 $ 1,687
Disability insurance:
Annualized premiums $ 1,426 0.4% $ 1,590 0.5% $ 2,529 0.7%
Number of policies 3,357 4,066 6,187
Average premium per policy $ 425 $ 391 $ 409
Medicare supplement:
Annualized premiums $ 11,890 3.5% $ 10,887 3.1% $ 9,726 2.7%
Number of policies 7,887 8,806 8,566
Average premium per policy $ 1,508 $ 1,236 $ 1,135
Life insurance:
Annualized premiums $ 2,480 0.7% $ 2,715 0.8% $ 2,957 0.8%
Number of policies 4,456 4,882 5,282
Average premium per policy $ 557 $ 556 $ 560
Other insurance:
Annualized premiums $ 257 0.1% $ 321 0.1% $ 424 0.1%
Number of policies 1,847 2,114 2,445
Average premium per policy $ 139 $ 152 $ 173
Total annualized premiums in force $ 342,083 100.0% $ 350,042 100.0% $ 360,407 100.0%
Total Policies 189,871 205,476 226,909
We received an insurance license in 1972, which permitted us to write
insurance in 12 states. In 1974, we offered our first extended care long-term
care policy, which was the first long-term care insurance product to cover all
levels of facility care, including skilled, intermediate and custodial care, and
which had an extended five-year benefit period.
In 1983, we began the sale of home health care riders, which pay for
licensed nurses, certified nurses' aides and home health care workers who
provide care/assistance in the policyholder's home. In 1987, we began offering a
stand-alone home care policy, which was the first in the industry to include a
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limited benefit for homemaker care provided by an unskilled, unlicensed
individual such as a friend or neighbor.
In 1986, we began the use of table-based underwriting, which enables
higher risk policyholders to receive coverage at a risk-adjusted premium rate.
The table-based underwriting method considers medical conditions and the
likelihood of an inability to perform daily activities developing to determine
appropriate premium levels. Multiple rate classes enabled us to penetrate an
untapped market in long-term care insurance sales.
Our long-term nursing facility policies provide a benefit payable during
periods of nursing facility confinement prescribed by a physician or
necessitated by a policyholder's cognitive impairment or inability to perform
two or more activities of daily living (such as bathing or dressing). These
policies also include built-in benefits for alternative plans of care, waivers
of premiums after 90 days of benefit payments on a claim, and restoration of the
policy's maximum benefit period. All levels of nursing care, including skilled,
intermediate and custodial (assisted living), are covered and benefits continue
even when the policyholder's required level of care changes. Skilled nursing
care refers to professional nursing care provided by a medical professional (a
doctor or registered or licensed practical nurse) located at a licensed facility
that cannot be provided by a non-medical professional. Intermediate nursing care
is designed to cover situations that would otherwise fall between skilled and
custodial care and includes situations in which an individual may require
skilled assistance on a sporadic basis. Custodial care generally refers to
non-medical care, which does not require professional treatment and can be
provided by a non-medical professional with minimal or no training.
Our current long-term nursing home care policies provide benefits that
are payable for defined benefit periods ranging from one to ten years, or the
lifetime of the policyholder. Certain of these policies provide for a maximum
daily benefit on an expense-incurred basis ranging from $60 to $300 per day. We
also offer policies that provide comprehensive coverage for nursing home and
home health care, and offer lifetime maximums that consist of "pools of
coverage", with the pools derived by multiplying the daily benefit selected by
the number of days in the benefit period chosen.
Our home health care policies generally provide a benefit payable on an
expense-incurred basis during periods of home care prescribed by a physician or
necessitated by the policyholder's cognitive impairment or inability to perform
two or more activities of daily living. These policies cover the services of
registered nurses, licensed practical nurses, home health aides, physical
therapists, speech therapists, medical social workers, and unlicensed or
unskilled homemakers. Benefits for our currently marketed home health care
policies are payable for defined benefit periods ranging from one to five years,
or the lifetime of the policyholder, and provide from $60 to $300 per day. Most
of our policies generally also include built-in benefits for waiver of premiums
after 90 days of benefit payments, and restoration of the policy's maximum
benefit period.
We currently offer the following products:
PERSONAL FREEDOM(R) POLICY. Our Personal Freedom(R) policy (offered
since 1996) provides comprehensive coverage through a pool of money which is
available to pay for long-term care services received in a nursing facility, an
assisted living facility or the policyholder's home.
ASSISTED LIVING(R) POLICY. The Assisted Living(R) policy (offered since
1999) provides facility coverage in either a traditional nursing home setting or
in an assisted living facility. This policy is a lower-priced alternative to the
Personal Freedom(R) policy. When coupled with an optional home health care
rider, the Assisted Living(R) policy offers benefits similar to those of the
Personal Freedom(R) policy,
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but provides the policyholder with the flexibility to determine at the time of
policy issuance how much coverage is available for each type of care, thereby
fixing each potential risk and reducing the policy cost.
INDEPENDENT LIVING(R) POLICY. The Independent Living(R) policy (offered
since 1994) provides coverage for all levels of care received at home. Besides
covering skilled care and care by home health care aides, this policy pays for
care provided by unlicensed, unskilled homemakers. This care includes assistance
with instrumental activities of daily living, such as cooking, shopping and
housekeeping when determined to be medically necessary. Family members also may
be reimbursed for any training costs incurred to provide in-home care.
SECURED RISK(R) POLICY. Our Secured Risk(R) policy (offered since 1998)
provides limited facility care benefits to people who would most likely not
qualify for long-term care insurance under traditional policies. Table-based
underwriting allows us to examine these applicants based on their level of
activity and independence. This policy provides coverage for all types of care,
but with coverage limitations and longer elimination period (initial time period
not covered by insurance) requirements than our other policies.
POST ACUTE RECOVERY POLICY. The PAR policy (offered since 1999) offers
short-term benefits for long-term care services. The policy is generally
purchased to provide supplemental coverage due to its limited benefits and
reduced price.
SIMPLE LTC SOLUTIONSM POLICY. The Simple LTC SolutionSM policy, which
was filed in 2004 and which we are just beginning to offer, is intended to
provide a simplified, more affordable approach to long-term care insurance. This
policy covers confinement in a nursing or assisted living facility and home
health care and includes cost-controlling features such as an automatic
deductible, an ongoing policyholder co-payment, and a fixed, limited lifetime
maximum that does not restore.
RIDERS. We offer numerous riders to our base policies, including
inflation protection, which provides escalating benefit amounts, and a
non-forfeiture benefit, which guarantees certain paid-up benefits in the event
the policy lapses in the future.
TAX QUALIFIED AND NON-QUALIFIED POLICIES. With the enactment of the
Health Insurance Portability and Accountability Act of 1996, we began offering a
tax qualified policy, which allows for certain income tax deductions for premium
payments and provides benefit payments that are not subject to tax. We continue
to offer both tax-qualified and non-tax-qualified policies, with the
non-tax-qualified policies having more access to benefits, but also not having
the same preferential tax treatment as a tax-qualified policy.
MARKETING
MARKETS. The following chart shows premium revenues by state (dollar
amounts in thousands):
22
($000)
YEAR ENDED DECEMBER 31, Current
Year -------------------------------- Year %
State Entered 2004 2003 2002 of Total
-------- ---- ---- ---- --------
Arizona 1988 $ 13,671 $ 13,947 $ 14,267 4.3%
California 1992 46,585 45,618 48,899 14.6%
Florida 1987 50,435 55,907 58,990 15.8%
Illinois 1990 17,535 17,104 17,472 5.5%
New Jersey 1996 6,756 6,887 7,695 2.1%
North Carolina (2) 1990 9,430 9,366 9,919 2.9%
Ohio (2) 1989 9,248 9,970 10,664 2.9%
Pennsylvania 1972 39,392 43,850 40,247 12.3%
Texas 1990 15,742 15,803 16,587 4.9%
Virginia 1989 22,477 23,008 21,442 7.0%
Washington 1993 10,270 10,060 10,407 3.2%
All Other States (1) 78,344 70,426 77,054 24.5%
------- ------- ------- -----
All States $319,885 $321,946 $333,643 100.0%
======== ======== ======== =====
(1) Includes all states with premiums of less than two percent of
total premiums in 2004.
(2) We have not recommenced new policy sales in these states or in
seven other states which are included in All Other States.
Historically, our business has been concentrated in a few key states.
During 2004, approximately 43% of our direct premium revenue came from sales of
policies in California, Florida and Pennsylvania. In 2001, we ceased new policy
sales nationwide as a result of our statutory surplus levels until we formulated
the Plan with the Department. Upon the Department's approval of the Plan in
February 2002, we recommenced new policy sales in 23 states, including
Pennsylvania. We have now recommenced new policy sales in 18 additional states,
including California and Florida. We are working with the remaining states to
recommence new policy sales in all jurisdictions.
The following table summarizes our sales of new policies in the periods
indicated (in thousands):
2004 2003 2002
---- ---- ----
Number of new policies sold 8 7 3
Annualized premiums $ 17,969 $ 13,722 $ 5,274
Our sales and marketing mission is to provide our distribution partners
with a full line of long-term care insurance products that are diverse in
benefit structure, competitively priced, have a wide underwriting window and are
also backed by personalized service. We provide training and marketing solutions
to our agents so they in turn can grow their sales volume. We closely monitor
the long-term care health care delivery system and develop products designed to
provide us with a competitive edge in the long-term care insurance market
segment. We measure our success by the growth of new business sales and the
retention of our current policyholders.
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DISTRIBUTION PARTNERS. Our distribution strategy for 2005 includes a
four-pronged marketing approach including:
1. Field Marketing Organizations
2. Penn Treaty Career Agent Division
3. PTAdvantageSM
4. Strategic Alliances
FIELD MARKETING ORGANIZATIONS. We will continue marketing our products
through Field Marketing Organizations ("FMOs") which are large multi-agent
networks utilized for the purpose of recruiting independent agents and
developing networks of agents in various states. FMOs receive an override
commission on business written in return for recruiting, training and motivating
independent agents to place business.
The FMOs actively recruit independent agents who must be authorized by
contract to sell our products in each state in which the agent and our insurance
subsidiaries are licensed. Some of our independent agents are large general
agencies with many sales persons (sub-agents or captive agents), while others
are operating as sole proprietors. Some independent agents sell multiple lines
of insurance, while others concentrate primarily or exclusively on accident and
health insurance. We do not have exclusive agency agreements with any of our
independent agents and they are free to sell policies of other insurance
companies, including competitors.
We believe the commissions we pay to independent agents are competitive
with the commissions paid by other insurance carriers selling similar products.
The independent agent's right to renewal commissions is vested and renewal
commissions are paid as long as the policy remains in-force, provided the agent
continues to abide by the terms of the contract.
PENN TREATY CAREER AGENT DIVISION. Our newly created Career Agent
Division, administered through our subsidiary, United Insurance Group Agency,
Inc., operates in 12 states, with approximately 100 agents. These are captive
agents who are dedicated to selling our products.
PTADVANTAGESM. During the fourth quarter of 2004, we launched
PTAdvantageSM, an innovative insurance marketing protocol developed by Insurance
IQ. PTAdvantageSM is designed to facilitate the recruitment of new FMOs and life
insurance agents to sell the Company's long-term care insurance products.
STRATEGIC ALLIANCES. In 2004, we began exploring partnerships with
competing long-term care insurance carriers who have captive sales agents who
would benefit from offering our long-term care insurance products. We offer
these carriers a revenue stream, increased agent retention and a reimbursement
of a portion of their underwriting expense upon the issuance of new business.
During the remainder of 2005, we will strive to cultivate new strategic
alliances and increase the volume of sales from current strategic alliances.
PRODUCT PORTFOLIO. In the second quarter of 2004, we introduced our
newest generation of flagship long-term care insurance products, building on our
current brand names, Personal Freedom(R), Independent Living(R) and Assisted
Living Plus(R). These products contain a fresh new design with a basis in our
long history of long-term care insurance product innovation. The plans were
designed based upon input from our top distributors, who have vast industry
knowledge, and offer unique benefit structures at competitive rates.
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In 2005, we are introducing a new product named Simple LTC SolutionSM.
This innovative product offers a less expensive solution to long-term care
insurance needs with simplified policy benefits and introduces a policyholder
co-payment feature.
Additionally, in the first quarter of 2005, we were approved to join the
Connecticut Partnership for Long-Term Care. As a member of this partnership, we
will sell our flagship long-term care insurance plan - Personal Freedom(R) 3.
The state of Connecticut has taken an active role in the promotion of long-term
care insurance coverage and its benefits to consumers and the majority of
statewide sales are made by partnership members. With Personal Freedom(R) 3, we
offer the greatest diversity of underwriting classes in the partnership.
PRODUCT DIVERSIFICATION. In the third quarter of 2004, we diversified
our product line by introducing a traditional Medicare Supplement policy in nine
states. We believe that the target market for Medicare Supplement plans is
similar to that of long-term care insurance. We also believe that a certain
level of product diversity is viewed favorably by independent rating agencies.
ADMINISTRATION
UNDERWRITING
We believe that the underwriting process through which we choose to
accept or reject an applicant for insurance is critical to our success. We have
offered long-term care insurance products for 30 years and we believe we have
benefited significantly from our longstanding focus on this specialized line.
Through our experience, we have been able to establish a system of underwriting
designed to permit us to process our new business and assess the risks presented
with new applications more effectively and efficiently. This experience has also
enabled us to devise a risk stratification system whereby we can accept a broad
array of risks with correspondingly appropriate premium levels.
Applicants for long-term care insurance are required to complete
applications and answer detailed medical questions about their health history,
medications, and other personal information. Additionally, each applicant must
complete a telephonic or face-to-face interview conducted by an employee of our
underwriting department or a nurse through an outside agency. These interviews
are used to verify the information provided on the application, as well as
obtain additional insight into an applicant's physical abilities, activity
level, living situation and cognitive functioning.
As part of these interviews, all applicants are screened for cognitive
impairment, a major contributor to the need for long-term care services. For
those under age 65, the Delayed Word Recall screen is utilized. For those 65 and
older, the Minnesota Cognitive Acuity Screen (MCAS) is performed by an outside
agency. Unless the underwriting department determines that an in-home assessment
is required, the MCAS is generally conducted telephonically for applicants
between 65 and 74 years of age. For those ages 75 and over, an in-home
assessment incorporating the MCAS is required. Depending on the applicant's
health history, copies of an applicant's medical records are also frequently
required. Our underwriting evaluation process not only assesses the risk the
applicant currently represents, but also takes into account how existing health
conditions and risk factors are likely to progress and affect an applicant's
level of independence as he or she ages.
We use table-based underwriting, or multiple rate classifications, as a
means to approve a greater number of applicants by obtaining the premiums for
appropriate additional risk levels. Applicants are placed in different risk
classes for acceptance and premium calculation based on medical conditions and
level of activity. We have an underwriting points-based scoring system, which
provides consistent underwriting and rate classification for applicants with
similar medical histories and conditions. We
25
currently offer Preferred, Premier, Select and Standard risk classifications. We
also offer the equivalent of a fifth underwriting class through our Secured
Risk(R) product, which allows us to accept applicants who would not otherwise
qualify for traditional long-term care insurance products.
CLAIMS
Our long-term care insurance claims are evaluated and processed by our
internal staff, which includes our care management unit. All Medicare Supplement
claims are processed by a third-party administrator.
Approximately half of our long-term care claims are for home health
care. These claims typically require the greatest amount of overview and we have
been utilizing care management techniques for over 10 years. Most of our
policies offer the insured an incentive to provide early notice of claim. This
early notice allows us to become involved with the claim shortly after the care
begins, and sometimes even before it begins. Involvement with the claim at this
stage is integral to our being able to deploy our care management approach in
the most effective manner. Through care management, we are able to assess the
insured's deficiencies and develop a plan of care, which sets out the type,
intensity and duration of services required, that is appropriate to the
insured's needs. Our care managers follow the claimant's progress with periodic
contact and adjust the plan of care as needs change. These efforts are aimed at
not only ensuring the plan of care is appropriate, but also at assisting the
policyholder to return to the highest possible level of functioning as quickly
as possible.
Our care management is administered through our care management unit,
which consists of registered nurses that we employ, as well as through
independent case management vendors, which offer a network of field assessors.
Our in-house nurses conduct assessments and manage the cases telephonically,
whereas external vendors are typically utilized for face-to-face assessments.
Some form of care management is employed on over 95% of our home care claims.
Additionally, one-third of our home care claimants also utilize our Care
Solutions service, which is also administered by our care management unit.
Through this service, we develop the plan of care and assist in setting up the
care itself by identifying providers in and around the policyholder's community
that we have relationships with, and by coordinating the delivery of that care.
By utilizing our Care Solutions service, many policyholders qualify to obtain
expanded home health care benefits under the provisions of our policies.
Our facility claims represent the other portion of our long-term care
claims. These are comprised of claims for confinements to both traditional
nursing facilities and assisted living facilities. The widespread availability
of and consumer preference for assisted living facilities represents the most
significant change in the long-term care delivery system in the past 10 years.
These facilities have also impacted the types of facility claims we receive,
where the level of disability and need for confinement may be less clear-cut
than with a claim for the traditional nursing home. In 2004, we continued to
increase utilization of face-to-face assessments as a tool for determining
benefit eligibility and identifying the care needs of policyholders with
facility-based claims.
We are presently refining our claims management and care management
techniques and believe there is significant potential for future claims savings.
The refinements include automating certain claims adjudication tasks, expanding
the number and geographic distribution of skilled long-term care providers and
network discounts that our policyholders can utilize, and focusing more
resources on identifying and mitigating fraud. In 2004, we fully implemented a
new pre-approval process for unskilled private or family caregivers. This
process ensures the caregivers are qualified to meet the care needs of the
policyholder.
SYSTEMS OPERATIONS
26
We maintain our own computer system for most aspects of our operations,
including policy issuance, billing, claims processing, commissions, premiums and
general ledger. We consider it critical to continue to provide the quality of
service for which we are known by our policyholders and agents. We believe that
our overall systems are an integral component in delivering that service. In
2002, we embarked on a system replacement project ("SRP"), initiated to redesign
our long-term care administration systems over the subsequent three years. After
evaluating the projected timing and expense of completing our SRP internally, we
entered an agreement with an outside vendor in the first quarter of 2005 to
customize an existing operating system for our own unique needs, while
maximizing the use of our efforts and capitalized costs to date. The revised
SRP, which is expected to be completed over the next 18 months, includes the
assessment of each major task performed in our daily operations and the
identification of value and non-value added functions. As part of the SRP, we
are redesigning each major process within our business model in order to gain
operational efficiency through the redesign and deployment of our resources. The
SRP design is specific to the processing and administration of long-term care
insurance.
The SRP is expected to provide us with a system that will support our
business plan, allow us to grow the business without a significant increase in
staffing, transform our existing processes from clerical-based to
knowledge-based, and allow us to continue to provide and improve our services to
both agents and policyholders. We believe the SRP will result in annual savings
once the entire system is in place. These savings are expected to be achieved
through productivity improvements, labor avoidance costs, and a reduction in the
transaction error rates caused by manual processing. We believe the project will
be implemented in the first half of 2006.
We have an outsourcing agreement with a computer services vendor
providing for the daily operations of our systems, future program development
and assurance of continued operations in the event of a disaster or business
interruption. In addition, all processing of our newly introduced Medicare
Supplement business is performed by a third-party administrator. We believe that
these vendors can provide better expertise in the evolving arena of information
technology and Medicare Supplement processing than we can.
PREMIUMS
Our long-term care policies provide for guaranteed renewability, at the
option of the policyholder, at then-current premium rates. The policyholder may
elect to pay premiums on a monthly, quarterly, semi-annual or annual basis. In
addition, we offer an automatic payment feature that allows policyholders to
have premiums automatically withdrawn from a checking account.
Premium rates for all lines of insurance are subject to state
regulation, which vary greatly among jurisdictions. Premium rates for our
insurance policies are established by our actuarial staff with the assistance of
our actuarial consultants and after consultation with executive management. All
premium rates, including changes to previously approved premium rates, must be
approved by the insurance regulatory authorities in each state. However,
regulators may not approve the premium rate increases we request, may approve
them only with respect to certain types of policies, or may approve increases
that are smaller than those we request.
As a result of minimum statutory loss ratio standards imposed by state
regulations, the premiums on our existing and future Medicare supplement polices
are subject to reduction and/or corrective measures in the event insurance
regulatory agencies in states where we do business determine that our loss
ratios either have not reached or will not reach required minimum levels.
27
In the past, we have filed with and received approval from certain state
insurance departments to increase policy premium rates. These premium rate
increases have resulted from a) claims experience that has differed from our
expectations at time of original policy issuance, and b) development of
alternative forms of facility care (assisted living centers) which were not
contemplated at time of original policy issuance, but for which we have
frequently made payment under the terms of our existing facility-based policy
forms.
We have and are continuing to file and implement premium rate increases
on the majority of our policies sold prior to 2002.
FUTURE POLICY BENEFITS, CLAIMS RESERVES AND DEFERRED ACQUISITION COSTS
Our insurance policies are accounted for as long duration contracts. As
a result, there are two components of policyholder liabilities. The first is a
policy reserve liability for future policyholder benefits, represented by our
estimate of the present value of future benefits less future premium collection.
These reserves are calculated based on assumptions that include estimates for
mortality, morbidity, interest rates, premium rate increases and persistency.
The assumptions are based on industry experience, our historical results and
recent trends.
The second is a reserve for claims which have already been incurred,
whether or not they have yet been reported. The amount of reserves relating to
claims incurred is determined by periodically evaluating statistical information
with respect to the number and nature of historical claims. We regularly review
our claims reserves, and any adjustments to previously established claims
reserves are recognized in operating income in the period that the need for such
adjustments becomes apparent.
In connection with the sale of our insurance policies, we defer and
amortize the policy acquisition costs over the related premium paying periods
throughout the life of the policy. These costs include all expenses that are
directly related to, and vary with, the acquisition of the policy, including
commissions, underwriting and other policy issue expenses. The amortization of
deferred policy acquisition costs ("DAC") is determined using the same projected
actuarial assumptions used in computing policy reserves. DAC can be affected by
unanticipated terminations of policies because, upon such terminations, we are
required to expense fully the DAC associated with the terminated policies. In
addition, we review and update the assumptions underlying DAC and our policy
reserves to reflect current experience on a quarterly basis. If, based on that
review, we determine that our DAC is not fully recoverable, we would impair the
value of our DAC and would fully expense the impaired amount.
We use an in-house actuarial staff and a firm of actuarial consultants
to assist us in establishing reserves. Additionally, actuaries assist us in the
documentation of our reserve methodology and in determining the adequacy of our
reserves and their underlying assumptions, a process that has resulted in
adjustments to our reserve levels from time to time. Although we believe that
our reserves are adequate to cover all policy liabilities, there can be no
assurance that reserves are adequate or that future claims experience will be
similar to, or accurately predicted by, our past or current claims experience.
REINSURANCE
We purchase reinsurance to increase the number and size of the policies
we may underwrite and as a tool to manage statutory surplus strain associated
with new business growth. Reinsurance is purchased by insurance companies to
insure their liability under policies written to their insureds. By
transferring, or ceding, certain amounts of premium (and the risk associated
with that premium) to reinsurers, we can limit our exposure to risk. However, if
a reinsurance company becomes insolvent or
28
otherwise fails to honor its obligations under any reinsurance agreements, we
would remain fully liable to the policyholder.
REINSURANCE AGREEMENTS WITH CENTRE SOLUTIONS (BERMUDA) LIMITED
Effective December 31, 2001, we entered into a reinsurance agreement
with Centre Solutions (Bermuda) Limited to reinsure, on a quota share basis,
substantially all of our long-term care insurance policies then in-force. The
following is a summary of the reinsurance agreement and is qualified in its
entirety by reference to the reinsurance agreement which has been filed with the
Securities and Exchange Commission. The agreement is subject to certain coverage
limitations and an aggregate limit of liability which may be reduced if we are
unable to obtain premium rate increases. This agreement does not qualify for
reinsurance treatment in accordance with GAAP because the agreement does not
result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to a number of factors related to the agreement,
including experience refund provisions, expense and risk charges that will be
credited against our notional experience account by the reinsurer and the
aggregate limit of liability. However, this agreement meets the requirements to
qualify for reinsurance treatment under statutory accounting rules.
The initial premium paid by us under the agreement was approximately
$619 million, comprised of $563 million of cash and securities, and $56 million
held as funds due to the reinsurer. Such withheld funds are scheduled to be
released to the reinsurer in increments between December 31, 2003 and December
31, 2008, subject to Centre Solutions (Bermuda) Limited's right to demand that
the withheld funds be released in their entirety at any time by giving us
fifteen business days prior written notice. We released $10 million during both
2003 and 2004. The initial premium and future cash flows from the reinsured
policies, less claims payments, ceding commissions and risk charges, will be
credited to a notional experience account, which is held for our benefit in the
event of commutation and recapture on or after December 31, 2007. The notional
experience account balance also receives an investment credit based upon the
total return of a series of benchmark indices and hedges, which are designed to
closely match the duration of our reserve liabilities.
For each of the first seven years of the reinsurance agreement, Centre
Solutions (Bermuda) Limited will assess against our notional experience account
an annual base fee of $2.8 million plus 0.4% of the statutory reserves ceded to
it. Thereafter, the fees rise to a maximum in year twelve and each year
thereafter of $5.4 million plus 0.8% of the statutory reserves ceded to it. In
addition, the fees include amounts for capital to support the business, and
certain brokerage, maintenance and asset security fees. These fees are to be
deducted from the notional experience account on a quarterly basis and are not
payable to the reinsurer until, and if, the agreement is commuted.
We receive a monthly payment based on a yearly reinsurance allowance
equal to (1) approximately 19.7% of the net premiums we submit to Centre
Solutions (Bermuda) Limited, subject to certain adjustments for premium rate
increases implemented in 2003 and thereafter and (2) 3.5% of certain incurred
net losses and statutory claim reserves. The yearly reinsurance allowance is not
permitted to exceed 25% of the net premiums received in the applicable calendar
year. We also received a fixed amount of $2 million for each of the 2002 and
2003 calendar years and we will pay $1.2 million for each of the 2004, 2005,
2006 and 2007 calendar years.
The reinsurance agreement excludes certain losses from coverage,
including liabilities arising from (1) our actions or failure to act, (2)
insolvency funds, (3) nuclear hazards, (4) terrorism and (5) war or military
action.
29
The reinsurance agreement is subject to certain coverage limitations,
including an aggregate limit of liability, which is the sum of (1) $200 million,
(2) the initial premium of approximately $619 million, (3) net premiums received
and retained by the reinsurer on or after December 31, 2001, less reinsurance
allowance and taxes related to such premiums, and (4) 4.5% of (1) through (3),
less certain losses and rate increase shortfalls as described below.
The reinsurance agreement requires us to review the performance of our
policies to compare their actual to expected loss experience at least every six
months and to conduct an analysis of our underlying actuarial assumptions to
ascertain the future morbidity experience at least once a year. If we have
reason to believe that future experience is likely to be worse than projected at
the later of December 31, 2001 or the date of the most recent rate increase
approval, and that such deterioration in expected experience would justify an
increase in premium rates of 5% or more on any individual policy form, we are
required to file for and obtain increases in premium rates. Failure to obtain
such increases would constitute a breach under the agreement, resulting in a
reduction in the aggregate limit of liability. We are currently in compliance
with the agreement.
The reinsurance agreement contains commutation provisions and allows us
to recapture the reserve liabilities and the notional experience account balance
as of (1) a change in control of our subsidiaries, PTNA or ANIC, (2) an
insolvency of either of these subsidiaries, (3) our material breach of the
reinsurance agreement, or (4) December 31, 2007 or December 31 of any year
thereafter. We intend to commute the reinsurance agreement on December 31, 2007;
and, for GAAP purposes, we are accounting for the reinsurance agreement in
anticipation of this commutation. In the event we do not commute the reinsurance
agreement on December 31, 2007, we will be subject to escalating expenses and a
fourth tranche of warrants held by Centre Solutions (Bermuda) Limited will
become exercisable for convertible preferred stock that, if converted, would
represent approximately 20% of our outstanding common stock following such
conversion on a fully diluted basis (and, together with the three other tranches
of warrants, if exercised, would represent approximately 35% of the outstanding
common stock following such conversion on a fully diluted basis).
Our current modeling and actuarial projections suggest that it is
probable that we will be able to commute the agreement, as planned, on December
31, 2007. In order to commute the agreement, our statutory capital following
commutation must be sufficient to support the reacquired business in compliance
with all statutory requirements. Upon commutation, we would receive cash or
other liquid assets equaling the value of our notional experience account from
the reinsurer. We would also record the necessary reserves for the recaptured
business in our statutory financial statements. Our ability to commute the
agreement is highly dependent upon the market value of the notional experience
account exceeding the level of required reserves to be established. As of
December 31, 2004, the statutory reserve liabilities of $1.026 billion exceeded
the value of the notional experience account and funds held due to the reinsurer
of $939 million. In addition to the performance of the reinsured policies from
now until 2007, the notional experience account value is susceptible to market
interest rate changes. A market interest rate increase of 100 basis points could
reduce the market value of the current notional experience account by
approximately $110 million and jeopardize our ability to commute as planned. As
we approach the intended commutation date, the sensitivity of our notional
experience account to market interest rate movement will decline as the duration
of the benchmark indices becomes shorter. However, the amount of assets
susceptible to such interest sensitivity will continue to grow as additional net
cash flows are added to the notional experience account balance prior to
commutation. We intend to give notice to the reinsurer of our intention to
commute on December 31, 2007 at such time as we are highly confident of our
ability to support the recaptured policies. The reinsurer has agreed to fix the
market value of the notional experience account upon such time of notice, and to
then invest the assets in a manner that we request in order to minimize short
term volatility.
30
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 $2.75 to $6.25 per share. If exercised and converted, the convertible
preferred stock would represent approximately 15% of the then-outstanding shares
of our common stock on a fully diluted basis. If the agreement is not commuted
on December 31, 2007, the reinsurer may exercise the fourth tranche of
convertible preferred stock purchase warrants at a common stock equivalent price
of $1.80 per share, which if converted would represent an additional 20% of the
then-outstanding common stock on a fully diluted basis. We are recognizing the
additional consideration of entering into the agreement, represented by the fair
value of the warrants granted to the reinsurer, over the period of time to the
expected commutation date.
As a result of our intention to commute, we considered only the expense
and risk charges anticipated prior to the commutation date in our DAC
recoverability analyses and have not recorded the potential of future escalating
charges. In the event we determine that commutation of the reinsurance agreement
is unlikely on December 31, 2007, but likely at some future date, we will
include additional annual expense and risk charge credits against our notional
experience account in our DAC recoverability analysis. As a result, we could
impair the value of our DAC asset and record the impairment in our financial
statements.
The reinsurance agreement also granted the reinsurer an option to
participate in reinsuring new business sales on a quota share basis. In August
2002, the reinsurer exercised its option to reinsure up to 50% of future sales,
subject to a limitation of the reinsurer's risk. In 2004 and 2003, approximately
$3.4 million and $2.6 million of newly issued premium was subject to this
agreement, respectively.
On March 29, 2004, the reinsurer notified us of its decision to cease
reinsuring newly issued policies on or after August 1, 2004. Our agreement with
the reinsurer to reinsure existing policies issued prior to December 31, 2001
and policies issued under the 2002 Centre Agreement prior to August 1, 2004, are
unaffected by the determination made by the reinsurer regarding newly issued
policies.
OTHER REINSURANCE
We have entered into a reinsurance agreement with General and Cologne
Life Re of America ("Cologne") with respect to home health care policies with
benefit periods exceeding 36 months. No new policies have been reinsured under
this agreement since 1998. Cologne has notified us that they believe we have
breached our current agreement by entering into the agreement with Centre
Solutions (Bermuda) Limited without the prior written approval of Cologne. We
have contested this assertion of breach and are continuing discussions with
Cologne to reach an equitable resolution, including, but not limited to,
arbitration, the recapture of the excess home health care coverage and reserves,
premium rate increases or additional reinsurance business in the future. On May
9, 2005, we notified Cologne that we were initiating arbitration proceedings.
Further, we believe that the agreement does not allow for unilateral
cancellation in the event of breach. Reinsurance recoverables related to this
agreement were $11.2 million and $10.6 million at December 31, 2004 and 2003,
respectively.
We are also party to a coinsurance agreement with Cologne on a
previously acquired block of long-term care business, whereby 66% is ceded to a
third party. Cologne has also claimed breach of this agreement. However, the
agreement did not require prior written approval to enter other reinsurance
agreements and we believe that any claim of breach is baseless.
We also have an agreement with Cologne to cede certain home health and
nursing home claims. The claims ceded are either in excess of 60 months,
$250,000 or $350,000 depending on the policy type.
31
Cologne has also claimed breach of this agreement. However, none of the
reinsured policies were ceded to Centre Solutions (Bermuda) Limited and we
believe any claim of breach is baseless.
We have an agreement with Lincoln Heritage Life Insurance Company to
cede 100% of certain whole life and deferred annuity policies on an assumption
basis effective December 31, 2002. Upon approval from state insurance
departments in which the policies were issued, or policyholder approval as may
be prescribed by state regulation, we will no longer record these policies in
our financial statements. No gain or loss was recognized from the cession of
these policies to the new insurer.
In 2001, we ceded substantially all of our disability policies to
Assurity Life Insurance Company on a 100% quota share assumption basis. The
reinsurer may assume ownership of the policies as a sale upon various state and
policyholder approvals.
The following table shows our historical use of reinsurance:
REINSURANCE RECOVERABLE
--------------------------------------
Company A.M. Best Rating December 31, 2004 December 31, 2003
--------------------------------------------- ---------------- ----------------- -----------------
(in thousands)
General and Cologne Life Re of American A+ $ 17,193 $ 16,907
Assurity Life Insurance Company A- 3,264 3,681
Lincoln Heritage Life Insurance Company B++ 2,862 2,923
Other (1) 99 423
(1) Reinsurance recoverables of less than $500 are combined.
INVESTMENTS
We have categorized all of our investment securities as available for
sale because they may be sold in response to changes in interest rates,
prepayments and similar factors. Investments in this category are reported at
their current market value with net unrealized gains and losses, net of the
applicable deferred income tax effect, being added to or deducted from total
shareholders' equity on the balance sheet. As of December 31, 2004,
shareholders' equity was increased by $147,000 due to unrealized gains of
$226,000 in the investment portfolio. The amortized cost and estimated market
value of our available for sale investment portfolio as of December 31, 2004 and
2003 are as follows (amounts in thousands):
32
DECEMBER 31, 2004
---------------------------------------------------------------------
Amortized Gross Unrealized Grossd Unrealized Estimated
Cost Gains Losses Market Value
----------- ------------------ ------------------- --------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 34,795 $ 298 $ (237) $ 34,856
Mortgage backed securities 1,874 21 (16) 1,879
Debt securities issued by
foreign governments 384 20 (2) 402
Corporate securities 21,892 245 (103) 22,034
----------- ------------------ ------------------- --------------
$ 58,945 $ 584 $ (358) $ 59,171
=========== ================== =================== ==============
DECEMBER 31, 2003
---------------------------------------------------------------------
Amortized Gross Unrealized Grossd Unrealized Estimated
Cost Gains Losses Market Value
----------- ------------------ ------------------- --------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 20,699 $ 624 $ (38) $ 21,285
Mortgage backed securities 2,020 39 (3) 2,056
Debt securities issued by
foreign governments 236 11 (2) 245
Corporate securities 19,978 375 (86) 20,267
----------- ------------------ ------------------- --------------
$ 42,933 $ 1,049 $ (129) $ 43,853
=========== ================== =================== ==============
Our investment portfolio, excluding our notional experience account,
consists primarily of investment grade fixed income securities. Income generated
from this portfolio is largely dependent on prevailing levels of interest rates
at the time of original purchase. Due to the duration of our investments
(approximately 4 years), investment income does not immediately reflect changes
in market interest rates.
In connection with our 2001 reinsurance agreement with Centre Solutions
(Bermuda) Limited, during the first quarter of 2002, we transferred
substantially our entire investment portfolio to the reinsurer as the initial
premium payment. The initial and future premium for the reinsured policies, less
claims payments, ceding commissions and risk charges is credited to a notional
experience account, the balance of which also receives an investment credit. The
notional experience account balance represents an amount to be paid to us in the
event of commutation of the agreement. We believe that the notional experience
account represents a hybrid instrument, containing both a fixed debt host
contract and an embedded derivative. The economic characteristics and risks of
the embedded derivative instrument are not clearly and closely related to the
economic characteristics and risks of the fixed debt host contract. We are
accounting for the investment credit received on the notional experience account
as follows:
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 Statements of Income and
Comprehensive Income.
33
2. The change in fair value of the embedded derivative represents
the percentage change in the underlying indices applied to the notional
experience account, similar to that of an unrealized gain/loss on a bond. The
change in the fair value of the embedded derivative is reported as a market gain
or loss on notional experience account in the Statements of Income and
Comprehensive Income.
As a result, our results of operations are subject to significant
volatility. The benchmark indices are comprised of United States treasury
strips, agencies and investment grade corporate bonds, with weightings of
approximately 25%, 15% and 60%, respectively, and have a duration of
approximately 14 years.
SELECTED FINANCIAL INFORMATION: STATUTORY BASIS
The following table shows certain ratios derived from our insurance
regulatory filings with respect to our accident and health policies presented in
accordance with accounting principles prescribed or permitted by insurance
regulatory authorities, which differ from the presentation under GAAP and which
also differ from the presentation under statutory accounting rules for purposes
of demonstrating compliance with statutorily mandated loss ratios.
Year ended December 31,
2004 2003 2002
---- ---- ----
Loss Ratio (1) (4) 69.6% 67.3% 75.8%
Expense ratio (2) (4) 52.1% 57.6% (8.2)%
----- ----- ------
Combined loss and expense ratio 121.7% 124.9% 67.6%
Persistency (3) 88.7% 88.1% 82.8%
(1) Loss ratio is defined as incurred claims and increases in policy
reserves divided by collected premiums.
(2) Expense ratio is defined as commissions and expenses, net of
ceding allowances from reinsurers, divided by collected
premiums.
(3) We measure persistency as the continuation of a benefit unit, or
an increment of $10 of coverage per day offered under a policy,
that remains in-force from one year to the next. We selected
this method rather than measuring renewing policies or premium
revenue due to the impact of premium rate increases we have
implemented. We believe that the higher premium revenue
following a premium rate increase would distort the actual
persistency of the policies in-force. In addition, we have
offered policyholders affected by premium rate increases a
choice of accepting the higher premium or reducing existing
benefits and continuing at their original premium amount, which,
if persistency was measured on renewing policies, would yield an
inaccurate measure of our continuing liability.
(4) The 2004, 2003 and 2002 loss ratios and expense ratios are
significantly affected by the reinsurance of approximately $303
million, $309 million and $326 million, respectively, in premium
revenue on a statutory basis under financial and other
reinsurance treaties. Change in reserves is accounted for as
offsetting negative benefits and negative premium, causing
substantial deviation in reported ratios.
STATUTORY ACCOUNTING PRACTICES. State insurance regulators require our
insurance subsidiaries to have statutory surplus at a level sufficient to
support existing policies and new business growth. Under statutory accounting
rules, we charge costs associated with sales of new policies against earnings as
such costs are incurred. These costs, together with required reserves, generally
exceed first year premiums and, accordingly, cause a reduction in statutory
surplus during periods of increasing first year sales. The commissions paid to
agents are generally higher for new policies than for renewing policies. Because
34
statutory accounting requires commissions to be expensed as paid, rapid growth
in first year policies generally results in higher expense ratios.
INSURANCE INDUSTRY RATING AGENCIES
Our insurance subsidiaries have A.M. Best financial strength ratings of
"B- (fair)" and Standard & Poor's claims paying ability ratings of "B- (weak),
with positive outlook." A.M. Best and Standard & Poor's ratings are based on a
comparative analysis of the financial condition and operating performance for
the prior year of the companies rated, as determined by their publicly available
reports. Penn Treaty also has a financial strength rating of "CCC- (weak)" from
Standard & Poor's for its subordinated convertible debt, but has no rating from
A.M. Best. A.M. Best's classifications range from "A++ (superior)" to "F (in
liquidation)." Standard & Poor's ratings range from "AAA (extremely strong)" to
"CC (extremely weak)." A.M. Best and Standard & Poor's insurer ratings are based
upon factors of concern to policyholders and insurance agents and are not
directed toward the protection of investors or recommendations to buy, hold or
sell a security. In evaluating a company's financial and operating performance,
the rating agencies review profitability, leverage and liquidity, as well as
book of business, the adequacy and soundness of reinsurance, the quality and
estimated market value of assets, the adequacy of reserves and the experience
and competence of management.
Certain distributors will not sell our group products unless we have a
higher financial strength rating. The inability of our subsidiaries to obtain
higher A.M. Best or Standard & Poor's ratings could adversely affect the sales
of our products if customers favor policies of competitors with better ratings.
In addition, a downgrade in our ratings may cause our policyholders to allow
their existing policies to lapse.
COMPETITION
We operate in a highly competitive industry. We believe that competition
is based on a number of factors, including service, products, premiums,
commission structure, financial strength, industry ratings and name recognition.
We compete with a large number of national insurers, smaller regional insurers
and specialty insurers, many of whom have considerably greater financial
resources, higher ratings from A.M. Best and Standard and Poor's and larger
networks of agents than we do. Many insurers offer long-term care policies
similar to those we offer and utilize similar marketing techniques. In addition,
we are subject to competition from insurers with broader product lines. We also
may be subject, from time to time, to new competition resulting from changes in
Medicare benefits.
We also actively compete with other insurers in attracting and retaining
agents to distribute our products. Competition for agents is based on quality of
products, commission rates, underwriting, claims service and policyholder
service. We continuously recruit and train independent agents to market and sell
our products. We also engage field marketing organizations from time to time to
recruit independent agents and develop networks of agents in various states. Our
business and ability to compete may suffer if we are unable to recruit and
retain insurance agents and if we lose the services provided by our field
marketing organizations.
We also compete with non-insurance financial services companies such as
banks, securities brokerage firms, investment advisors, mutual fund companies
and other financial intermediaries marketing insurance products, annuities,
mutual funds and other retirement-oriented investments. The ability of banks to
affiliate with insurers may adversely affect our ability to remain competitive.
The insurance industry may undergo further change in the future and,
accordingly, new products and methods of service may be introduced. In order to
keep pace with any new developments, we may need to expend significant capital
to offer new products and to train our agents and employees to sell and
35
administer these products and services. Our ability to compete with other
insurers depends on our success in developing new products.
GOVERNMENT REGULATION
GENERAL
Insurance companies are subject to supervision and regulation in all
states in which they transact business. Regulation and scrutiny of the insurance
industry has intensified due to recent events. Penn Treaty is registered and
approved as a holding company under the Pennsylvania Insurance Code. Our
insurance company subsidiaries are chartered in the states of Pennsylvania and
New York.
The extent of regulation of insurance companies varies, but generally
derives from state statutes which delegate regulatory, supervisory and
administrative authority to state insurance departments. Although many states'
insurance laws and regulations are based on models developed by the National
Association of Insurance Commissioners ("NAIC"), and are therefore similar,
variations among the laws and regulations of different states are common.
The NAIC is a voluntary association of all of the state insurance
commissioners in the United States. The primary function of the NAIC is to
develop model laws on key insurance regulatory issues that can be used as
guidelines for individual states in adopting or enacting insurance legislation.
While the NAIC model laws are accorded substantial deference within the
insurance industry, these laws are not binding on insurance companies unless
adopted by states, and variation from the model laws by states is common.
The Pennsylvania Insurance Department, the New York Insurance Department
and the insurance regulators in other jurisdictions have broad administrative
and enforcement powers relating to the granting, suspending and revoking of
licenses to transact insurance business, the licensing of agents, the regulation
of premium rates and trade practices, the content of advertising material, the
form and content of insurance policies and financial statements and the nature
of permitted investments. In addition, regulators have the power to require
insurance companies to maintain certain deposits, capital, surplus and reserve
levels calculated in accordance with prescribed statutory standards. The NAIC
has developed minimum capital and surplus requirements utilizing certain
risk-based factors associated with various types of assets, credit, underwriting
and other business risks. This calculation, commonly referred to as Risk-Based
Capital, serves as a benchmark for the regulation of insurance company solvency
by state insurance regulators. The primary purpose of such supervision and
regulation is the protection of policyholders, not investors.
Most states mandate minimum benefit standards and policy lifetime loss
ratios for long-term care insurance policies and for other accident and health
insurance policies. A significant number of states, including Pennsylvania and
Florida, have adopted the NAIC's proposed minimum loss ratio of 60% for both
individual and group long-term care insurance policies. Certain states,
including New Jersey and New York, have adopted a minimum loss ratio of 65% for
long-term care. The states in which we are licensed have the authority to change
these minimum ratios, the manner in which these ratios are computed and the
manner in which compliance with these ratios is measured and enforced.
In December 1986, the NAIC adopted the Long-Term Care Insurance Model
Act (the "Model Act"), to promote the availability of long-term care insurance
policies, to protect applicants for such insurance and to facilitate flexibility
and innovation in the development of long-term care coverage. The Model Act
establishes standards for long-term care insurance, including provisions
relating to disclosure and performance standards for long-term care insurers,
incontestability periods, nonforfeiture benefits,
36
severability, penalties and administrative procedures. Model regulations were
also developed by the NAIC to implement the Model Act. Some states have also
adopted standards relating to agent compensation for long-term care insurance.
Some state legislatures have adopted NAIC proposals to limit significant
premium rate increases on long-term care insurance products. Instead, these
states have required that new long-term care policies sold after the adoption of
the NAIC proposals include additional margin for moderately adverse deviation in
claims expectations. This additional margin included in the original pricing of
policies is designed to partially protect policyholders from future premium rate
increases. In the past, we have been generally successful in obtaining premium
rate increases when necessary. We currently have premium rate increases on file
with various state insurance departments. If we are unable in the future to
obtain premium rate increases, or in the event of legislation limiting premium
rate increases, we believe it would have a negative impact on our financial
condition and future earnings.
Under the Health Insurance Portability and Accountability Act ("HIPAA"),
premiums paid for eligible long-term care insurance policies are treated as
deductible medical expenses for federal income tax purposes. The deduction is
limited to a specified dollar amount ranging from $260 to $3,250, with the
amount of the deduction increasing with the age of the taxpayer. In order to
qualify for the deduction, the insurance contract must, among other things,
provide for limitations on pre-existing condition exclusions, prohibitions on
excluding individuals from coverage based on health status and guaranteed
renewability of health insurance coverage. Although we offer tax-deductible
policies, we will continue to offer a variety of non-deductible policies as
well. We have long-term care policies that qualify for tax exemption under HIPAA
in all states in which we are licensed.
We are also subject to the insurance holding company laws of
Pennsylvania and of the other states in which we are licensed to do business.
These laws generally require insurance holding companies and their subsidiary
insurers to register and file certain reports, including information concerning
their capital structure, ownership, financial condition and general business
operations. Further, states often require prior regulatory approval of changes
in control of an insurer and of intercompany transfers of assets within the
holding company structure. The Pennsylvania Insurance Department and the New
York Insurance Department must approve the purchase of more than 10% of the
outstanding shares of our common stock by one or more parties acting in concert,
and may subject such party or parties to the reporting requirements of the
insurance laws and regulations of Pennsylvania and New York and to the prior
approval and/or reporting requirements of other jurisdictions in which we are
licensed. In addition, our officers and directors and those of our insurance
subsidiaries and our 10% shareholders are subject to the reporting requirements
of the insurance laws and regulations of Pennsylvania and New York, as the case
may be, and may be subject to the prior approval and/or reporting requirements
of other jurisdictions in which they are licensed.
States also restrict the dividends our insurance subsidiaries are
permitted to pay. Dividend payments will depend on profits arising from the
business of our insurance company subsidiaries, computed according to statutory
formulae. Under the insurance laws of Pennsylvania and New York, where our
insurance subsidiaries are domiciled, insurance companies can pay ordinary
dividends only out of earned surplus. In addition, under Pennsylvania law, our
Pennsylvania insurance subsidiaries (including our primary insurance subsidiary)
must give the Department at least 30 days' advance notice of any proposed
"extraordinary dividend" and cannot pay such a dividend if the Department
disapproves the payment during that 30-day period. For purposes of that
provision, an extraordinary dividend is a dividend that, together with all other
dividends paid during the preceding twelve months, exceeds the greater of 10% of
the insurance company's surplus as shown on the company's last annual statement
filed with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to
37
the immediate or accelerated recognition of all costs associated with premium
growth and benefit reserves. Additionally, our Plan requires the Department to
approve all dividend requests made by PTNA, regardless of normal statutory
requirements for allowable dividends. We believe that the Department is unlikely
to consider any dividend request in the foreseeable future as a result of PTNA's
current statutory surplus position. Although not stipulated in the Plan, this
requirement is likely to continue until such time as PTNA meets normal statutory
allowances, including reported net income and positive cumulative earned
surplus.
Under New York law, our New York insurance subsidiary (American
Independent Network Insurance Company of New York) must give the New York
Insurance Department 30 days' advance notice of any proposed dividend and cannot
pay any dividend if the regulator disapproves the payment during that 30-day
period. In addition, our New York insurance company must obtain the prior
approval of the New York Insurance Department before paying any dividend that,
together with all other dividends paid during the preceding twelve months,
exceeds the lesser of 10% of the insurance company's surplus as of the preceding
December 31 or its adjusted net investment income for the year ended the
preceding December 31.
PTNA and ANIC have not paid any dividends to Penn Treaty for the past
three years and are unlikely in the foreseeable future to be able to make
dividend payments due to insufficient statutory surplus and anticipated
earnings. However, our New York subsidiary is not subject to the Plan and in
March 2002 we received a dividend from our New York subsidiary of $651,000. The
New York subsidiary did not pay any dividends in 2003 or 2004.
Periodically, the federal government has considered adopting a national
health insurance program. Although it does not appear that the federal
government will enact an omnibus health care reform law in the near future, the
passage of such a program could have a material impact on our operations. In
addition, other legislation enacted by Congress could impact our business. As
with any pending legislation, it is possible that any laws finally enacted will
be substantially different from the current proposals. Accordingly, we are
unable to predict whether the impact of any such legislation on our business and
operations would be positive or negative.
Compliance with multiple Federal and state privacy laws may affect our
profits. Congress enacted the Gramm-Leach-Bliley Financial Services
Modernization Act (GLB) in 1999 and the Health Insurance Portability and
Accountability Act (HIPAA) in 1996. GLB was effective November 13, 2000 with
full compliance required by July 1, 2001. The United States Department of Health
and Human Services adopted privacy rules under HIPAA to protect the privacy and
confidentiality of consumer's protected health information. The HIPAA privacy
rules took effect April 14, 2003. Subsequently, additional rules were adopted
addressing security standards for protection of electronic protected health
information with compliance required by April 20, 2005. States were encouraged
by the preemption provisions of these laws to enact their own privacy rules and
regulations. In addition, the NAIC adopted the Insurance Information and Privacy
Model Act as a model for states to follow in enacting their own privacy laws and
regulations. While many states had enacted privacy laws and regulations prior to
the advent of GLB and HIPAA, a majority of states have enacted new laws and
regulations following passage of GLB and HIPAA to be consistent with or more
stringent than the NAIC model act and those provided for under federal law.
Compliance with different laws in states where we are licensed could prove to be
costly.
STATE REGULATORY ACTIONS
Our insurance subsidiaries are regulated by various state insurance
departments. In its ongoing effort to improve solvency regulation, the NAIC has
adopted Risk-Based Capital ("RBC") requirements
38
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, PTNA, ANIC and American Independent Network
Insurance Company of New York (representing approximately 91%, 8% and 1% of our
in-force premium, respectively), are each required to hold statutory surplus
that is above a certain required level. If the statutory surplus of either of
our Pennsylvania subsidiaries falls below such level, the Department may be
required to place such subsidiary under regulatory control, leading to
rehabilitation or liquidation. At December 31, 2000, PTNA had Total Adjusted
Capital below the Regulatory Action level. As a result, it was required to file
a Corrective Action Plan ("the Plan") with the Pennsylvania Insurance Department
(the "Department"). On February 12, 2002, the Department approved the Plan by
way of a Corrective Order.
The Corrective Order requires PTNA and ANIC to comply with certain
agreements at the direction of the Department, including, but not limited to:
o New investments are limited to NAIC 1 or 2 rated securities;
o An agreement to increase statutory reserves by an additional
$125 million by December 31, 2004, which has been completed.
o Enter into a reinsurance treaty with Centre Solutions (Bermuda)
Limited through which PTNA and ANIC reinsure 100% of their
individual long term care insurance business in effect on
December 31, 2001;
o File with the Department monthly statements of the balance of
the trust account required under the trust agreement among them,
Centre Solutions (Bermuda) Limited, and The Bank of New York
within five days of receipt of any such statement;
o Compute contract and unearned premium reserves using the initial
level net premium reserve methodology;
o Submit to the Department all filings made by Penn Treaty with
the Securities and Exchange Commission, and all press releases
issued by Penn Treaty, PTNA or ANIC;
o Not enter into any new reinsurance contract or treaty, or amend,
commute or terminate any existing reinsurance treaty without the
prior written approval of the Department, such approval not to
be unreasonably withheld;
o Not make any new special deposits or make any changes to
existing special deposits without the prior written approval of
the Department, such approval not to be unreasonably withheld;
39
o Not enter into any new agreements or amend any existing
agreements with Penn Treaty or any affiliate in excess of
$100,000 or make any dividends or distributions to Penn Treaty
or any affiliate without the prior written approval of the
Department, such approval not to be unreasonably withheld; and
o Notify the Department within five days of receiving notification
of default on Penn Treaty debt requiring acceleration of
repayment.
We are in compliance with all terms of the Corrective Order as of the
date of this prospectus. If we fail to continue to comply with the terms of the
Corrective Order, the Department could take action to suspend our ability to
continue to write new policies, or impose other sanctions on us.
The Florida Department of Insurance issued a Consent Order dated July
30, 2002, as amended, reinstating PTNA's Certificate of Authority in Florida as
a foreign insurer. The Consent Order sets forth the following obligations which
PTNA must satisfy to maintain its Certificate of Authority in Florida:
o Maintain compliance with Florida laws which establish minimum
surplus required for health and life insurers;
o Submit monthly financial statements to the Department of
Insurance;
o Maintain compliance with Florida laws governing investments in
subsidiaries and related corporations;
o Limit direct premiums on new business in Florida so as not to
exceed $4 million during 2002 and $15 million during 2003;
o Limit direct premium growth in Florida to ten percent annually
after 2003 ($16.5 million in 2004) unless otherwise approved in
writing by the Department of Insurance based upon evidence of
adequate capitalization;
o Maintain a RBC ratio in excess of 200%; and
o Submit quarterly reports to the Department of Insurance
demonstrating all claims that have been assumed by Centre
Solutions (Bermuda) Limited.
In the event that PTNA fails to maintain compliance with Florida laws or
the above requirements, the Department of Insurance will notify PTNA and could
require it to take corrective action. If the Department of Insurance determines
that the corrective action is not timely, PTNA's Certificate of Authority could
be suspended and it could be required to cease writing new direct business in
Florida until such time as it took any required corrective action.
In March of 2005 the Florida Department of Insurance notified us that,
based upon our most recent statutory filing, we were in marginal violation of
the gross premium to surplus ratio and of the consent order. However, we
subsequently entered into a sale/leaseback arrangement which increases statutory
surplus by $3 million, bringing us into compliance with the corrective order. As
a result, we do not anticipate any interruption in our ability to sell new
policies in Florida.
In January 2003, PTNA received approval from the Illinois Department of
Insurance to recommence the sale of new policies. As a condition of
recommencement, PTNA agreed to provide a second actuarial asset adequacy review
on a biannual basis.
In March 2003, we received approval from the California Insurance
Department to recommence sales in California subject to certain conditions to be
met prior to recommencement of sales and in order to continue to write new
policies in the future. The additional conditions included:
o The additional certification of the Company's reserves for 2002,
and annually thereafter by May 1, to be performed by an
independent actuary of the Department's choice. The Company will
bear the cost of additional certifications.
o The Company's commitment that, if an unqualified actuarial
opinion is not received as of any subsequent year-end, it will
voluntarily discontinue writing new business in California until
that condition is corrected.
We are in compliance with all conditions established by the California
and Illinois Departments of Insurance.
40
EMPLOYEES
As of December 31, 2004, we had approximately 301 full-time employees.
We are not a party to any collective bargaining agreements.
PROPERTIES
Our principal offices in Allentown, Pennsylvania occupy two buildings,
totaling approximately 37,000 square feet of office space in a 40,000 square
foot building and all of a 16,879 square foot building. We own both buildings
and a 2.42 acre undeveloped parcel of land located across the street from our
home offices. We also lease additional office space for ancillary operations of
our captive agencies, New York staff and actuarial staff.
LEGAL PROCEEDINGS
We 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.
Penn Treaty and its subsidiary, PTNA, are defendants in an action in the
Fifth Judicial Circuit of the State of Florida in and for Marion County, Civil
Division (Forest, et al. v. Penn Treaty Network America Insurance Company).
Plaintiffs filed this matter on January 10, 2003 in Florida State Court, on
behalf of themselves and a class of similarly situated Florida long-term care
policyholders. We removed this case to United States District Court, Middle
District of Florida, Ocala Division for a second time in November 2003.
Plaintiffs' motion to remand the case to Florida State Court was granted in
April 2004. Plaintiffs claim wrongdoing in connection with the sale of long-term
care insurance policies to the Plaintiffs and the class. Plaintiffs allege
claims for reformation, breach of fiduciary duty, breach of the implied duty of
good faith and fair dealing, negligent misrepresentation, fraudulent
misrepresentation, and restitution and pray for relief in the form of
compensatory damages and restitution, an order of reformation of the polices,
and attorney fees and court costs. No amounts were specified for compensatory
damages and restitution. We have filed motions to dismiss for failure to state a
claim, lack of personal jurisdiction against Penn Treaty, and to strike certain
allegations of the complaint as irrelevant and improper. While we deny liability
to Plaintiffs and intend to contest this vigorously, we are continuing our
negotiations in this matter.
Penn Treaty and PTNA are defendants in an action in the Orange County
Superior Court in the state of California (Bartolini, et al. v. Penn Treaty
Network America Insurance Company). Plaintiffs filed this matter in November
2003 on behalf of themselves, all other persons similarly situated and the
general public. Plaintiffs claim wrongdoing in violation of the California
Business & Professions Code in connection with the sale of long term care
insurance policies. Plaintiffs allege unlawful business acts, claims for
reformation, breach of fiduciary duty, breach of the implied duty of good faith
and fair dealing, and negligent misrepresentation and pray for relief in the
form of compensatory damages and restitution, punitive damages, an order of
reformation of the policies, and attorney fees and court costs. No amounts were
specified for compensatory damages and restitution. After review of our motions
related to the plaintiffs' complaint, the court dismissed plaintiffs' claim for
breach of fiduciary duty, and we filed an answer to the plaintiffs' other claims
in the complaint. While we deny liability to Plaintiffs and intend to contest
this vigorously, we are continuing our negotiations in this matter.
41
Penn Treaty, PTNA and another subsidiary, Senior Financial Consultants
Company, were defendants in an action instituted on June 5, 2002 in the United
States District Court for the Eastern District of Pennsylvania (National
Healthcare Services, Inc. v. Penn Treaty American Corporation, et al.). The
complaint sought compensatory damages for an alleged breach of contract and
misappropriation. The parties have settled the matter for value of $1.35 million
to be paid in a combination of our common shares (at our option) and cash. We
deny liability to plaintiffs but entered into the settlement to avoid the risks,
uncertainties and costs inherent in litigation. The case has now been dismissed
with prejudice pursuant to the settlement agreement.
PTNA is a defendant in an action in the Los Angeles County Superior
Court in the state of California (Westfall, et al. v. Penn Treaty Network
America Insurance Company, et al.). Plaintiffs filed this matter on May 28, 2004
on behalf of themselves and all other persons similarly situated and the general
public. The plaintiffs allege wrongdoing in connection with the payment of
long-term care insurance claims. The plaintiffs allege violations of the
California Consumer Legal Remedies Act, the California Business and Professions
Code, breach of the implied duty of good faith and fair dealing, financial elder
abuse and prays for relief in the form of compensatory damages and restitution,
punitive damages, any accounting, attorney fees and court costs. No amounts were
specified for compensatory damages and restitution or punitive damages. We
removed this case to United States District Court for the Central District of
California in March 2005. We have filed a motion to dismiss all counts of the
plaintiffs' complaint, and a motion to strike allegations of the complaint,
including plaintiffs' class allegations. While we cannot predict the outcome of
this case, it could have a material adverse impact upon our financial condition
and results of operations in the event of an unfavorable outcome. However, we
believe that the complaint is without merit and intend to continue to defend the
matter vigorously.
Penn Treaty's subsidiary, PTNA, is a party to reinsurance agreements to
cede the risk of certain home health care and nursing home claims. The
reinsurer, General and Cologne Life Re of America ("Cologne"), has notified PTNA
that it believes that the Company is in breach of its agreements as a result of
entering into the 2001 Centre Agreement without the prior written approval of
the reinsurer. PTNA has contested this assertion and, on May 9, 2005, PTNA
notified Cologne that PTNA was initiating arbitration proceedings.
42
SELECTED FINANCIAL DATA
The following selected consolidated statement of operations data and
balance sheet data as of and for the years ended December 31, 2004, 2003, 2002,
2001 and 2000 have been derived from our Consolidated GAAP Financial Statements.
2003 2002 2001 2000
2004 RESTATED (1) RESTATED (1) RESTATED (1) RESTATED (1)
--------- ------------ ------------ ------------ ------------
STATEMENT OF INCOME AND COMPREHENSIVE INCOME DATA:
Revenues:
Total premiums $ 319,885 $ 321,946 $ 333,643 $ 350,391 $ 357,113
Net investment income 46,839 43,273 40,107 30,613 27,408
Net realized gains (losses) 167 237 15,663 (4,367) 652
Trading account loss - - - (3,428) -
Market gain (loss) on experience account (2) 39,749 (9,494) 56,555 - -
Change in preferred interest on early conversion
liabilitity (3) 2,237 (981) - - -
Other income 5,864 9,082 11,585 9,208 8,096
--------- --------- --------- --------- ---------
Total revenues 414,741 364,063 457,553 382,417 393,269
--------- --------- --------- --------- ---------
Benefits and expenses:
Benefits to policyholders (4) 232,698 247,822 374,085 240,750 244,933
Commissions 39,115 40,800 45,741 76,805 102,313
Net acquisition costs amortized (deferred) (5) 11,578 10,243 7,515 9,972 (43,109)
Impairment of net unamortized policy
acquisition costs (6) - - 1,100 61,800 -
General and administrative expenses 52,970 59,110 46,472 49,282 49,973
Impairment of goodwill (7) 13,376 - - - -
Litigation expense (8) 4,150 - - (250) 1,000
Expense and risk charge and excise tax (9) 14,199 14,138 17,227 5,635 -
Interest expense 10,443 8,112 5,733 4,999 5,134
--------- --------- --------- --------- ---------
Total benefits and expenses 378,529 380,225 497,873 448,993 360,244
--------- --------- --------- --------- ---------
Income (loss) before federal income taxes and
cumulative effect of accounting change 36,212 (16,162) (40,320) (66,576) 33,025
(Provision) benefit for federal income taxes (15,676) 2,992 13,728 16,877 (11,214)
--------- --------- --------- --------- ---------
Net income (loss) before cumulative effect -
of accounting change (10) $ 20,536 $ (13,170) $ (26,592) $ (49,699) $ 21,811
========= ========= ========= ========= =========
Net income (loss) $ 20,536 $ (13,170) $ (31,743) $ (49,699) $ 21,811
========= ========= ========= ========= =========
Net income (loss) adjusted for accounting change (11) $ 20,536 $ (13,170) $ (31,743) $ (48,846) $ 22,664
========= ========= ========= ========= =========
Basic earnings per share before cumulative effect
of accounting change (10) $ 0.54 $ (0.63) $ (1.38) $ (3.49) $ 3.00
========= ========= ========= ========= =========
Diluted earnings per share before cumulative effect
of accounting change (10) $ 0.30 $ (0.63) $ (1.38) $ (3.49) $ 2.52
========= ========= ========= ========= =========
Basic earnings per share $ 0.54 $ (0.63) $ (1.65) $ (3.49) $ 3.00
========= ========= ========= ========= =========
Diluted earnings per share $ 0.30 $ (0.63) $ (1.65) $ (3.49) $ 2.52
========= ========= ========= ========= =========
Basic earnings per share adjusted for accounting
change (11) $ 0.54 $ (0.63) $ (1.65) $ (3.43) $ 3.11
========= ========= ========= ========= =========
Diluted earnings per share adjusted for accounting
change (11) $ 0.30 $ (0.63) $ (1.65) $ (3.43) $ 2.61
========= ========= ========= ========= =========
Weighted average shares outstanding (12) 37,720 20,970 19,240 14,248 7,279
Weighted average diluted shares outstanding (13) 86,306 20,970 19,240 14,248 9,976
43
2003 2002 2001 2000
2004 RESTATED (1) RESTATED (1) RESTATED (1) RESTATED (1)
--------- ------------ ------------ ------------ ------------
GAAP RATIOS:
-------------------------------------------------
Loss ratio (2) 72.7% 77.0% 112.1% 68.7% 68.6%
Expense ratio 36.8% 38.6% 35.4% 58.0% 30.9%
--------- --------- --------- --------- ---------
Total (14) 109.5% 115.6% 147.5% 126.7% 99.5%
========= ========= ========= ========= =========
Return on average equity (15) 12.0% (9.0)% (18.9)% (26.8)% 12.9%
-------------------------------------------------
BALANCE SHEET DATA:
Total investments (16) $ 59,509 $ 44,141 $ 28,692 $ 488,591 $ 366,126
Total assets 1,244,677 1,145,494 1,079,843 939,930 855,806
Total debt 85,167 88,467 76,245 79,190 81,968
Shareholders' equity 197,370 144,079 148,342 187,263 183,638
Book value per share $ 4.57 $ 5.83 $ 7.64 $ 9.94 $ 25.20
SELECTED STATUTORY DATA:
-------------------------------------------------
Net premiums written (17) $ 29,888 $ 27,008 $ 22,440 $ (64,689) $ 130,676
Statutory surplus (beginning of period) $ 30,638 $ 34,234 $ 35,551 $ 30,137 $ 67,070
Ratio of net premiums written to
statutory surplus 1.0x .8x .6x (2.1)x 1.9x
Notes to Selected Financial Data (in thousands)
(1) In March 2005, in conjunction with the preparation of the financial
statements for the year ended December 31, 2004, we concluded that
certain policy riders were not reserved for in prior years. Therefore,
we have determined that we have not properly accounted for benefits
expense and policy reserves. As a result of this conclusion, we have
restated our previously issued financial statements for the years ended
December 31, 2003 and 2002 to reflect the inclusion of the policy
riders. In addition, we have restated the financial information in the
Selected Financial Data table for 2001 and 2000 to reflect the impact of
the previously unreserved policy riders.
The impact of the restatement on net income and shareholders' equity
was:
Increase (Decrease)
Shareholders'
Year Ended Net Income Equity
--------------------------------------------------------
2000 $ (939) $ (4,424)(1)
2001 (1,110) (5,533)
2002 (1,305) (6,838)
2003 183 (6,655)
(1) Shareholders' equity was reduced $3,484 on January 1, 2000
due to the impact of the unreserved policies in previous years.
(2) Effective December 31, 2001, we entered into a reinsurance agreement for
substantially all of our long-term care insurance policies, which we are
accounting for as deposit accounting. The reinsurer maintains a notional
experience account for our benefit in the event of commutation. The
notional experience account receives an investment credit, derived from
the separate components of the notional experience account. This gain
represents the income from the embedded derivative portion of our
notional experience account, similar to that of an unrealized gain or
loss on a bond.
(3) Holders of our convertible subordinated notes are entitled to convert
their notes into shares of our common stock before October 2005 and
receive a discounted amount of interest that they would have otherwise
received until that date. We have determined that this feature is an
embedded derivative as defined in Statement of Financial Accounting
Standards No. 133 "Accounting for Derivative Instruments and
44
Hedging Activities." As a result of this determination, we have
separately valued and bifurcated the embedded derivative from the host
contract. At each balance sheet date, the embedded derivative must be
recorded at fair value, with any change in fair value recognized in
current operations.
(4) During the third quarter of 2002, we determined to refine certain of our
processes and assumptions in the establishment of our reserves for
current claims. As a result of this change, we increased our reserves
for current claims by approximately $83,000 for claims incurred prior to
the third quarter of 2002.
(5) Effective September 10, 2001, we discontinued the sale, nationally, of
all new long-term care insurance policies until our Corrective Action
Plan was completed and approved by the Pennsylvania Insurance
Department. As a result, there was a substantial reduction in the
deferral of costs associated with new policy issuance, while we
continued to amortize existing deferred acquisition costs.
(6) Our reinsurance agreement requires us to accrue an annual expense and
risk charge to the reinsurer. Primarily as a result of these anticipated
charges, we impaired the value of our net unamortized policy acquisition
costs by $61,800 in 2001. In the third quarter of 2002, we impaired the
value of our deferred acquisition cost asset by approximately $1,100 as
a result of the change in our assumptions regarding the future
profitability of our existing business in force.
(7) We test for impairment of goodwill on an annual basis unless an event
occurs or circumstances change that would more likely than not indicate
that an impairment has occurred. We tested our goodwill quarterly during
2004 due to decreasing sales levels. During our impairment test in the
first quarter of 2005, we determined that the goodwill related to the
agency reporting unit was impaired. This impairment was a result of
declining sales, particularly in the fourth quarter of 2004, which led
to lower than planned net income at the reporting unit level. During the
most recent impairment test, we lowered the assumptions related to
future sales growth and as a result recognized an impairment of $13,376
in 2004.
(8) In 2004 we recorded $4,150 of litigation expense related to the
settlement of one lawsuit and the anticipated settlement of two other
lawsuits. There were no material litigation accruals in 2003, 2002, 2001
or 2000.
(9) As a result of our December 31, 2001 reinsurance agreement with a
foreign reinsurer, we must pay federal excise tax of 1% on all ceded
premium. The 2001 expense represents excise taxes due for premiums
transferred at the inception of the contract. Beginning in 2002, we also
accrue an annual expense and risk charge payable to the reinsurer in the
event of future commutation of the agreement.
(10) Excludes $5,151 impairment charge of goodwill from the adoption of SFAS
Nos. 141 and 142, which was recorded as a cumulative effect of change in
accounting principle. In 2002, in accordance with SFAS No. 142, we
determined that the goodwill associated with our insurance subsidiaries
was impaired and recognized an impairment loss of $5,151, net of related
tax effect, which we recorded as a cumulative effect of change in
accounting principle.
(11) As a result of the adoption of SFAS No. 142 in 2002, we discontinued the
amortization of goodwill. We have provided adjusted results for the
fiscal periods 2001 and 2000 that reflect the impact of this accounting
change as though SFAS No. 142 had been adopted at that time. Net income
would have been increased in each adjusted period by $853.
(12) On May 25, 2001, we issued approximately 11,547 new shares of our common
stock, for net proceeds of $25,726, through a rights offering. We also
issued approximately 570 new shares in 2002 through a direct equity
placement. In 2003, approximately $2,000 of convertible debt due 2003
was exchanged for new convertible debt due 2008. In addition, we issued
approximately $33,000 in new convertible debt due 2008 and used a
portion of the proceeds to retire approximately $9,000 in convertible
debt due 2003. During 2003, holders of approximately $8,000 of the
convertible debt due 2008 converted their debt for approximately 5,000
shares of our common stock. During 2004, holders of approximately
$29,500 of the convertible debt due 2008 converted their debt for
approximately 18,500 shares of our common stock.
45
(13) Diluted shares outstanding include shares issuable upon the conversion
of our existing convertible debt and exercise of options outstanding,
except in 2003, 2002 and 2001, for which the inclusion of such shares
would be anti-dilutive. The inclusion of converted shares from the
issuance of our Convertible Subordinated Notes due 2008 is expected to
produce significant dilution in earnings per share in future periods.
(14) We measure our combined ratio as the total of all expenses, including
benefits to policyholders, related to policies in-force divided by
premium revenue. This ratio provides an indication of the portion of
premium revenue that is devoted to the coverage of policyholder related
expenses. We depend on our investment returns to offset the amounts by
which our combined ratio is greater than 100%. In 2001, reduced premium
revenue, the impairment of our DAC asset in the fourth quarter (see note
4) and the payment of excise taxes on the initial premium for our new
reinsurance agreement (see note 5) increased our combined ratio above
what it otherwise would have been. For 2002, see note 2. In 2004
goodwill impairment and litigation expense is not included in the
expense ratio.
(15) Return on equity, which is the ratio of net income or losses to average
shareholders' equity, measures the current period return provided to
shareholders on invested equity. New or existing shareholders could be
dissuaded from future investment in our common stock and may choose to
sell their common stock if they are not satisfied with our return on
equity.
(16) As a result of our reinsurance agreement, which was effective December
31, 2001, we transferred substantially all of our investable assets to
the reinsurer.
(17) Under statutory accounting principles, ceded reserves are accounted for
as offsetting negative benefits and negative premium. Our 2004, 2003,
2002, 2001 and 2000 premium is reduced by approximately $303,000
$309,000, $326,000, $408,000 and $226,000, respectively from reinsurance
transactions.
46
QUARTERLY DATA
Our unaudited quarterly data for each quarter of 2004 and 2003 have been
derived from unaudited financial statements and include all adjustments,
consisting only of normal recurring accruals, which we consider necessary for a
fair presentation of the results of operations for these periods. Such quarterly
operating results are not necessarily indicative of our future results of
operations. The following is our 2004 quarterly data on both a restated and as
reported basis:
2004 RESTATED
------------------------------------------------------
First Second Third
Quarter Quarter Quarter Fourth
Restated (1) Restated (1) Restated (1) Restated (1)
------------ ------------ ------------ ------------
(in thousands, except per share data and ratios)
Total premiums $ 82,288 $ 79,197 $ 80,309 $ 78,091
Net investment income 10,987 11,542 12,055 12,255
Net realized capital gains and losses and
other income 36,672 (61,536) 57,838 15,043
------------ ------------ ------------ ------------
Total revenues 129,947 29,203 150,202 105,389
------------ ------------ ------------ ------------
Benefits to policyholders 59,386 56,768 56,256 60,288
Commissions & expenses (excluding interest) 27,488 26,656 25,773 26,367
Goodwill impairment and litigation accrual - - - 17,526
Net acquisition costs amortized 3,955 4,447 1,246 1,930
------------ ------------ ------------ ------------
Net income (loss) $ 23,300 $ (40,163) $ 41,740 $ (4,341)
============ ============ ============ ============
GAAP loss ratio 72.2% 71.7% 70.0% 77.2%
GAAP expense ratio (2) 38.2% 39.3% 33.6% 36.2%
------------ ------------ ------------ ------------
Total 110.4% 111.0% 103.6% 113.4%
============ ============ ============ ============
Basic earnings per share $ 0.79 $ (1.03) $ 1.03 $ (0.10)
Diluted earnings per share $ 0.32 $ (1.03) $ 0.48 $ (0.10)
2004 RESTATED
------------------------------------------------------
First Second Third
Quarter Quarter Quarter Fourth
------------ ------------ ------------ ------------
(in thousands, except per share data and ratios)
Total premiums $ 82,288 $ 79,197 $ 80,309 $ 78,091
Net investment income 10,987 11,542 12,055 12,255
Net realized capital gains and losses and
other income 36,672 (61,536) 57,838 15,043
------------ ------------ ------------ ------------
Total revenues 129,947 29,203 150,202 105,389
------------ ------------ ------------ ------------
Benefits to policyholders 59,159 57,596 56,151 60,288
Commissions & expenses (excluding interest) 27,488 26,656 25,773 26,367
Goodwill impairment and litigation accrual - - - 17,526
Net acquisition costs amortized 3,955 4,425 1,250 1,930
------------ ------------ ------------ ------------
Net income (loss) $ 23,448 $ (40,686) $ 41,805 $ (4,341)
============ ============ ============ ============
GAAP loss ratio 71.9% 72.7% 69.9% 77.2%
GAAP expense ratio (2) 38.2% 39.2% 33.6% 36.2%
------------ ------------ ------------ ------------
Total 110.1% 111.9% 103.5% 113.4%
============ ============ ============ ============
Basic earnings per share $ 0.79 $ (1.05) $ 1.03 $ (0.10)
Diluted earnings per share $ 0.32 $ (1.05) $ 0.48 $ (0.10)
(1) Restated to reflect impact of the previously unreserved policy riders.
(2) GAAP expense ratio excludes interest expense, goodwill impairment and
litigation accrual
47
The following is our 2003 quarterly data on both a restated and as
reported basis:
2003 RESTATED
------------------------------------------------------
First Second Third
Quarter Quarter Quarter Fourth
Restated (1) Restated (1) Restated (1) Restated (1)
------------ ------------ ------------ ------------
(in thousands, except per share data and ratios)
Total premiums $ 83,578 $ 78,707 $ 81,471 $ 78,190
Net investment income 10,347 10,572 11,144 11,209
Net realized capital gains and losses and
other income 6,583 41,463 (33,159) (16,042)
------------ ------------ ------------ ------------
Total revenues 100,508 130,742 59,456 73,357
------------ ------------ ------------ ------------
Benefits to policyholders 64,283 61,487 63,618 58,434
Commissions & expenses (excluding interest) 27,001 30,779 28,081 28,187
Net acquisition costs amortized 2,698 2,139 3,870 1,536
------------ ------------ ------------ ------------
Net income (loss) $ 3,212 $ 22,718 $ (25,306) $ (13,794)
============ ============ ============ ============
GAAP loss ratio 76.9% 78.1% 78.1% 74.7%
GAAP expense ratio (2) 35.5% 41.8% 39.2% 38.0%
------------ ------------ ------------ ------------
Total 112.4% 119.9% 117.3% 112.7%
============ ============ ============ ============
Basic earnings per share $ 0.17 $ 1.16 $ (1.20) $ (0.58)
Diluted earnings per share $ 0.08 $ 0.32 $ (1.20) $ (0.58)
2003 RESTATED
------------------------------------------------------
First Second Third
Quarter Quarter Quarter Fourth
------------ ------------ ------------ ------------
(in thousands, except per share data and ratios)
Total premiums $ 83,578 $ 78,707 $ 81,471 $ 78,190
Net investment income 10,347 10,572 11,144 11,209
Net realized capital gains and losses and
other income 6,583 41,463 (33,159) (16,042)
------------ ------------ ------------ ------------
Total revenues 100,508 130,742 59,456 73,357
------------ ------------ ------------ ------------
Benefits to policyholders 64,167 60,873 63,763 58,927
Commissions & expenses (excluding interest) 27,001 30,779 28,081 28,187
Net acquisition costs amortized (deferred) 3,054 2,140 3,870 1,552
------------ ------------ ------------ ------------
Net (loss) income $ 3,056 $ 23,116 $ (25,398) $ (14,125)
============ ============ ============ ============
GAAP loss ratio 76.8% 77.3% 78.3% 75.4%
GAAP expense ratio (excluding interest) (2) 36.0% 41.8% 39.2% 38.0%
------------ ------------ ------------ ------------
Total 112.8% 119.1% 117.5% 113.4%
============ ============ ============ ============
Basic earnings per share $ 0.16 $ 1.18 $ (1.20) $ (0.59)
Diluted earnings per share $ 0.07 $ 0.32 $ (1.20) $ (0.59)
(1) Restated to reflect impact of the previously unreserved policy riders.
(2) GAAP expense ratio excludes interest expense, goodwill impairment and
litigation accrual
48
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESTATEMENT (amounts in thousands)
In March 2005, in conjunction with the preparation of the financial
statements for the year ended December 31, 2004, we concluded that certain
policy riders were not reserved for in prior years. The policy riders are
options chosen by the policyholders and the previously unidentified policy
riders include inflation, restoration of benefit and return of premium benefit.
A significant majority of these policy riders were inflation riders. The
premiums associated with the policies were properly billed and any claims
incurred on these policies were properly paid. However, the policy riders were
not identified in the data utilized to calculate policy reserves. As a result of
this conclusion, we have restated our previously issued financial statements for
the years ended December 31, 2003 and 2002 to reflect the inclusion of the
policy riders and reduced shareholders' equity by $5,533 as of January 1, 2002
to reflect the impact of the previously unidentified policy riders for prior
years.
The total cumulative impact of the restatement that affected
shareholders' equity as of December 31, 2003 was a decrease in shareholders'
equity of $6,655, which includes a decrease in beginning shareholders' equity as
of January 1, 2002 of $5,533. The overall financial decrease on shareholders'
equity of the restatement as of each year end was as follows:
December 31, 2001 (1) $ (5,533)
December 31, 2002 (2) (1,305)
December 31, 2003 (2) 183
(1) The adjustment as of December 31, 2001 represents an opening
retained earnings adjustment on January 1, 2002.
(2) The adjustment represents the retained earning impact of the
restatement to net income in the respective period.
As to the individual financial statement line items, our historical
consolidated financial statements for the years ended December 31, 2003 and
2002, reflect the effects of the restatement on (i) net policy acquisition costs
amortized and its effects on unamortized deferred policy acquisition costs, (ii)
benefits to policyholders expense and its effects on policy reserves, (iii) the
Federal income tax benefit and its effects of deferred income taxes and (iv)
basic and diluted earnings per share. A summary of the effects of the
restatement on reported amounts for the years ended December 31, 2003 and 2002
is presented below.
49
CONSOLIDATED BALANCE SHEETS
----------------------------------------------------------------------------------
DECEMBER 31, 2003 DECEMBER 31, 2002
------------------------------------- -------------------------------------
As Previously As As Previously As
Reported Adjustment Restated Reported Adjustment Restated
------------- ---------- -------- ------------- ---------- --------
Unamortized deferred policy acquisition costs $ 160,740 $ 18 $ 160,758 $ 171,357 $ (357) $ 171,000
Policy reserves (accident and health) (508,344) (10,256) (518,600) (464,318) (10,163) (474,481)
Deferred income tax liability (19,314) 3,583 (15,731) (23,101) 3,682 (19,419)
Total shareholders' equity 150,734 (6,655) 144,079 155,180 (6,838) 148,342
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME FOR THE YEARS ENDED
----------------------------------------------------------------------------------
DECEMBER 31, 2003 DECEMBER 31, 2002
------------------------------------- -------------------------------------
As Previously As As Previously As
Reported Adjustment Restated Reported Adjustment Restated
------------- ---------- -------- ------------- ---------- --------
Benefits to policyholders $ (247,730) $ (92) $(247,822) $ (371,998) $ (2,087) $(374,085)
Net policy acquisition costs amortized (10,617) 374 (10,243) (7,595) 80 (7,515)
Federal income tax benefit 3,091 (99) 2,992 13,026 702 13,728
Net loss (13,353) 183 (13,170) (30,438) (1,305) (31,743)
Basic earnings per share from net loss $ (0.64) $ 0.01 $ (0.63) $ (1.58) $ (0.07) $ (1.65)
Diluted earnings per share from net loss $ (0.64) $ 0.01 $ (0.63) $ (1.58) $ (0.07) $ (1.65)
The restatement did not have any impact on total cash flows from
operations, investing or financing activities. We have restated all pertinent
historical information in "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
CRITICAL ACCOUNTING POLICIES
(amounts in thousands, except per share data)
The preparation of financial statements in accordance with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions that affect the reported amounts and related disclosures. Such
estimates and assumptions significantly affect various reported amounts of
assets and liabilities. Management has made estimates in the past that we
believed to be appropriate but were subsequently revised to reflect actual
experience. If our future experience differs materially from these estimates and
assumptions, our results of operations and financial condition could be
affected. Management considers an accounting estimate to be critical if:
o It requires assumptions to be made that were uncertain at the
time the estimate was made; and
o Changes in the estimate or different estimated amounts that
could have been selected could have a material impact on our
results of operations or financial condition.
POLICY RESERVES
Our policies are accounted for as long duration policies. As a result
there are two components of the liabilities associated with our policies. The
first is a liability for future policyholder benefits, represented by the
present value of future benefits less the present value of future premium
collections. In calculating these reserves we utilize assumptions, including
estimates for persistency (policies that do not terminate), morbidity (claims
expectations), interest rates, and premium rate increases. These assumptions are
estimated in the year a policy is issued. Once the assumptions are established,
we
50
continue to utilize those assumptions unless our assessment of deferred
acquisition costs ("DAC") indicates that the current unamortized DAC asset is
not recoverable in future periods. Any variance from the assumptions established
in the year a policy is issued could have a material impact on our results of
operations and financial condition.
The significant assumptions utilized in setting our future reserves for
policyholder benefits are:
o A voluntary lapse rate that ranges from 2.5% to 38%, depending
on the age of the policyholder and the number of years the
policy has been in-force. The high end of the lapse rate range
is 38% for our more recently issued policies. A significant
majority of our policyholders are between the ages of 60 to 79
at the time we issue them a policy. The lapse rates range from
30% in the early duration for these policies down to 2.5% in the
later durations.
o Morbidity based upon our past experience and industry data. We
also include an estimate for improving morbidity trends in the
general population.
o The use of the 1990-1995 Select and Ultimate, Sex Distinct,
actuarial table for mortality.
o For policies issued in 2002 through 2004, we use a 4.5% interest
rate to discount future experience. For policies issued prior to
2002, we use a 5.7% interest discount rate.
o We also include an estimate of premium rate increases based on
what we had planned to implement as of September 30, 2002 when
we last revised our assumptions at the time we recorded an
impairment to our DAC.
Long-term care insurance has fixed annual premiums that can be adjusted
only upon approval of the insurance departments of the states where the premiums
were written. The process for filing for premium rate increases requires us to
demonstrate to the insurance department that expected claims experience is
anticipated to exceed original assumptions. The approval of premium rate
increases is at the discretion of the insurance department.
We have filed and implemented premium rate increases on most of our
in-force policies. We have and are continuing to file and implement additional
premium rate increases on the majority of our policies issued prior to 2002. We
have been successful in obtaining premium rate increases in the past. However,
there has been increased public and regulatory scrutiny over the practice of
obtaining premium rate increases on long-term care insurance.
We base our premium rate increase assumptions on our past experience and
our expectations of the amounts of actual rate increases that we will be able to
achieve. If we are unsuccessful in obtaining the assumed level of rate
increases, we could recognize an impairment in the future, which could have a
material adverse effect on our results of operations and financial position. In
addition we are currently in litigation concerning the premium rate increases we
have implemented, which could have a material adverse effect on our results of
operations and financial position.
Our assumptions remain unchanged in future periods regardless of actual
experience unless we impair our DAC due to an expected loss in future periods
using updated assumptions for all of the above. However, when actual experience
differs from our expectations, the incremental difference between actual and
expected results is recognized in the current period.
CLAIM RESERVES
The second component of the liabilities associated with our policies is
a reserve we establish for incurred, either reported or not yet reported,
claims. This amount represents the benefits to be paid in the future for our
current claims. The significant assumptions utilized in establishing claim
reserves are
51
expectations about the duration, cost of care being reimbursed and incidence of
claims and the interest rate utilized to discount the claim reserves. These
assumptions are based on our past experience, industry experience and current
trends. We establish our claim reserves in each period based upon our most
currently available information and assumptions.
We use a discount rate of 5.9% for claim reserves, which approximates
the current yield to maturity of our assets. A 50 basis point decrease in the
discount rate can cause our claim reserves to increase by approximately $2,000.
As part of our monitoring of claims reserves, we compare actual results
to our expectations. Any deviation from our expectations is recorded in the
period in which the deviation occurs. Any changes in our estimates in the future
may have a material impact on our financial condition and results of operations.
DEFERRED ACQUISITION COSTS
In connection with the sale of our insurance policies, we defer and
amortize a portion of the policy acquisition costs over the related premium
paying periods of the life of the policy. These costs include all expenses that
are directly related to, and vary with, the acquisition of the policy, including
commissions, underwriting and other policy issue expenses. The DAC is determined
using the same projected actuarial assumptions used in computing benefit
reserves.
We regularly assess the recoverability of our unamortized DAC asset
through actuarial analysis. To determine recoverability, the present value of
anticipated future premiums less future costs and claims are added to current
reserve balances. If this amount is greater than the current unamortized DAC
then the DAC is deemed recoverable. If this amount is less than the current
unamortized DAC, then we impair our DAC and record a charge in our current
period results of operations.
The DAC recoverability analysis includes our most recent assumptions for
persistency, morbidity, interest rates, and premium rate increases, all or any
of which may be different than the assumptions utilized in establishing our
benefit reserves.
The significant assumptions utilized in the DAC recoverability analysis
that differ from our current assumptions for policy reserves and DAC include:
o Investment of future cash flows in instruments and at durations
similar to our current investment mix, using current market
interest rates for new investments (new investments are assumed
to average 5.34%).
o An estimate that claims will improve due to the expected results
from recently implemented and future planned improvements to our
claims adjudication procedures.
o An estimate that the ultimate level of premium rate increases
that will be approved and implemented will be higher than the
originally assumed percentage of 77%.
Changes in one or a combination of these assumptions can produce
significant volatility in the recoverability of DAC.
LITIGATION AND CONTINGENCIES
We are involved in lawsuits relating to our operations. These lawsuits
include, but are not limited to, allegations as to improper sales practices in
connection with the recent premium rate increases on our long-term care
policies.
52
We recognize an estimated loss for contingencies when we believe it is
probable that a loss has occurred and the amount of loss can be reasonably
estimated. However, it is difficult to measure the actual loss that might be
incurred related to litigation and contingency matters. As time passes and
additional facts and circumstances become known, our estimation of the
probability of loss as well as our ability to reasonably estimate a loss may
change. The ultimate outcome of litigation and other contingencies could have a
material adverse impact on our results of operations and financial position in
the future.
DEPOSIT ACCOUNTING FOR 2001 CENTRE REINSURANCE AGREEMENT
The 2001 Centre reinsurance agreement is being accounted for utilizing
deposit accounting for reinsurance contracts. We are using deposit accounting
because we believe the reinsurance contract does not result in the reasonable
possibility that the reinsurer will suffer a significant loss. We assessed this
long-duration reinsurance contract using the reasonable possibility of
significant loss criteria due to certain contract provisions that limit the risk
to the reinsurer, including an aggregate limit of liability for the reinsurer,
experience refund provisions, and expense and risk charges provided to the
reinsurer. We also entered into the reinsurance agreement with the intent of
commuting the agreement at December 31, 2007, which further supports the use of
deposit accounting.
We have established the accounting model for this reinsurance agreement
assuming that we will commute the contract on December 31, 2007, the first
available commutation date. We intend, but are not required, to commute the
agreement on the first commutation date. We have significant incentive to
commute the agreement on December 31, 2007 as the expense and risk charges
applied to the notional experience account for the benefit of the reinsurer
begin to escalate after that date and the reinsurer may exercise warrants at a
common stock equivalent price of $1.80 per share, representing approximately 20%
of the then outstanding common stock on a fully diluted basis.
Our current modeling and actuarial projections suggest that it is
probable we will be able to commute the agreement, as planned, on December 31,
2007. In order to commute the agreement, our statutory capital following
commutation must be sufficient to support the reacquired business in compliance
with all statutory requirements. Upon commutation, we would receive cash or
other liquid assets equaling the market value of our notional experience account
from the reinsurer. We would also record the necessary reserves for the business
in our statutory financial statements. Our ability to commute the agreement is
highly dependent upon the market value of the notional experience account
exceeding the level of required reserves to be established. As of December 31,
2004, the statutory basis reserve liabilities of $1,026,341 exceed the
combination of the notional experience account value and funds held due to the
reinsurer of $939,452. Based upon our current modeling and actuarial
projections, management believes it is probable that the value of the notional
experience account will exceed the reserve liabilities at December 31, 2007. In
addition to the performance of the reinsured policies from now until 2007, the
notional experience account value is susceptible to market interest rate
changes. A market interest rate increase of 100 basis points could reduce the
market value of the current notional experience account by approximately
$110,000 and jeopardize our ability to commute as planned. As we approach the
intended commutation date, the sensitivity of our notional experience account to
market interest rate movement will decline as the duration of the benchmark
indices becomes shorter; however, the amount of assets susceptible to such
interest sensitivity will continue to grow as additional net cash flows are
added to the experience account balance prior to commutation. The reinsurer has
agreed to fix the market value of the experience account and to invest the
assets in a manner that we request in order to minimize short term volatility
when we inform the reinsurer of our intention to commute the agreement.
As a result of our intention to commute, we considered only the expense
and risk charges anticipated prior to the commutation date in our unamortized
DAC recoverability analyses and have not
53
recorded the potential of future escalating charges. In the event we determine
that commutation of the reinsurance agreement is unlikely on December 31, 2007,
but likely at some future date, we will include additional annual expense and
risk charge credits against our notional experience account in our DAC
recoverability analysis. As a result, we could impair the value of our DAC asset
and record the impairment in our financial statements. However, we currently
believe that it is probable we will have sufficient statutory capital and
surplus to commute the reinsurance agreement on December 31, 2007 or that other
alternatives, such as new reinsurance opportunities or, additional capital
issuances will be available to enable us to commute the agreement as planned.
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 $2.75 to $6.25 per share. If exercised and converted, the convertible
preferred stock would represent approximately 15% of the then outstanding shares
of our common stock on a fully diluted basis. If the agreement is not commuted
on December 31, 2007, the reinsurer may exercise the fourth tranche of
convertible preferred stock purchase warrants at a common stock equivalent price
of $1.80 per share, which if converted would represent an additional 20% of the
then outstanding common stock on a fully diluted basis. We are recognizing the
additional consideration of entering into the agreement, represented by the fair
value of the warrants granted to the reinsurer, over the period of time to the
expected commutation date.
NOTIONAL EXPERIENCE ACCOUNT
Our 2001 Centre reinsurance agreement includes a provision for the
maintenance of a notional experience account for our benefit in the event we
elect to, and are able to, commute the reinsurance agreement in the future. The
notional experience account balance was $901,368 as of December 31, 2004. We
receive a return on the experience account that is based on a series of
benchmark indices and derivative hedges. 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 a duration of
approximately 14 years.
We believe the return on the notional experience account represents a
hybrid instrument, containing both a fixed debt host and an embedded derivative,
as defined in Statement of Financial Accounting Standards No. 133, "Accounting
for Derivative Instruments and Hedging Activities" (SFAS 133). In accordance
with SFAS 133, we are accounting for the investment return on the experience
account as follows:
a). 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 Statements of Income and Comprehensive
Income.
b). 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 or loss on
notional experience account in the Statements of Income and Comprehensive
Income.
Our conclusion that the return on the notional experience account
represents a hybrid instrument with an embedded derivative is based on our
belief that the economic characteristics and risk of the fixed debt host
contract are not clearly and closely related to those of the embedded
derivative. When we determine the yield on the fixed debt host and the value of
the embedded derivate, we reconcile these amounts to the amount credited to the
experience account by the reinsurer, as we believe the actual return
54
credited by the reinsurer should equal the sum of the amounts recognized in our
Statements of Income and Comprehensive Income.
A market interest rate increase of 100 basis points could reduce the
market value of the current notional experience account by approximately
$110,000 and jeopardize our ability to commute as planned. As we approach the
intended commutation date, the sensitivity of our experience account to market
interest rate movement will decline as the duration of the benchmark indices
becomes shorter, however, the amount of assets susceptible to such interest
sensitivity will continue to grow as additional net cash flows are added to the
experience account balance prior to commutation. We intend to give notice to the
reinsurer of our intention to commute on December 31, 2007 at such time as we
are highly confident of our ability to support the reacquired policies. The
reinsurer has agreed to fix the market value of the experience account at that
time, and to then invest the assets in a manner that we request in order to
minimize short term volatility.
GOODWILL
The balance of our goodwill was $6,985 and $20,360 at December 31, 2004
and 2003, respectively.
The goodwill at both December 31, 2004 and 2003 relates to the purchase
of our insurance agencies, UIG and NISHD. We test for impairment of goodwill on
an annual basis unless an event occurs or circumstances change that would more
likely than not indicate that an impairment has occurred. During 2004 we
performed our impairment test on a quarterly basis due to declining sales. The
test is done at a reporting unit level, which combines the operations of UIG and
NISHD. UIG and NISHD are both insurance agencies that sell senior market
insurance products, and therefore have similar economic characteristics.
During our quarterly impairment test as of December 31, 2004, we
determined that the goodwill related to the agency reporting unit was impaired.
This impairment was a result of declining sales, particularly in the fourth
quarter of 2004, which led to lower than planned net income at the reporting
unit level. The decline in sales is attributable to a decline in sales across
the long-term care industry during 2004 as a result of higher priced policies
and the negative impact of premium rate increases that have been implemented on
previously issued policies. The fair value of the reporting unit is determined
utilizing the present value of cash flows, which includes assumptions for future
growth in sales. During the most recent impairment test, we lowered the
assumptions related to future sales growth and as a result recognized an
impairment of $13,376 in 2004.
The valuation is sensitive to future growth in sales of insurance
policies, the persistency of the renewal commission stream and expense savings
initiatives that we have implemented. We utilized a 15% discount rate in the
goodwill analysis. We assume that our agencies are capable of future growth from
both the sale of our products and from the sale of other carriers' products.
Our future growth assumptions now range from 15% in the first years and
stabilize at 5% in the later years of our analysis. The growth rates in the
early years are dependent upon the ability of our agencies to execute on
recently signed agreements with unaffiliated insurance companies and to sell
policies underwritten by our insurance subsidiaries especially in states such as
California where we have recently received approval to sell our products.
Our insurance subsidiaries have recommenced sales in 41 states since
February 2002, after the cessation of sales in September 2001. The goodwill
analysis for our agencies is sensitive to the ability of our insurance
subsidiaries to successfully supply product that is competitive and to improve
their financial
55
strength ratings. Future growth in sales is also dependent upon recent contracts
to sell insurance products of unaffiliated insurance companies. If the future
growth in sales or expense savings initiatives do not occur as we anticipate, we
may realize an additional impairment in the goodwill allocated to the agency
operations in the future.
PREFERRED INTEREST ON EARLY CONVERSION
Holders of our convertible subordinated notes are entitled to convert
their notes into shares of our common stock before October 2005 and receive a
discounted amount of interest that they would have otherwise received until that
date. We may elect to pay this interest in cash or in newly issued shares of
common stock. If we elect to pay in newly issued shares of common stock, the
stock is valued at a 10% discount to the then fair market value of traded
shares. We have determined that this feature is an embedded derivative as
defined in Statement of Financial Accounting Standards No. 133 "Accounting for
Derivative Instruments and Hedging Activities." This embedded derivative is not
clearly and closely related to the host contract, the convertible subordinated
notes, because it could at least double the investor's initial rate of return on
the host contract and could also result in a rate of return that is at least
twice what otherwise would be the market return for a contract that has the same
terms as the host contract and that involves a debtor with a similar credit
quality.
As a result of this determination, we have separately valued and
bifurcated the embedded derivative from the host contract. At each balance sheet
date, the embedded derivative must be recorded at fair value, with any change in
fair value recognized in current operations.
As of December 31, 2004 the fair value of the embedded derivative was
$1,403. In determining the fair value of the embedded derivative, we make
certain assumptions, including the future volatility and liquidity of our common
stock. We believe the liquidity of the stock significantly impacts the assumed
value of the embedded derivative due to the ability of a converting holder to
liquidate the shares and recognize its intended value. We also take into
consideration recent trends in the number of holders converting. If we assumed
that all holders converted on December 31, 2004, without giving any
consideration to the relationship of the current share price to the conversion
price or to the impact of this level of conversions on the stock price, the
value of the embedded derivative would be $4,567.
If actual experience differs from our current assumptions, our results
of operations may be subject to significant volatility in future periods.
VALUATION ALLOWANCE FOR INCOME TAXES
We have net operating loss carryforwards of $39,876 or $13,957 on a tax
effected basis, which have been generated by taxable losses at the parent
company, and if unused will expire between 2012 and 2024. We have net operating
loss carryforwards of $27,102 or $9,486 on a tax effected basis, which have been
generated by taxable losses at our insurance subsidiaries, and if unused, will
expire in 2016. The parent company's net operating loss carryforwards can be
utilized by our insurance subsidiaries, subject to a limitation equal to the
lesser of 35% of the insurance subsidiary taxable income or 35% of the current
aggregate carryforward amount.
We have recorded a valuation allowance of $8,275 against our net
operating loss carryforwards on a tax affected basis. We recorded the valuation
allowance due to a change in ownership as defined in the Internal Revenue Code.
As a result of the change in ownership we are now subject to a limitation on the
amount of prior period net operating loss carryforwards we can utilize. If we do
not generate enough taxable income in the future we may need to record an
additional valuation allowance, which could have a material impact on our
financial condition and results of operations.
56
OVERVIEW
Our principal products are individual, defined benefit accident and
health insurance policies that consist of nursing home care, home health care
and Medicare supplement. Our insurance subsidiaries are subject to the insurance
laws and regulations of the states in which they are licensed to write
insurance. These laws and regulations govern matters such as payment of
dividends, settlement of claims and loss ratios. State regulatory authorities
must approve premiums charged for insurance products. In addition, our insurance
subsidiaries are required to establish and maintain reserves with respect to
reported and incurred but not reported claims, as well as estimated future
benefits payable under our insurance policies. These reserves must, at a
minimum, comply with mandated standards. Our reserves are certified annually by
our consulting actuary as to standards required by the insurance departments for
our domiciliary states and for the other states in which we conduct business. We
believe we maintained adequate reserves as mandated by each state in which we
are currently writing business at December 31, 2004.
RESULTS OF OPERATIONS
TWELVE MONTHS ENDED DECEMBER 31, 2004 AND 2003
(Certain amounts related to 2003 have been restated to reflect the impact of
previously unreserved policy riders) (amounts in thousands)
PREMIUM REVENUE. Total premium revenue earned in the twelve months ended
December 31, 2004, including long-term care, disability, life and Medicare
supplement, decreased 0.6% to $319,885, compared to $321,946 in the same period
in 2003.
Effective September 10, 2001, we discontinued the sale nationally of all
new long-term care insurance policies until the Corrective Action Plan (the
"Plan") was completed and approved by the Pennsylvania Insurance Department (the
"Department"). Upon the Department's approval of the Plan in February 2002, we
recommenced new policy sales in 23 states, including Pennsylvania. We are now
approved to recommence new policy sales in 18 additional states, including
Florida and California (subject to corrective orders). These 41 states accounted
for approximately 91% in aggregate of our total direct premium revenue in 2004.
Florida, California and Pennsylvania accounted for approximately 16%, 15% and
12%, respectively of our direct premium revenue in 2004. We are working with the
remaining states to recommence new policy sales in all jurisdictions.
Total first year premium revenue earned in 2004 increased 40.9% to
$11,186, compared to $7,942 in 2003. First year long-term care premiums earned
in 2004 increased 47% to $10,358, compared to $7,040 in 2003. We believe that
the increase in first year premiums is due to (1) the recommencement of sales in
additional states during 2004, (2) the engagement of additional independent
agents that had not previously sold our policies, and (3) the introduction of
our new products, which have higher annual premiums than our previously sold
products. We anticipate that first year premium revenue will continue to
increase as independent agents that sold our policies prior to the cessation of
sales are reengaged and independent agents that had not previously sold our
policies are recruited. We also anticipate that we will recommence sales in
additional states in which we are currently not writing new business.
Total renewal premium revenue earned in 2004 decreased 1.7% to $308,699,
compared to $314,004 in 2003. Renewal long-term care premiums earned in 2004
decreased 2.2% to $295,959, compared to $301,916 in 2003. The decrease in
renewal premium revenue is due to the lapsation of existing policies and a
reduced level of new premium levels compared to periods prior to the cessation
of sales in 200l. We anticipate that we will continue to experience reduced
levels of renewal premium
57
revenue until such time as an increased level of new premiums is sufficient to
offset the lapsation of existing policies. Our persistency was 88.7% and 88.1%
in 2004 and 2003, respectively.
NET INVESTMENT INCOME. Net investment income earned in 2004 increased
8.2% to $46,839, from $43,273 in 2003.
Our average yield on invested assets at cost, including cash and cash
equivalents, was 5.17% and 5.19%, in 2004 and 2003, respectively. The investment
income component of our notional experience account investment credit generated
$46,172 and $41,426 in 2004 and 2003, respectively. The notional experience
account yields a fixed return based upon the yield to maturity of the underlying
benchmark indices, which are comprised of U.S. Treasury strips, government
agencies and investment grade corporate bonds with weightings of approximately
25%, 15% and 60%, respectively, and have duration of approximately 14 years. The
average yield on the notional experience account was 5.65% and 5.63% in 2004 and
2003, respectively.
MARKET GAIN (LOSS) ON NOTIONAL EXPERIENCE ACCOUNT. We recorded a gain on
our notional experience account of $39,749 in 2004 compared to a market loss of
$9,494 in 2003.
During 2004 the interest rates on the underlying investments in the
benchmark indices supporting our notional experience account were lower at the
end of the year compared to the beginning of the year, resulting in a market
gain. During 2003, although interest rates were volatile during the year,
interest rates at the beginning and end of the year were relatively unchanged.
The total return of the Lehman Brothers US Aggregate Bond Index was 4.3%
and 4.11% in 2004 and 2003, respectively. The total return on our notional
experience account, which generates the majority of our net investment income,
was 10.51% and 4.34% in 2004 and 2003, respectively. Management attributes the
favorable return achieved from its notional experience account in 2004 to the
impact of declining market interest rates upon the long duration of the
underlying benchmark indices. In 2003, market interest rates remained stable,
producing an immaterial impact upon the total market return of the notional
experience account.
CHANGE IN PREFERRED INTEREST ON EARLY CONVERSION. The fair value of the
embedded derivative as of the date that the option to receive discounted
interest was granted was $2,038. Due to the issuance of additional convertible
debt in February and November of 2004, we recorded an additional $622,
representing the fair values of these embedded derivatives. As of December 31,
2004, we adjusted the embedded derivative to its then fair value of $1,403 by
recording a gain of $2,237 compared to a loss of $981 in 2003. We believe that
the value of the embedded derivative is significantly affected by the ability of
the investor to liquidate their shares in the market. We further believe that
the number of shares of our common stock outstanding and the average daily
trading volume of our common stock provide an indication of the ability for the
market to bear additional sales of stock without a material reduction of the
current market value of those shares. The value decreased in 2004 as a result of
$29,499 of conversions and the decrease in the value of the interest we would
pay upon the conversion due to the shortening of the time period between the
date of conversion and October 2005. During 2003, the liquidity of our common
stock rose significantly, as did the average daily trading volume, which
indicated that the market could absorb additional shares without significant
reduction of the market price. As a result, we increased our estimates of the
value of the embedded derivative based on an assumption that conversions were
more likely to occur without stock price deflation.
In determining the fair value of the embedded derivative, we make
certain assumptions, including the future volatility and liquidity of our common
stock. If actual experience deviates from current assumptions, our financial
results may be significantly impacted in future periods.
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OTHER INCOME. We recorded $5,864 in other income in 2004, as compared to
$9,082 in 2003. The income generated from our ownership of corporate owned life
insurance policies decreased to $322 in 2004, as compared to $2,036 in 2003. The
cash value of these policies is invested in investment grade corporate bonds and
equity indexes. We receive a crediting rate net of insurance costs and fees for
maintaining a stable value of the assets, which was reduced significantly during
2004 due to deterioration in the underlying bond and equity investments of the
funds supporting the corporate owned life insurance. In addition, the average
balance decreased from approximately $59,000 in 2003 to approximately $53,300 in
2004 due to death benefit payments. The average yield on the income generated
from the corporate owned life insurance was 0.22% in 2004, compared to 3.10% in
2003. The commission income related to our agency subsidiaries decreased to
$4,979 in 2004 compared to $6,947 in 2003. This decrease was a result of lower
sales in 2004, primarily related to the sale of long-term care insurance. The
long-term care industry experienced a 25% decrease in new policy sales in 2004
compared to 2003.
BENEFITS TO POLICYHOLDERS. (2003 has been restated to reflect the impact
of previously unreserved policy riders.) Total benefits to policyholders in 2004
decreased 6.1% to $232,698 compared to $247,822 in 2003. Our loss ratio, or
policyholder benefits to premiums, was 72.7% in 2004, compared to 77.0% in 2003.
We believe the improvement in the 2004 loss ratio is primarily due to the impact
of premium rate increases, changes in certain assumptions used in the
calculation of our claim reserves and improved claims adjudication procedures
implemented during 2003 and 2004.
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.
The amount of reserves relating to reported and unreported claims incurred is
determined by periodically evaluating historical claims experience and
statistical information with respect to the probable number and nature of such
claims. We compare actual experience with estimates and adjust reserves on the
basis of such comparisons.
We evaluate our prior year assumptions by reviewing the development of
reserves for the prior period. During 2004, reserve amounts relating to December
31, 2003 and prior had a favorable development of $19,404 compared to a
favorable development of $3,095 during 2003 for reserve amounts relating to
December 31, 2002 and prior. These changes to prior year reserve amounts
(particularly when calculated as a percentage of the prior year-end reserve
balance) provide a relative measure of deviation in actual performance as
compared to our initial assumptions.
The adjustments to reserves for claims incurred in prior periods are
primarily attributable to claims incurred from our long-term care insurance
policies, which represent approximately 95% of our premium in-force. The
favorable development in 2004 is attributable to:
o Refinements to the model we utilized to calculate claim
reserves, including the addition of diagnosis code data, payment
frequency data, and further delineation of policy forms for
purposes of evaluation of existing continuance tables. As a
result claims reserves were reduced by approximately $6,000.
o An increase in the discount rate used for claims reserves from
5.7% to 5.9%, reflecting our improved investment portfolio
performance, which reduced reserves by approximately $1,000.
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o During 2004, fewer claims that were closed as of December 31,
2003 reopened than we had estimated, resulting in a reduction of
approximately $4,500; and
o Claim reserve adjudication process improvements implemented in
the second half of 2003 and throughout 2004.
The development of our prior year assumptions were in line with our
expectations for 2003.
COMMISSIONS. Commissions to agents decreased 4.13% to $39,115 in 2004,
compared to $40,800 in 2003.
First year commissions on accident and health business in 2004 increased
52.3% to $6,530 compared to $4,288 in 2003, primarily due to the increase in
first year accident and health premiums. The ratio of first year accident and
health commissions to first year accident and health premiums was 58.4% in 2004
and 54.0% in 2003. The first year commission ratio for both 2004 and 2003 is
lower than the first year commission ratio prior to the cessation of sales in
2001, due to the increased sale of our Secured Risk, Medicare Supplement and
franchise group policies as a percentage of total new sales. All of these
policies pay a lower commission as a percentage of premium revenue to agents
than our individual long-term care policies. We believe that sales of these
policies as a percentage of new sales are likely to decrease as our total sales
increase, resulting in an increase in this ratio. We believe that the sale of
long-term care policies has declined as a percentage of sales as a result of our
lower financial ratings with A.M. Best and Standard and Poor's rating services
and continued consumer and agent concerns regarding our financial strength.
Renewal commissions on accident and health business in 2004 decreased
10.6% to $34,708, compared to $38,802 in 2003 due to the decrease in renewal
accident and health premiums. The ratio of renewal accident and health
commissions to renewal accident and health premiums was 11.3% in 2004 and 12.5%
in 2003. We have implemented premium rate increases on a majority of policies
written prior to December 31, 2001. We do not pay commissions on the additional
premium collected as a result of a rate increase, which reduces the ratio of
renewal commissions to renewal premium revenue. We anticipate that this ratio
will continue to decline until the premium rate increases are fully implemented,
which we anticipate will occur prior to the end of 2006.
NET POLICY ACQUISITION COSTS AMORTIZED. (2003 has been restated to
reflect the impact of previously unreserved policy riders.) The net deferred
policy acquisition costs amortized in 2004 increased to $11,578, compared to
$10,243 in 2003.
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 commissions less
ultimate renewal commissions, and variable general and administrative expenses
related to policy sales, underwriting and issuance. Deferred costs are amortized
over the life of the policy based upon actuarial assumptions, including
persistency of policies in-force. In the event that a policy lapses prematurely
due to death or termination of coverage, the remaining unamortized portion of
the deferred amount is immediately recognized as expense in the current period.
The net amortization of deferred policy acquisition costs is affected by
new business generation, imputed interest on prior reserves and policy
persistency. The amortization of deferred costs is generally offset largely by
the deferral of costs associated with new premium generation. However, lower new
premium sales during the 2004 and 2003 periods, as compared to sales prior to
the cessation of new sales in 2001, produced significantly less expense deferral
to offset amortized costs.
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We regularly assess the recoverability of deferred acquisition costs
through actuarial analysis. To determine recoverability, the present value of
future premiums less future costs and claims are added to current reserve
balances. If this amount is greater than current unamortized deferred
acquisition costs, the unamortized amount is deemed recoverable. In the event
recoverability is not demonstrated, we reassess the calculation using
justifiable premium rate increases. If rate increases are not received or are
deemed unjustified, we will expense, as impaired, the attributed portion of the
deferred asset in the current period. If we conclude that the deferred
acquisition costs are impaired, we will record an impairment loss and a
reduction in the deferred acquisition cost asset. In the event of an impairment,
we will also evaluate our historical assumptions utilized in establishing the
policy reserves and deferred acquisition costs and may update those assumptions
to reflect current experience (referred to as "unlocking"). The primary
assumptions include persistency, claims expectations, interest rates and rate
increases.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
in 2004 decreased 10.4% to $52,970, compared to $59,110 in 2003. The ratio of
total general and administrative expenses to premium revenues was 16.6% in 2004,
compared to 18.4% in 2003.
In 2003 we recorded expenses of $2,668 related to the initial
recognition of future retirement benefits payable to our former chairman and
severance related expenses for certain managers and employees whose positions
were eliminated. We did not have a similar charge in 2004. Expenses at one of
our agency subsidiaries were approximately $2,000 less in 2004 than in 2003 due
to reductions in staff and the closing of certain unprofitable agency offices.
Legal fees were approximately $900 less in 2004 than 2003 due to a reduction in
activity related to our litigation. Outside actuarial fees were approximately
$1,200 less in 2004 than in 2003 as the combination of less premium rate
increase filings and increased internal staffing levels served to reduce
reliance on outside parties. Also in 2004 there was a reduction in expenses
related to the implementation of internally developed software of approximately
$900 while we were in the process of choosing a new vendor. These reductions
were partially offset by increases in variable costs related to increased sales
levels.
IMPAIRMENT OF GOODWILL. The goodwill at both December 31, 2004 and 2003
relates to the purchase of our insurance agencies, UIG and NISHD. We test for
impairment of goodwill on an annual basis unless an event occurs or
circumstances change that would more likely than not indicate that an impairment
has occurred. We tested for impairment on a quarterly basis during 2004 due to
declining sales. The test is done at a reporting unit level, which combines the
operations of UIG and NISHD. UIG and NISHD are both insurance agencies that sell
senior market insurance products, and therefore have similar economic
characteristics.
During our quarterly impairment test as of December 31, 2004, we
determined that the goodwill related to the agency reporting unit was impaired.
This impairment was a result of declining sales, particularly in the fourth
quarter of 2004, which led to lower than planned net income at the reporting
unit level. The decline in sales is attributable to a decline in sales across
the long-term care industry during 2004 as a result of higher priced policies
and the negative impact of premium rate increases that have been implemented on
previously issued policies. The fair value of the reporting unit is determined
utilizing the present value of cash flows, which includes assumptions for future
growth in sales. During the most recent impairment test, we lowered the
assumptions related to future sales growth and as a result recognized an
impairment of $13,376 in 2004. There was no impairment recognized in 2003.
LITIGATION SETTLEMENT EXPENSE. During 2004, we accrued $3,000 related to
the anticipated resolution of two lawsuits related the sale of long-term care
policies. In addition, we accrued $1,150 related to the settlement of a separate
lawsuit. (See Item 3 - "Legal Proceedings" for details.)
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EXPENSE AND RISK CHARGES ON REINSURANCE AND EXCISE TAX EXPENSE. Our
reinsurance agreement provides the reinsurer with annual expense and risk
charges, which are credited against our 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 2004 and 2003, we incurred charges of $11,230
and $11,073, respectively for this item. In addition, we are subject to an
excise tax for premium payments made to a foreign reinsurer equal to one percent
of the premium revenue ceded to the foreign reinsurer. We recorded $2,969 and
$3,065 for excise tax expenses in 2004 and 2003, respectively. We anticipate
that this expense will continue to decrease as policies issued prior to January
1, 2002 continue to lapse, resulting in the ceding of a lower amount of premium
revenue to the foreign reinsurer.
INTEREST EXPENSE. Interest expense in 2004 increased 28.7% to $10,443,
compared to $8,112 in 2003. During February and November of 2004, we issued
$16,000 and $10,000, respectively of additional convertible subordinated notes.
During 2003, we issued $32,421 of additional convertible subordinated notes and
paid our entire obligation of $8,957 related to convertible subordinated notes
that matured in 2003. Our average outstanding convertible subordinated debt for
2003 was $97,099 compared to $84,884 in 2004. The amount of interest expense
related to the outstanding principal balance was $5,302 and $5,974 in 2004 and
2003, respectively.
Holders of our convertible subordinated notes are entitled to convert
their notes into shares of our common stock before October 2005 and receive a
discounted amount of interest that they would have otherwise received through
October 2005 had they not converted the notes. We incurred $2,809 and $1,069 of
interest expense from the early conversion of $29,499 and $8,122 in convertible
subordinated notes during 2004 and 2003, respectively.
The $10,000 of convertible subordinated notes issued in November of
2004, were issued when the price of our common stock was $1.87 per share.
Because this price exceeded the conversion price of $1.75 per share, we recorded
additional interest expense of $686 in 2004.
(PROVISION) BENEFIT FOR FEDERAL INCOME TAXES. (2003 has been restated to
reflect the impact of previously unreserved policy riders.) In 2004, we recorded
a provision for Federal income taxes of $15,676 compared to a benefit from
Federal income taxes of $2,992 in 2003. The effective tax rate was 43.3% in 2004
compared to 18.5% in 2003.
In 2004, the effective tax rate utilized to record our provision for
Federal income taxes was higher than our statutory tax rate of 35% primarily due
to the impairment charge recorded against the goodwill of UIG, which is not
deductible for Federal income tax purposes. In 2003, the effective tax rate
utilized to record our benefit from Federal income taxes was lower than our
statutory rate due to the valuation allowance we recorded.
TWELVE MONTHS ENDED DECEMBER 31, 2003 AND 2002
(Certain amounts related to 2003 and 2002 have been restated to reflect the
impact of previously unreserved policy riders.)
(amounts in thousands)
PREMIUM REVENUE. Total premium revenue earned in the twelve months ended
December 31, 2003, including long-term care, disability, life and Medicare
supplement, decreased 3.5% to $321,946, compared to $333,643 in the same period
in 2002.
Total first year premium revenue earned in 2003 increased 23.4% to
$7,942, compared to $6,436 in 2002. First year long-term care premiums earned in
2003 increased 28.0% to $7,040, compared to
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$5,501 in 2002. We anticipate that first year premium revenue will continue to
increase as independent agents that sold our policies prior to the cessation of
sales are reengaged and independent agents that had not previously sold our
policies are recruited. We also anticipate that we will recommence sales in
additional states in which we are currently not writing new business.
Total renewal premium revenue earned in 2003 decreased 4.0% to $314,004,
compared to $327,207 in 2002. Renewal long-term care premiums earned in 2003
decreased 4.6% to $301,916, compared to $316,338 in 2002. The decrease in
renewal premium revenue is due to the lapsation of existing policies and a
reduced level of new premium levels compared to periods prior to the cessation
of sales in 200l. We anticipate that we will continue to experience reduced
levels of renewal premium revenue until such time as an increased level of new
premiums is sufficient to offset the lapsation of existing policies. Our
persistency was 88.1% and 82.8% for the 2003 and 2002 periods, respectively. The
persistency in 2002 was significantly affected due to high lapses after the
implementation of premium rate increases.
NET INVESTMENT INCOME. Net investment income earned in 2003 increased
7.9% to $43,273, from $40,107 in 2002.
As a result of our 2001 Centre Agreement, substantially all of our
investments generated from business written prior to December 31, 2001 were
transferred to the reinsurer in February 2002. The reinsurer maintains a
notional experience account on our behalf in the event that the reinsurance
agreement is later commuted. 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 derivative hedges, which are designed to closely match the
duration of our liabilities.
Our average yield on invested assets at cost, including cash and cash
equivalents, was 5.19% and 5.91%, respectively, in 2003 and 2002. The investment
income component of our notional experience account investment credit generated
$41,426 and $38,375 in 2003 and 2002, respectively. The notional experience
account yields a fixed return based upon the yield to maturity of the underlying
benchmark indices, which are comprised of U.S. Treasury strips, government
agencies and investment grade corporate bonds with weightings of approximately
25%, 15% and 60%, respectively, and have duration of approximately 14 years. The
average yield on the notional experience account was 5.63% and 6.51% for 2003
and 2002, respectively.
NET REALIZED CAPITAL GAINS AND TRADING ACCOUNT ACTIVITY. During 2003,
our capital gains were $237, compared to capital gains of $15,663 in 2002. We
accounted for the transfer of the securities portion of the initial premium
payment for our 2001 Centre Agreement during 2002 as a sale of these assets.
Substantially all of the recognized capital gains in 2002 resulted from the
transfer of the initial premium of approximately $563,000 to the reinsurer. The
results in 2003 were recorded due to normal investment management activity.
MARKET GAIN (LOSS) ON NOTIONAL EXPERIENCE ACCOUNT. We recorded a loss on
our notional experience account of $9,494 in 2003 compared to a market gain of
$56,555 in 2002.
During 2002 the interest rates on the underlying investments in the
benchmark indices supporting our notional experience account were declining,
resulting in a market gain. During 2003, although interest rates were volatile
during the year, interest rates at the beginning and end of the year were
relatively unchanged.
The total return of the Lehman Brothers US Aggregate Bond Index was
4.11% and 10.26% for 2003 and 2002, respectively. The total return on our
notional experience account, which generates the
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majority of our net investment income, was 4.34% and 16.08% in 2003 and 2002,
respectively. Management attributes the favorable return achieved from its
notional experience account in 2002 to a longer duration of the underlying
benchmark indices, which were positively impacted by declining market interest
rates during 2002. The lower interest rates that caused the gains in 2002
produced lower yields in 2003.
CHANGE IN PREFERRED INTEREST ON EARLY CONVERSION. The fair value of the
embedded derivative as of the date that the option to receive discounted
interest was granted was $2,038. As of December 31, 2003, we adjusted the
embedded derivative to its then fair value of $3,018 by recording a loss of
$981. We believe that the value of the embedded derivative is significantly
affected by the ability of the investor to liquidate their shares in the market.
We further believe that the number of shares of our common stock outstanding and
the average daily trading volume of our common stock provide an indication of
the ability for the market to bear additional sales of stock without a material
degradation of the current market value of those shares. During 2003, the
liquidity of our common stock rose significantly, as did the average daily
trading volume, which indicated to us that the market could absorb additional
shares without significant degradation of the market price. As a result, we
increased our estimates of the value of the embedded derivative based on an
assumption that conversions were more likely to occur without stock price
deflation.
In determining the fair value of the embedded derivative, we make
certain assumptions, including the future volatility and liquidity of our common
stock. If actual experience deviates from current assumptions, our financial
results may be significantly impacted in future periods.
OTHER INCOME. We recorded $9,082 in other income during 2003, as
compared to $11,585 in 2002. In 2003, we recorded approximately $896 as other
income related to the recognition of a deferred gain relating to the 2001 sale
of our disability business, as compared to $1,593 in 2002. 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. The gain on the
sale is recognized as the ownership of the policies changes. In addition, the
income generated from our ownership of corporate owned life insurance policies
decreased to $2,036 in 2003, as compared to $3,455 in 2002. The cash value of
these policies is invested in investment grade corporate bonds and equity
indexes. The average yield on the income generated from the corporate owned life
insurance was 3.10% in 2003, compared to 5.82% in 2002.
BENEFITS TO POLICYHOLDERS. (Restated to reflect the impact of previously
unreserved policy riders.) Total benefits to policyholders in 2003 decreased
33.8% to $247,822 compared to $374,085 in 2002. Our loss ratio, or policyholder
benefits to premiums, was 77.0% in 2003, compared to 112.1% in 2002. Excluding
the impact of a refinement of our assumptions and processes and a change in
interest discounting, our loss ratio in 2002 was approximately 87.2% compared to
the 2003 loss ratio of 77.0%. We believe the improvement in the 2003 loss ratio
is primarily due to the impact of premium rate increases and better than
anticipated development of our claim reserves for prior year incurrals.
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.
The amount of reserves relating to reported and
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unreported claims incurred is determined by periodically evaluating historical
claims experience and statistical information with respect to the probable
number and nature of such claims. We compare actual experience with estimates
and adjust reserves on the basis of such comparisons.
We evaluate our prior year assumptions by reviewing the development of
reserves for the prior period. During 2003, reserves amounts relating to
December 31, 2002 and prior had a favorable development of $3,095 compared to an
unfavorable development of $80,948 during 2002 for reserve amounts relating to
December 31, 2001 and prior. These changes to prior year reserve amounts
(particularly when calculated as a percentage of the prior year-end reserve
balance) provide a relative measure of deviation in actual performance as
compared to our initial assumptions.
The adjustments to reserves for claims incurred in prior periods are
primarily attributable to claims incurred from our long-term care insurance
policies, which represent approximately 95% of our premium in-force. The
development of our prior year assumptions were in line with our expectations and
included the reduction of our claim reserves of approximately $5,200 in the
quarter ended June 30, 2003. The reduction related to new claims adjudication
procedures for family member and private caregiver services, following an
internal review of historic home health care claims and external consultant
guidance. The new protocols include increased in-home assessments and additional
plan of care structure.
During 2002 we refined our assumptions and process for developing our
claim reserves. This included redefining certain "multiple" claims as a single
claim and employing new assumptions and processes for predicting the
continuance, or the likelihood of a claim continuing in the future. This
resulted in an increase to claims reserves of approximately $78,200.
Further we employed a lower discount rate of 5.7% in 2002, which
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
matched our anticipated return from the investment of assets supporting these
reserves.
COMMISSIONS. Commissions to agents decreased 10.8% to $40,800 in 2003,
compared to $45,741 in 2002.
First year commissions on accident and health business in 2003 increased
19.7% to $4,288, compared to $3,582 in 2002, due to the increase in first year
accident and health premiums. The ratio of first year accident and health
commissions to first year accident and health premiums was 54.0% in 2003 and
55.7% in 2002. The first year commission ratio for both the 2003 and 2002 is
lower than the first year commission ratio prior to the cessation of sales in
2001, due to the increased sale of our Secured Risk, Medicare Supplement and
franchise group policies as a percentage of total new sales. All of these
policies pay a lower commission as a percentage of premium revenue to agents
than our individual long-term care policies. We believe that sales of these
policies as a percentage of new sales are likely to remain at this level as we
recommence sales in many states. We believe that the sale of long-term care
policies has declined as a percentage of sales as a result of our lower
financial ratings with A.M. Best and Standard and Poor's rating services and
continued consumer and agent concerns regarding our financial strength.
Renewal commissions on accident and health business in 2003 decreased
12.1% to $38,802, compared to $44,127 in 2002 due to the decrease in renewal
accident and health premiums. The ratio of renewal accident and health
commissions to renewal accident and health premiums was 12.5% in 2003 and 13.6%
in 2002. We have implemented premium rate increases on a majority of policies
written prior to December 31, 2001. We do not pay commissions on the additional
premium collected as a result of a rate increase, which reduces the ratio of
renewal commissions to renewal premium revenue. We
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anticipate that this ratio will continue to decline until the premium rate
increases are fully implemented, which we anticipate will occur prior to the end
of 2005.
NET POLICY ACQUISITION COSTS AMORTIZED. (Restated to reflect the impact
of previously unreserved policy riders.) The net deferred policy acquisition
costs amortized in 2003 increased $10,243, compared to $8,615 in 2002.
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 commissions less
ultimate renewal commissions, and variable general and administrative expenses
related to policy sales, underwriting and issuance. Deferred costs are amortized
over the life of the policy based upon actuarial assumptions, including
persistency of policies in-force. In the event that a policy lapses prematurely
due to death or termination of coverage, the remaining unamortized portion of
the deferred amount is immediately recognized as expense in the current period.
The net amortization of deferred policy acquisition costs is affected by
new business generation, imputed interest on prior reserves and policy
persistency. The amortization of deferred costs is generally offset largely by
the deferral of costs associated with new premium generation. However, lower new
premium sales during 2003 and periods, as compared to sales prior to the
cessation of new sales in 2001, produced significantly less expense deferral to
offset amortized costs.
We regularly assess the recoverability of deferred acquisition costs
through actuarial analysis. To determine recoverability, the present value of
future premiums less future costs and claims are added to current reserve
balances. If this amount is greater than current unamortized deferred
acquisition costs, the unamortized amount is deemed recoverable. In the event
recoverability is not demonstrated, we reassess the calculation using
justifiable premium rate increases. If rate increases are not received or are
deemed unjustified, we will expense, as impaired, the attributed portion of the
deferred asset in the current period. If we conclude that the deferred
acquisition costs are impaired, we will record an impairment loss and a
reduction in the deferred acquisition cost asset. In the event of an impairment,
we will also evaluate our historical assumptions utilized in establishing the
policy reserves and deferred acquisition costs and may update those assumptions
to reflect current experience (referred to as "unlocking"). The primary
assumptions include persistency, claims expectations, interest rates and rate
increases.
During 2002, we determined to recognize a DAC impairment charge of
$1,100 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 reasonable 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, or our actual experience differs from
our assumptions, our DAC could be further impaired and we would incur an expense
in the amount of the impairment.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
in 2003 increased 27.2% to $59,110, compared to $46,472 in 2002. The ratio of
total general and administrative expenses to premium revenues was 18.4% in 2003,
compared to 13.9% in 2002. The primary contributors to our expense growth in
2003 were as follows:
1) New sales related expenses --
As our new premium revenue has increased with the recommencement of
sales, the variable costs associated with marketing and acquiring new premium
revenue has also increased. These costs which
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include medical records and cognitive impairment screenings associated with the
underwriting process, printing, supplies and sales promotions were $5,977 in
2003, compared to $3,158 in 2002. In addition to the variable costs associated
with new premium growth we also increased our marketing infrastructure during
2003 through the addition of a Chief Marketing Officer, a national sales vice
president and two additional field vice presidents. The salaries and benefits
associated with these new positions was $699 in 2003.
Expenses increased approximately $1,500 in 2003 compared to 2002 at one
of our agency subsidiaries, primarily because it had expanded its regional
office structure in order to increase its ability to sell additional new
long-term care policies that we and other companies offer. We determined that
certain of these offices are not generating sufficient additional revenue to
support existing overhead, and, as a result closed several unproductive sites
prior to December 31, 2003 and closed additional sites in 2004.
2) Financial and actuarial capability --
We added two actuarial officers and three finance officers during 2002
and 2003. These positions were added in order to enhance our abilities to
analyze our business through the use of customized actuarial models and to
improve our financial analysis capabilities. The salaries and benefits
associated with these new positions were $497 in 2003 as compared to $86 in
2002.
3) Human resource modifications --
During 2003 we recorded expense of approximately $2,668 related to the
initial recognition of future retirement benefits payable to our former chairman
and severance related expenses for certain managers and employees whose
positions were eliminated. In addition, salary increases, changes in our
vacation policy, increases in the cost of healthcare and officer bonuses
increased salary and benefit expense by approximately $1,754 in 2003.
4) Litigation expenses --
Legal fees increased to $2,936 in 2003, compared to $1,238 in 2002. The
increase related to expenses associated with the discovery process and the
completion of depositions in the National Healthcare Services, Inc. litigation,
and expenses associated with numerous motions filed and preliminary discovery
conducted in connection with litigation related to the sale of long-term care
policies.
EXPENSE AND RISK CHARGES ON REINSURANCE AND EXCISE TAX EXPENSE. Our
reinsurance agreement provides the reinsurer with annual expense and risk
charges, which are credited against our 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 2003 and 2002, we incurred charges of $11,073
and $14,308, respectively for this item. In addition, we are subject to an
excise tax for premium payments made to a foreign reinsurer equal to one percent
of the premium revenue ceded to the foreign reinsurer. We recorded $3,065 and
$2,919 for excise tax expenses in 2003 and 2002, respectively.
INTEREST EXPENSE. Interest expense in 2003 increased 41.5% to $8,112,
compared to $5,733 in 2002. The interest expense in 2002 is primarily related to
our convertible subordinated notes, which pay interest at an annual percentage
rate of 6.25% and had an outstanding aggregate principal balance of $74,750
throughout 2002. During 2003, we issued $32,421 of additional convertible
subordinated notes and paid our entire obligation of $8,957 related to
convertible subordinated notes that matured in 2003. Our average outstanding
convertible subordinated debt for 2003 was $97,099.
67
Holders of our convertible subordinated notes are entitled to convert
their notes into shares of our common stock before October 2005 and receive a
discounted amount of interest that they would have otherwise received through
October 2005 had they not converted the notes. As a result of additional
issuances of notes, interest expense in 2003 increased $1,283. In addition, we
incurred $1,069 of interest expense from the early conversion of $8,122 in
convertible subordinated notes during 2003.
BENEFIT FOR FEDERAL INCOME TAXES. (Restated to reflect the impact of
previously unreserved policy riders.) Our benefit for Federal income taxes for
2003 decreased to $2,992, compared $13,728 for 2002. Our effective tax rate
decreased to 18.5% in 2003 compared to 34.0% in 2002. The decrease in the
effective rate is due to a $2,500 valuation allowance we recorded in 2003 for a
portion of our current tax net operating loss carryforwards as a result of
potential future limitations on their use due to Internal Revenue Code Section
382. The Internal Revenue Service has established rules that potentially limit a
company's use of prior period net operating loss carryforwards in the event that
a majority of the company's common stock ownership changes within any three
year-period. Due to the issuance of additional shares of our common stock since
May 2001 and conversions of our convertible subordinated notes during 2003 and
the first quarter of 2004, we have become subject to these limitations.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE. We recognized an impairment loss
of $5,151 in 2002 as a result of our transitional impairment test of goodwill.
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 from
normal operations 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 and
other capital markets activities including the sale or exchange of debt
instruments. Our primary uses of cash are policy acquisition costs (principally
commissions), claim payments to policyholders, investment purchases, deposits to
our notional experience account, debt service and general and administrative
expenses.
Our cash increased $2,488 in 2004 primarily due to $26,000 in additional
funds generated from the issuance of convertible subordinated debt. This was
supplemented by $30,076 from operations and the sale of $34,177 of bonds. The
major source of cash from operations was premium received. Cash decreased in
2004 primarily due to payments made to our reinsurer of $43,354 and the purchase
of $51,469 in bonds.
Our cash decreased $16,398 in 2003 primarily due to payments made to our
reinsurer of $58,110 and the purchase of $59,817 in bonds. In 2003, our cash was
also decreased as a result of the repayment of approximately $9,000 of
convertible subordinated notes due 2003. Our cash was increased during the
period due primarily to $32,421 in additional funds generated from the issuance
of convertible subordinated debt. This was supplemented by $40,070 from
operations. The major source of cash from operations was premium received.
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets. As of December 31, 2004, shareholders' equity was increased by $147 due
to unrealized gains of $226 in the investment portfolio. As of December 31,
2003, shareholders' equity was increased by $598 due to unrealized gains of $920
in the investment portfolio.
68
PARENT COMPANY OPERATIONS
We have engaged in financing activities, including issuance of debt
securities, over the past two years to fund our liquidity and subsidiary capital
needs. These activities have included:
1. In the first quarter of 2003, we completed the sale of 6 1/4%
convertible subordinated notes due 2008 (the "2008 Notes") and
received proceeds of $32,421. We used $16,000 of the proceeds to
satisfy the premium to surplus requirements of our voluntary
consent order with the Florida Insurance Department. We used the
remaining proceeds to supplement parent liquidity, retire our
remaining 6 1/4% convertible subordinated notes due 2003 and for
general working capital purposes.
2. In the first and third quarters of 2004, we issued an additional
$16,000 and $10,000, respectively, in aggregate principal amount
of 2008 Notes. We used the proceeds to supplement parent
liquidity, for general working capital purposes and to further
supplement our subsidiaries' statutory surplus.
During 2004, holders of $29,499 in aggregate principal amount of our
2008 Notes elected to convert their 2008 Notes into 18,347 shares of our common
stock, which includes 1,490 shares issued for interest paid for conversion prior
to October 15, 2005, and during 2003, holders of $8,122 of our 2008 Notes
elected to convert their 2008 Notes into 5,184 shares of our common stock, which
includes 543 shares issued for interest paid for conversion prior to October 15,
2005.
The maturities of our principal contractual cash obligations, excluding
insurance liabilities, at December 31, 2004, are as follows:
2010 and
2005 2006 2007 2008 2009 Thereafter Total
---- ---- ---- ---- ---- ---------- ----------
On Balance Sheet:
Long-term debt $ - $ - $ - $ 86,593 $ - $ - $ 86,593
Pension and post-retirement
benefits 154 115 113 111 108 484 1,085
Insurance liabilities (1) 180,515 181,881 178,885 172,016 157,810 3,712,881 4,583,988
Off-Balance Sheet:
Operating leases (2) 460 349 277 214 170 - 1,470
Interest on long-term debt 5,064 4,870 4,870 4,870 - - 19,674
Reinsurance arrangements (3) 9,000 9,000 9,000 9,000 - - 36,000
Vendor contracts (4) 2,800 469 - - - - 3,269
---------- ---------- ---------- ---------- ---------- ---------- ----------
Total $ 197,993 $ 196,684 $ 193,145 $ 272,804 $ 158,088 $3,713,365 $4,732,079
========== ========== ========== ========== ========== ========== ==========
(1) Insurance liabilities consist of future policy benefits and unpaid claims
and claim expenses relating to the Company's insurance products.
Substantially all of the amounts contained in this table with respect to
such liabilities consist of estimates by the Company's management based on
various actuarial and other assumptions relating to morbidity, mortality
and persistency. In accordance with GAAP, a substantial portion of such
liabilities are carried on a discounted basis on the consolidated balance
sheet, however, the amounts contained in this table are presented on an
undiscounted basis. The actual payments relating to these liabilities will
differ, both in amount and timing, from indicated in the table.
(2) Amounts after 2009 are immaterial.
(3) Primarily represents the pay down of funds held due to a reinsurer.
(4) Contractual payments owed to a vendor relating to the outsourcing
arrangement for the daily operations of our information technology
department. The contract expires in the first quarter of 2006.
69
Penn Treaty's cash flow needs primarily include interest payments on
outstanding debt and operating expenses. The funding is primarily derived from
the operating cash flow of our agency subsidiary operations and dividends from
the insurance subsidiaries. However, as noted above, the dividend capabilities
of the insurance subsidiaries are limited and we may need to rely upon the
dividend capabilities of our agency subsidiaries to meet current liquidity
needs. We believe that our current cash on hand and these sources of funds will
be sufficient to service our debt obligations through at least April 15, 2006
and potentially through October 15, 2006, which is dependent upon our parent
company expenses and liquidity, agency dividend capabilities or our subsidiary
surplus needs. If we are unable to generate sufficient funds through operations
or raise additional capital to meet our debt service obligations during 2006 or
if our assumptions about our ability to service our debt prior to 2006 are not
correct, we may default on our debt obligations. We will need to raise
additional capital to satisfy any parent company liquidity needs, including debt
service payments, beyond October 2006, particularly if the price of our common
stock on or after October 15, 2005 is insufficient to cause mandatory conversion
of our 2008 Notes.
Our anticipated cash needs for 2005 are as follows:
Debt interest payments $ 5,064
Litigation settlements 3,844
Parent expenses 1,200
---------
Cash requirements $ 10,108
=========
Our anticipated cash provided for 2005 is as follows:
Cash and investments on hand $ 12,400
Subsidiary sources 1,500
---------
Cash sources $ 13,900
=========
SUBSIDIARY OPERATIONS
Our insurance subsidiaries are regulated by various state insurance
departments. The National Association of Insurance Commissioners ("NAIC") has
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, PTNA, ANIC, and AINIC (representing
approximately 91%, 8% and 1% of our direct in-force premium, respectively) are
required to hold statutory surplus that is above a certain required level. At
December 31, 2000, PTNA had Total Adjusted Capital at the Regulatory Action
level, which required it to file a Plan with the Department. ANIC is also
subject to the Plan because it is 100% owned by PTNA.
On February 12, 2002, the Department approved the Plan. As a primary
component of the Plan, effective December 31, 2001, PTNA and ANIC entered a
reinsurance transaction to reinsure, on a quota
70
share basis, substantially all of our long-term care insurance policies then
in-force. The agreement is subject to certain coverage limitations, including an
aggregate limit of liability that is a function of certain factors and that may
be reduced in the event that the rate increases that the reinsurance agreement
may require are not obtained. We are required to perform annual comparisons of
our actual to expected claims experience. If we have reason to believe, whether
from this analysis or other available information, that at least a 5% premium
rate increase is necessary, we are obligated to file and obtain such premium
rate increases in order to comply with the requirements of the agreement. If we
do not file and obtain such premium rate increases, our aggregate limit of
liability would be reduced by 50% of the premium amount that would have
otherwise been received.
As part of this agreement, annual risk charges in excess of $11,000 are
assessed against our experience account by the reinsurer. The annual amount
increases if we do not commute on December 31, 2007. 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 GAAP because, the agreement does not result in the reasonable
possibility that the reinsurer may realize a significant loss. This is due to a
number of factors related to the agreement, including experience refund
provisions, the expense and risk charges credited to the experience account by
the reinsurer and the aggregate limit of liability.
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
subsequent cash flows from the reinsured policies, less claims payments, ceding
commissions and risk charges, is credited to a notional experience account,
which is held for our benefit in the event of commutation and recapture on or
after December 31, 2007. The notional experience account balance receives an
investment credit based upon the total return from a series of benchmark indices
and derivative hedges that are intended to match the duration of our reserve
liability.
Our current modeling and actuarial projections suggest that it is
probable that we will be able to commute the agreement, as planned, on December
31, 2007. In order to commute the agreement, our statutory capital following
commutation must be sufficient to support the reacquired business in compliance
with all statutory requirements. Upon commutation, we would receive cash or
other liquid assets equaling the market value of our experience account from the
reinsurer. We would also record the necessary reserves for the business in our
statutory financial statements. Our ability to commute the agreement is highly
dependent upon the market value of the notional experience account exceeding the
level of required reserves to be established. In addition to the performance of
the reinsured policies from now until 2007, the notional experience account
value is susceptible to market interest rate changes. A market interest rate
increase of 100 basis points could reduce the market value of the current
notional experience account by approximately $110,000 and jeopardize our ability
to commute as planned. As we approach the intended commutation date, the
sensitivity of our notional experience account to market interest rate movement
will decline as the duration of the benchmark indices becomes shorter, however
the amount of assets susceptible to such interest sensitivity will continue to
grow as additional net cash flows are added to the notional experience account
balance prior to commutation. The reinsurer has agreed to fix the market value
of the experience account and to invest the assets in a manner that we request
in order to minimize short term volatility when we inform the reinsurer of our
intention to commute the agreement.
The reinsurance agreement also granted the reinsurer an option to
participate in reinsuring new business sales on a quota share basis. In August
2002, the reinsurer exercised its option to reinsure up to 50% of future sales,
subject to a limitation of the reinsurer's risk. This agreement does not qualify
for reinsurance treatment in accordance with GAAP because, the agreement does
not result in the reasonable possibility that the reinsurer may realize a
significant loss. This is due to an aggregate limit of liability
71
that reduces the likelihood of the reinsurer realizing a significant loss on the
agreement. However, this agreement meets the requirements to qualify for
reinsurance treatment under statutory accounting rules.
In March 2004, the reinsurer notified us of its decision to cease
reinsuring newly issued policies on August l, 2004. Policies reinsured prior to
August 1, 2004 will be unaffected by the termination of this agreement. Our
separate agreement with the reinsurer to reinsure existing policies issued prior
to December 31, 2001 will be unaffected by the determination made by the
reinsurer regarding newly issued policies.
Upon the Department's approval of the Plan in February 2002, we
recommenced new policy sales in 23 states, including Pennsylvania. We have now
recommenced new policy sales in 18 additional states, including Florida and
California (subject to Corrective Orders). Florida, California and Pennsylvania
accounted for approximately 16%, 15% and 12%, respectively, of our direct
premium revenue for the year ended December 31, 2004. We are actively working
with the remaining states to recommence new policy sales in all jurisdictions.
The Plan requires us to comply with certain agreements at the direction
of the Department, including, but not limited to:
o New investments are limited to NAIC 1 or 2 rated securities.
o Affiliated transactions are limited and require Department
approval.
o An agreement to increase statutory reserves by an additional
$125,000 throughout 2002-2004, which has been completed.
Effective September 10, 2001, we determined to discontinue the sale
nationally of all new long-term care insurance policies until the Plan was
approved by the Department. The decision resulted from our concern about further
depletion of statutory surplus from new sales prior to the completion and
approval of the Plan and from increasing concern regarding our status by many
states in which we are licensed to conduct business. The form of our cessation
varied by state, ranging from no action to certificate suspensions.
The majority of our insurance subsidiaries' cash flow results from our
existing long-term care policies, which have been ceded to the reinsurer under
this agreement. Our subsidiaries' ability to meet additional liquidity needs and
cover fixed expenses in the future is highly dependent upon our ability to issue
new policies and to control expense growth. Our future growth and new policy
issuance is dependent upon our ability to continue to expand our historical
markets, retain and expand our network of agents and effectively market our
products and our ability to fund our marketing and expansion while maintaining
minimum statutory levels of capital and surplus required to support such growth.
Under the insurance laws of Pennsylvania and New York, where our
insurance subsidiaries are domiciled, insurance companies can pay ordinary
dividends only out of earned surplus. In addition, under Pennsylvania law, our
Pennsylvania insurance subsidiaries (including our primary insurance subsidiary)
must give the Department at least 30 days advance notice of any proposed
"extraordinary dividend" and cannot pay such a dividend if the Department
disapproves the payment during that 30-day period. For purposes of that
provision, an extraordinary dividend is a dividend that, together with all other
dividends paid during the preceding twelve months, exceeds the greater of 10% of
the insurance company's surplus as shown on the company's last annual statement
filed with Department or its statutory net income as shown on that annual
statement. Statutory earnings are generally lower than earnings reported in
accordance with generally accepted accounting principles due to the immediate or
accelerated recognition of all costs associated with premium growth and benefit
reserves. Additionally, the Plan requires the Department to approve all dividend
requests made by PTNA, regardless of normal statutory requirements
72
for allowable dividends. We believe that the Department is unlikely to consider
any dividend request in the foreseeable future, as a result of PTNA's current
statutory surplus position. Although not stipulated in the Plan, this
requirement is likely to continue until such time as Penn Treaty meets normal
statutory allowances, including reported net income and positive cumulative
earned surplus. We do not expect that this will occur in the foreseeable future.
Under New York law, our New York insurance subsidiary (AINIC) must give
the New York Insurance Department 30 days advance notice of any proposed
dividend and cannot pay any dividend if the regulator disapproves the payment
during that 30-day period. In addition, 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.
PTNA and ANIC have not paid any dividends to Penn Treaty for the past
three years and are unlikely in the foreseeable future to be able to make
dividend payments due to insufficient statutory surplus and anticipated
earnings. However, our New York subsidiary is not subject to the Plan and was
permitted by New York statute to make a dividend payment following December 31,
2001. Consequently, in 2002, Penn Treaty received a dividend from our New York
subsidiary of $651.
At December 31, 2004, our subsidiaries had no debt outstanding.
NEW ACCOUNTING PRINCIPLES
(amounts in thousands)
In December 2004, the Financial Accounting Standards Board ("FASB")
issued FASB Statement No. 123R ("SFAS 123R") "Share-Based Payment". SFAS 123R
replaces SFAS 123, "Accounting for Stock-Based Compensation," and supersedes APB
Opinion 25, "Accounting for Stock Issued to Employees." SFAS 123R requires that
the cost of share-based payment transactions (including those with employees and
non-employees) be recognized in the financial statements. SFAS 123R applies to
all share-based payment transactions in which an entity acquires goods or
services by issuing (or offering to issue) its shares, share options, or other
equity instruments (except for those held by an ESOP) or by incurring
liabilities (1) in amounts based (even in part) on the price of the entity's
shares or other equity instruments, or (2) that require (or may require)
settlement by the issuance of an entity's shares or other equity instruments.
SFAS 123R is effective for public companies for annual periods beginning after
June 15, 2005. We will adopt the provisions of SFAS 123R on January 1, 2006 and
have not yet determined the impact on its financial position or results of
operations.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets. A significant portion of assets and liabilities are financial
instruments, which are subject to the market risk of potential losses from
adverse changes in market rates and prices. Our primary market risk exposures
relate to interest rate risk on fixed rate domestic medium-term instruments and,
to a lesser extent, domestic short-term and long-term instruments. We have
established strategies, asset quality standards, asset allocations and other
relevant criteria for our portfolio to manage our exposure to market risk.
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
73
segments or geographic regions. However, our notional experience account
balance, which represents a substantial portion of our investable assets at
December 31, 2004, is with one reinsurer. Although sufficient assets to support
our statutory reserve liabilities are secured by trust accounts and irrevocable
letters of credit with major United States financial institutions, the
accumulated profits of our reinsured business are susceptible to significant
credit risk of the reinsurer.
We urge caution in evaluating overall market risk from the information
below. Actual results could differ materially because the information was
developed using estimates and assumptions as described below, and because
insurance liabilities and reinsurance receivables are excluded in the
hypothetical effects (insurance liabilities represent 86.5% of total liabilities
and reinsurance receivables on unpaid losses and the notional experience account
due from reinsurer represent 72.4% 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 our financial instruments (including our notional experience
account balance, as discussed below) as of December 31, 2004, excluding
insurance liabilities and reinsurance receivables on unpaid losses because such
insurance related assets and liabilities are not carried at fair value, would
have been as follows:
If interest rates had increased by 100 basis points at December 31,
2004, there would have been a decrease of approximately $116 million in the net
fair value of our investment portfolio (including our national experience
account) less our long-term debt. A 200 basis point increase in market rates at
December 31, 2004 would have resulted in a decrease of approximately $217
million in the net fair value. If interest rates had decreased by 100 and 200
basis points, there would have been a net increase of approximately $133 million
and $285 million, respectively, in the net fair value of our total investments
and debt.
If interest rates had increased by 100 basis points at December 31,
2003, there would have been a decrease of approximately $84 million in the net
fair value of our investment portfolio (including our notional experience
account) less our long-term debt. A 200 basis point increase in market rates at
December 31, 2003 would have resulted in a decrease of approximately $159
million in the net fair value. If interest rates had decreased by 100 and 200
basis points, there would have been a net increase of approximately $94 million
and $198 million, respectively, in the net fair value of our total investments
and debt.
Effective December 31, 2001, we entered a reinsurance agreement to
reinsure, on a quota share basis, substantially all of our long-term care
insurance policies in-force. The transaction resulted in the transfer of debt
and equity securities of approximately $563 million to the reinsurer. The
agreement provides us the opportunity to commute and recapture on or after
December 31, 2007. To that end, the reinsurer will maintain a notional
experience account for our benefit only in the event of commutation and
recapture, which reflects the initial premium paid, future premiums collected
net of claims, expenses and accumulated investment earnings. The notional
experience account balance will receive an investment credit based upon the
total return of a series of benchmark indices and hedges that are designed to
closely match the duration of reserve liabilities. As a result, we will likely
experience significant volatility in our future financial statements.
Our ability to commute the agreement is highly dependent upon the market
value of the notional experience account exceeding the level of required
reserves to be established. In addition to the performance of the reinsured
policies from now until 2007, the notional experience account value is
susceptible to market interest rate changes. A market interest rate increase of
100 basis points could reduce the market value of the current notional
experience account by approximately $110 million and jeopardize our ability to
commute as planned. As we approach the intended commutation date, the
74
sensitivity of our notional experience account to market interest rate movement
will decline as the duration of the benchmark indices becomes shorter, however
the amount of assets susceptible to such interest sensitivity will continue to
grow as additional net cash flows are added to the notional experience account
balance prior to commutation. We intend to give notice to the reinsurer of our
intention to commute on December 31, 2007 at such time as we are highly
confident of our ability to support the reacquired policies. The reinsurer has
agreed to fix the market value of the notional experience account at that time,
and to then invest the assets in a manner that we request in order to minimize
short term volatility.
We hold certain mortgage and asset backed securities as part of our
investment portfolio. The fair value of these instruments may react in a convex
or non-linear fashion when subjected to interest rate increases or decreases.
The anticipated cash flows of these instruments may differ from expectations in
changing interest rate environments, resulting in duration drift or a varying
nature of predicted time-weighted present values of cash flows. The result of
unpredicted cash flows from these investments could cause the above hypothetical
estimates to change. However, we believe that the minimal amount we have
invested in these instruments and their broadly defined payment parameters
sufficiently outweigh the cost of computer models necessary to accurately
predict the possible impact on our investment income of hypothetical effects of
changes in market rates or prices on the fair values of financial instruments as
of December 31, 2004.
75
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
DIRECTORS
The following table and paragraphs set forth information about the
directors of Penn Treaty. The information has been furnished to Penn Treaty by
the directors.
NAME AGE POSITION(S) WITH PENN TREATY DIRECTOR SINCE
---- --- ---------------------------- --------------
CLASS III: DIRECTORS WITH TERMS EXPIRING IN 2005:
Francis R. Grebe 73 Director 1999
Gary E. Hindes 54 Chairman of the Board of Directors 2002
Peter M. Ross 65 Director 2003
CLASS I: DIRECTORS WITH TERMS EXPIRING IN 2006:
William W. Hunt, Jr. President, Chief Executive Officer
45 and Director 2003
Irving Levit 75 Founding Chairman and Director 1971
Domenic P. Stangherlin 78 Director 1971
CLASS II: DIRECTORS WITH TERMS EXPIRING IN 2007:
Alexander M. Clark 71 Director 1999
Patrick E. Falconio 63 Director 2004
Matthew W. Kaplan 46 Director 2001
76
FRANCIS R. GREBE has served as Director of Penn Treaty since 1999 and as
Director of PTNA since May 2004. Mr. Grebe has been a Senior Vice President at
The Pennsylvania Trust Company in Radnor, Pennsylvania since February 2004. Mr.
Grebe was previously a partner at the investment counseling firm of Davidson
Investment Counselors, formerly James M. Davidson and Company. He held this
position from 1988 to February 2004. Mr. Grebe also served as an Administrative
Officer of Davidson Trust Company, formerly The Main Line Trust Company, a
private fiduciary, from 1996 to December 2003. Mr. Grebe has over 40 years
experience with leading financial institutions in the trust and investment area,
including Girard Trust Bank, Philadelphia National Bank and U.S. Trust Company
of Florida. Mr. Grebe currently serves as a Director of the Athenaeum of
Philadelphia and as a Trustee of The Guthrie Healthcare System. He is also a
Director and former President of Family Services of Montgomery County,
Pennsylvania and currently serves on The Board of Surrey Services for Seniors,
as well as a Director of Associated Services for the Blind, Philadelphia,
Pennsylvania. He also serves as Trustee of the Meshewa Farm Foundation and The
Sylvan Foundation. Mr. Grebe is a Phi Beta Kappa graduate of the University of
Rochester and the University of Michigan Law School.
GARY E. HINDES has served as non-executive Chairman of the Board of
Directors of Penn Treaty since May 2003 and has served as Director of Penn
Treaty since 2002. He has also served as Director of UIG since May 2004. Mr.
Hindes has served as Managing Director of Deltec Asset Management, LLC, a
professional investment management firm located in New York City, since 2000.
From 1996 to 2000, Mr. Hindes was a principal of PMG Capital, Inc., a
Philadelphia investment banking and brokerage concern. From 1986 to 1996, Mr.
Hindes served as Chief Executive Officer of the Delaware Bay Company, Inc. Mr.
Hindes has formerly served on the Board of Directors of Lancer Industries and
Intranet Corporation. Mr. Hindes has also served as the Chairman of the Board of
Trustees of Wilmington Head Start, Inc. since 1982 and served by presidential
appointment from 1993 to 2001 for the John F. Kennedy Center for the Performing
Arts. Mr. Hindes is currently a member of the Investment Oversight Committee of
the United States Holocaust Memorial Museum and is a commissioner of the
Wilmington Housing Authority.
PETER M. ROSS has served as Director of Penn Treaty since December 2003,
and as Director of PTNA and ANIC since May 2004. Mr. Ross has over thirty years
experience in the development and implementation of public financial policy. He
has served as an independent consultant on public policy since November 2004.
From 2002 until his retirement in February 2005, Mr. Ross served as a Senior
Policy Scientist with the Institute for Public Administration with the
University of Delaware, where he was involved in assisting local government with
budget management. He held the same position in 2000. Mr. Ross previously served
as the State of Delaware Budget Director from 2001 to 2002 and from 1994 to
2000; as Director of Operations, Office of Controller General, State of
Delaware; as a Senior Legislative Fiscal Management Analyst, Office of
Controller General, State of Delaware; and as Chief Administrative Officer, New
Castle County, Delaware. Mr. Ross is a member of the Delaware Economic
Forecasting Advisory Committee and serves as Co-Chairman of the Delaware
Compensation Commission. He holds a Bachelor of Arts in Political Science and a
Master of Arts in Public Administration.
WILLIAM W. HUNT, JR. has served as President of Penn Treaty, ANIC, AINIC
and PTNA since May 2002, and assumed the position of Chief Executive Officer of
Penn Treaty, ANIC, AINIC and PTNA in May 2003. In May 2003, Mr. Hunt became a
Director of Penn Treaty, and Chairman of the Board of Directors of ANIC, AINIC
and PTNA. He has also served as Director of NISHD and the Agency since April
2003 and of UIG since May 2004. From May 2002 to May 2003, Mr. Hunt served as
President and Chief Operating Officer, and from May 2001 to May 2002 served as
Senior Vice President of Finance, of Penn Treaty, ANIC, AINIC and PTNA. From
1999 to 2000, Mr. Hunt served as Vice President and Chief Financial Officer of
the Individual Life Insurance Unit of Prudential Insurance Company of America.
From 1997 to 1999, Mr. Hunt served as Vice President of Corporate Planning and
77
Development for Provident Mutual Life Insurance Company. Prior to joining
Provident, Mr. Hunt served in financial management roles at Advanta Corporation,
Covenant Life Insurance Company and Reliance Insurance Companies. Mr. Hunt, a
Certified Public Accountant, began his career as an auditor with Touche Ross &
Co. Mr. Hunt has over 15 years experience in the insurance business.
IRVING LEVIT serves as Founding Chairman of Penn Treaty and Director of
ANIC, AINIC, PTNA and the Agency. Mr. Levit previously served as Chairman of the
Board of Directors and Chief Executive Officer of Penn Treaty from 1972 to 2003.
He also served as President of Penn Treaty from 1972 to May 2002, and of PTNA,
ANIC and AINIC from December 2000 to May 2002. Mr. Levit served as the Chairman
of the Board of Directors and Chief Executive Officer of PTNA from 1989 to 2003,
of ANIC from 1996 to 2003 and of AINIC since its inception in 1997 to 2003, as
well as the Chairman of the Board of Directors, President and Chief Executive
Officer of the Agency from 1988 to 2003. He also served as Chairman of the
Board, President and Chief Executive Officer of NISHD from 2000 to 2003, and
Chairman of the Board of UIG from 1999 to 2003. Mr. Levit continues to serve as
Director of AINIC, ANIC, PTNA and the Agency. In addition, Mr. Levit has been
the sole owner of the Irv Levit Insurance Management Corporation ("IMC"), an
insurance agency, since 1961. Mr. Levit has over 40 years experience in the
insurance business. On April 29, 2005, Mr. Levit resigned as a member of the
Board of Directors of Penn Treaty and as a member of the Boards of Directors of
all Penn Treaty subsidiaries effective June 2, 2005.
DOMENIC P. STANGHERLIN has served as Director of Penn Treaty since 1971,
of the Agency since 1988, of PTNA since 1989 and of ANIC since 1996. Mr.
Stangherlin also served as Secretary of Penn Treaty from 1971 to 1999, of the
Agency from 1988 to 2000, of PTNA from 1989 to 2000, of ANIC from 1996 to 2000,
and of AINIC from 1997 to 2000. Mr. Stangherlin is the owner and manager of the
Line Tool Company, a manufacturer of micropositioners, located in Allentown,
Pennsylvania.
ALEXANDER M. CLARK has served as Director of Penn Treaty since 1999 and
of AINIC since its inception in 1997. Mr. Clark is a Managing Director of
Advest, Inc., a position he has held since 1993. He previously served as Senior
Vice President at Gramercy Partners and McKinley Allsopp, both of New York; as
President of John Alden Life Insurance Company of New York; and as Associate
Director of Research at Dean Witter & Co. Mr. Clark is a graduate of Dartmouth
College and Harvard Business School, where he earned a M.B.A., and he pursued
further studies at Brown University. Mr. Clark has earned the Chartered
Financial Analyst designation. Mr. Clark has also served as a Director of
Pennsylvania National Insurance Group since 1989, of Great American Life
Insurance Company of New York, a subsidiary of Great American Financial
Resources, Inc., since 2001, and of Unity Financial Life Insurance Company, an
affiliate of Unity Mutual Life Insurance Company, since 2002.
PATRICK E. FALCONIO was elected to serve as Director of Penn Treaty at
the Annual Meeting of Shareholders in May 2004. He has also served as Director
of PTNA since May 2004. He retired in 1999 as Executive Vice President and Chief
Investment Officer of Aegon USA, Inc., a position he held since 1987. Since
2003, he has served as Director of Financial Industries Corporation, a Texas
domiciled life company. He also serves as Director for two non-public companies
and for several charitable organizations. Mr. Falconio holds a Chartered
Financial Analyst designation and is a graduate of Duquesne University. He also
holds an M.B.A. from the University of Georgia.
MATTHEW W. KAPLAN has served as Director of Penn Treaty and AINIC since
2001. He has also served as Director of NISHD since May 2004. He is currently a
Principal of Northstar Consulting, a position he has held since 2001, President
of Second Street Resources, LLC, and a Director of Actis Assurance Segregated
Portfolio Company ("Actis Assurance SPC"). From January 2002 to January 2003, he
served as Managing Director of Oakbridge Capital Partners LLC, and from 1999 to
2003, he also served as Chairman and Chief Executive Officer of Crown
Reinsurance Company (Cayman)
78
Limited. Mr. Kaplan previously served as Vice President of Bench International
LLC during 2001, and as President and Chief Executive Officer of U.S. Care, Inc.
from 1996 to 2000. From 1995 to 1996, Mr. Kaplan served as Chief Marketing
Officer for U.S. Care. Prior to joining U.S. Care, he served as Vice Chairman
and General Manager of the North Melbourne Giants Basketball Pty. Ltd.;
Consultant, Strategic Planning and Evaluation for the World Health Organization,
Regional Office for Europe ("WHO EURO") and for the Commission for the European
Communities ("CEC"); and as Executive Vice President of U.S. Administrators,
Inc. Mr. Kaplan is a member of the Board of Directors of Actis Assurance SPC
(Chairman), Northstar TeleFilms, Inc. (Chairman), the American Manufacturers
Warranty Association, Cancervive (Founding Director) and a member of the Board
of Trustees for the UCLA Center on Aging.
OFFICERS
MARK D. CLOUTIER (39) has served as Senior Vice President, Chief
Financial Officer and Treasurer of Penn Treaty since May 2004. He previously
served as Vice President and Chief Accounting Officer of Penn Treaty from 2002
to May 2004. Prior to joining Penn Treaty, Mr. Cloutier held the position of
Assistant Vice President of Operational Accounting and Analysis with a major
health insurer based in Philadelphia, PA. Previously, he served as a senior
manager with a Big Four public accounting firm. With over 10 years of experience
in the financial services sector, Mr. Cloutier has specialized in the complex
accounting issues and financial management of insurance companies, banks and
employee benefit plans. His expertise includes an intimate knowledge of the
accounting treatment for long-term care insurance contracts, public reporting
and internal financial controls. Mr. Cloutier is a Certified Public Accountant
and earned his B.S. from Temple University. Mr. Cloutier is a member of both the
American Institute of Certified Public Accountants and the Pennsylvania
Institute of Certified Public Accountants.
JAMES M. HEYER (41) has served as a Senior Vice President of Penn Treaty
and its insurance company subsidiaries since May 2002. Mr. Heyer also served as
the Chief Operating Officer of Penn Treaty's insurance company subsidiaries from
January 1999 to May 2002. Mr. Heyer served as a director of Penn Treaty from May
2001 to May 2002, of ANIC since 1996, and of AINIC since 1997. From 1993 to
1998, Mr. Heyer served as the companies' Vice President of Administration. Mr.
Heyer oversees all aspects of underwriting, compliance, risk analysis and
product development for Penn Treaty's insurance company subsidiaries. Prior to
joining Penn Treaty in 1988, Mr. Heyer was employed by The Guardian Life
Insurance Company of North America. Mr. Heyer received his B.S. in Business
Administration and Marketing from Penn State University. Mr. Heyer has over 16
years experience in the insurance business.
STEPHEN R. LA PIERRE (47) has served as Senior Vice President, Claims
Management & Policyholder Services of Penn Treaty since January 2005. Mr.
LaPierre has over 20 years of healthcare and long-term care insurance risk
management experience. From 2002 to January 2005, he served as the President of
LaPierre & Associates, LLC, a consulting firm that provided comprehensive claim
management and long-term care insurance operations risk audit services to
insurance carriers and third party administrators. As an independent consultant,
Mr. LaPierre provided consulting services to many top long-term care insurers in
the nation, including Penn Treaty. From 1996 to 2002, he held various risk
management positions with the long-term care insurance division of Fortis/John
Hancock Financial Services, most recently as Vice President Underwriting and
Claims from 1999 to 2002, and also held various roles in PPO network development
and healthcare administration. Mr. La Pierre holds an M.B.A. from the University
of Wisconsin-Milwaukee, and a Bachelor's degree from the University of
Wisconsin-Parkside.
PATRICK D. PATTERSON (53) has served as Executive Vice President and
Chief Marketing Officer of Penn Treaty, ANIC, AINIC and PTNA since April 2003.
He also serves as Director of AINIC, NISHD
79
and UIG. Mr. Patterson founded UIG in 1980, serving as President and Chief
Executive Officer of UIG until its acquisition by Penn Treaty in 1999. Prior to
1980, Mr. Patterson was employed as an agent and sales manager with Bankers Life
and Casualty Insurance Company.
BRUCE A. STAHL (47) has served as Chief Actuary of Penn Treaty, ANIC,
AINIC and PTNA since July 2001, and was promoted to Senior Vice President of
Penn Treaty, ANIC, AINIC and PTNA in March 2004. Mr. Stahl previously served as
Vice President of Penn Treaty, ANIC, AINIC and PTNA from July 2001 to March
2004. From 1994 to 2001, Mr. Stahl owned BAS Actuarial Services, an actuarial
consulting services firm. Prior to 1994, Mr. Stahl served as a consulting
actuary for KPMG and as Assistant Actuary for American Integrity Insurance
Company. Mr. Stahl is a graduate of the Wharton School of the University of
Pennsylvania, and is a member of the Society of Actuaries and the American
Academy of Actuaries. Mr. Stahl has over 25 years experience in the insurance
business.
CAMERON B. WAITE (44) has served as Executive Vice President of
Strategic Operations since May 2004. He previously served as Executive Vice
President of Penn Treaty from May 2002 to May 2004, and as Chief Financial
Officer of Penn Treaty from May 1996 to May 2004. Mr. Waite also serves as
Director of AINIC, ANIC, NISHD, and UIG. From 1994 to 1996, Mr. Waite was Chief
Financial Officer and Treasurer of Blue Fish Clothing, Inc. From 1983 to 1994,
Mr. Waite held various positions with Independence Bancorp, Inc., which merged
with CoreStates Financial Corporation, his last position being Vice President of
Asset Liability Management. Mr. Waite holds a B.A. in Economics from Dickinson
College and an M.B.A. from Lehigh University.
EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table sets forth information concerning the annual and
long-term compensation for services in all capacities to Penn Treaty for the
fiscal years ended December 31, 2002, 2003 and 2004 for the Chief Executive
Officer and the four other most highly compensated individuals who were
Executive Officers at December 31, 2004.
LONG-TERM
ANNUAL COMPENSATION COMPENSATION
----------------------------------------- --------------
SECURITIES ALL OTHER
NAME AND OTHER UNDERLYING COMPENSATION
PRINCIPAL POSITION YEAR SALARY BONUS (1) OPTIONS (2)
------------------------------ ---- ------- ------ --- -------- ---
William W. Hunt, Jr. 2004 $291,966 $96,250 $0 75,000 $10,950
--------------------
President and Chief 2003 $266,454 $68,600 $0 75,000 $9,600
Executive Officer 2002 $197,500 $0 $0 0 $6,525
Cameron B. Waite 2004 $248,436 $65,520 $0 60,000 $25,019
----------------
Executive Vice President 2003 $234,000 $63,000 $0 60,000 $14,760
Strategic Operations 2002 $182,500 $0 $800 0 $6,075
Patrick D. Patterson (3) 2004 $265,423 $31,250 $0 60,000 $8,900
------------------------
Executive Vice President 2003 $170,193 $0 $0 20,000 $5,706
and Chief Marketing
Officer
Bruce A. Stahl 2004 $208,215 $39,780 $0 15,000 $7,440
---------------
Senior Vice President and 2003 $176,800 $34,000 $0 15,000 $6,324
Chief Actuary 2002 $157,500 $0 $0 0 $4,725
James M. Heyer 2004 $187,707 $39,780 $0 22,500 $6,825
--------------
Senior Vice President 2003 $176,800 $34,000 $0 22,500 $6,324
Risk Management 2002 $147,500 $0 $1,200 0 $4,425
80
----------------------
(1) Represents directors' fees for each regular board meeting of the
insurance company subsidiaries attended during the applicable calendar
year. Effective July 2002, directors who are employees no longer receive
separate compensation for service on the Board of Directors or
Committees of the Board of Directors.
(2) Represents our contributions to Penn Treaty's 401(k) Plan on behalf of
each of the named individuals and certain allowances for automobile
expenses and reimbursements.
(3) Mr. Patterson's employment with Penn Treaty began on April 16, 2003.
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth information concerning grants of stock
options during the fiscal year ended December 31, 2004 to each of the executive
officers named in the Summary Compensation Table.
Potential Realizable
Value at Assumed Compound
Annual Rates of Stock
Price Appreciation for
Individual Grants Option Term (1)
-------------------------------------------------- ---------------
% of Total
Options Granted
Options to Employees Exercise or Expiration
Name Granted in Fiscal Year Base Price Date 5% 10%
---- --------- -------------- -------------- ---------- ---- ------
William W. Hunt, Jr. 75,000 21.6% $1.70 3/12/14 $80,184 $203,202
Cameron B. Waite 60,000 17.3% $1.70 3/12/14 $64,147 $162,562
Patrick D. Patterson 60,000 17.3% $1.70 3/12/14 $64,147 $162,562
Bruce A. Stahl 15,000 4.3% $1.70 3/12/14 $16,037 $ 40,640
James M. Heyer 22,500 6.5% $1.70 3/12/14 $24,055 $ 60,961
------------------------------------------
(1) The dollar amounts set forth under these columns are the result of
calculations made at assumed 5% and 10% appreciation rates as required
by the SEC regulations and are not intended to indicate future price
appreciation, if any, of our common stock.
AGGREGATED OPTION EXERCISES AND YEAR-END OPTION VALUES
The following table sets forth the number of shares acquired on exercise
of stock options and the aggregate gains realized on exercise of stock options
in 2004 by the executive officers named in the Summary Compensation Table. The
table also sets forth the number of shares covered by exercisable and
unexercisable options held by such executive officers on December 31, 2004 and
the aggregate gains that would have been realized had these options been
exercised on December 31, 2004, even though these options were not exercised,
and the unexercisable options could not have been exercised, on December 31,
2004.
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NUMBER OF SECURITIES VALUE OF UNEXERCISED
SHARES UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
ACQUIRED ON VALUE OPTIONS AT FISCAL YEAR-END AT FISCAL YEAR-END(2)
NAME EXERCISE REALIZED(1) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- -------- ----------- ----------- ------------- ----------- -------------
William W. Hunt, Jr. 0 $0 105,000 75,000 $38,250 $29,250
Cameron B. Waite 0 $0 68,000 60,000 $30,600 $23,400
Patrick D. Patterson 0 $0 20,000 60,000 $11,400 $23,400
Bruce A Stahl 0 $0 15,000 15,000 $ 7,650 $5,850
James M. Heyer 0 $0 60,000 22,500 $11,475 $8,775
-----------------
(1) The value realized represents the difference between the fair market
value per share of our common stock on the date of exercise and the per
share exercise price, multiplied by the applicable number of options.
(2) These values represent the difference between the closing price per
share on The New York Stock Exchange on December 31, 2004 ($2.09) and
the per share exercise price of the option.
401(K) PLAN
On August 1, 1996, Penn Treaty adopted a 401(k) retirement plan,
covering substantially all employees with one year of service. Under the plan,
participating employees may contribute up to 15% of their annual salary on a
pre-tax basis, subject to applicable law, and Penn Treaty equally matches
employee contributions up to the first 3% of the employee's salary. The Penn
Treaty and employee portions of the plan vest immediately. Penn Treaty's expense
in 2004 under the plan was $269,000. Penn Treaty may elect to make a
discretionary contribution to the plan, which will be contributed
proportionately to each eligible employee. Penn Treaty did not make a
discretionary contribution in 2004.
INCENTIVE STOCK OPTION PLANS
Our shareholders adopted an Incentive Stock Option Plan (the "Plan") in
March 1987. The Plan, as amended by shareholder action on May 25, 1990, May 28,
1993, and May 23, 1997, provided for the granting of options to purchase up to
1,200,000 shares of our common stock. In 2001, the Plan was replaced by the 1998
Employee Non-Qualified Incentive Stock Option Plan (the "1998 Plan") and all
options under the Plan were forfeited and replaced under the 1998 Plan. No new
options may be granted under the Plan.
82
Our shareholders adopted the 2002 Employee Incentive Stock Option Plan
(the "2002 Plan") in May 2002. The 2002 Plan does not replace the 1998 Plan,
which continues in effect. The 2002 Plan authorizes us to grant "incentive stock
options" under Section 422 of the Internal Revenue Code and non-qualified stock
options covering up to an aggregate of 2,000,000 shares of our common stock. The
purpose of the 2002 Plan is to enable us to offer our officers, directors and
employees options to acquire equity interests in Penn Treaty, thereby
attracting, retaining and rewarding such persons, and strengthening the
mutuality of interests between such persons and our shareholders. The maximum
allowable term of each option granted under the 2002 Plan is ten years (five
years in the case of holders of more than 10% of the combined voting power of
all classes of outstanding stock), and the options become exercisable one year
from the option grant date.
As of April 14, 2005, 917,542 stock options with exercise prices ranging
from $1.52 to $4.40 had been issued and were outstanding under the 2002 Plan and
no stock options had been cancelled or exercised. As of April 14, 2005 588,897
options with exercise prices ranging from $3.40 to $32.25 were outstanding under
the 1998 Plan.
AGENT STOCK OPTION PLAN
In May 1995, the Board of Directors of Penn Treaty adopted a stock
option plan for its agents (the "Agent Plan"). The Agent Plan provides for the
grant of options to purchase up to 300,000 shares of common stock and is
designed to reward Penn Treaty's agents by providing for the grant of options to
purchase common stock to agents who attain certain sales objectives determined
by the Board of Directors. The exercise price of all options granted under the
Agent Plan may not be less than the fair market value of the shares on the date
of grant. The maximum allowable term of each option is ten years, and the
options become exercisable in four equal annual installments commencing one year
from the option grant date. Under the Agent Plan, stock options with respect to
47,900 shares have been granted and are outstanding. Exercise prices of these
options range from $12.63 to $32.25 per share. No options were granted under the
Agent Plan during 2002, 2003 or 2004.
COMPENSATION OF DIRECTORS
Each director who is not an employee receives as compensation for
services as a director an annual retainer of $10,000, meeting fees of $1,500 for
each Board Meeting attended and $500 for each Committee meeting attended and an
annual grant of 20,000 options to purchase shares of Penn Treaty common stock.
Directors who are employees receive no separate compensation for service on the
Board of Directors or Committees of the Board of Directors. These compensation
policies were adopted by the Board in August 2004.
CHANGE IN CONTROL, EMPLOYMENT AND CONSULTING AGREEMENTS
We have entered into change in control agreements with each of the
executive officers named in the Summary Compensation Table. Under these
agreements, if Penn Treaty merges into another entity or ownership of the voting
control of Penn Treaty otherwise changes and, as a result of such change in
control, any of the named executive officers are terminated or their positions
or work locations are materially changed at any time during the three-year
period after the change in control, they will be entitled to receive a lump sum
payment equal to the aggregate base salary they would have received through the
end of the three-year period and they shall be entitled to continue to receive
certain other insurance and retirement benefits for the remainder of the
three-year period.
83
We and William W. Hunt, Jr. entered into an Employment Agreement on June
1, 2001 under which it was agreed that Mr. Hunt will serve in an executive
capacity on an at-will basis for an unspecified term. Pursuant to the Agreement,
Mr. Hunt's salary is determined at the discretion of the Board of Directors and
Mr. Hunt is eligible to participate in the various employee benefit plans that
cover our salaried employees and executives, including insurance benefits, stock
option grants and bonus programs. The Agreement provided for an initial grant to
Mr. Hunt of 30,000 stock options at an exercise price of $3.40 with 10,000
options vesting on the initial grant date and the remaining options vesting on
July 31, 2002. If Penn Treaty terminates the Agreement for a reason other than
cause, or if Mr. Hunt terminates the Agreement for good reason as defined in the
Agreement, we must pay Mr. Hunt a severance payment in an amount equal to twelve
months of Mr. Hunt's most current base salary rate.
On April 28, 2003, we executed a Consulting Agreement with our former
Chief Executive Officer, Irving Levit. Mr. Levit's Consulting Agreement provides
that he is to serve as our Founding Chairman for up to two years. Under the
terms of the Consulting Agreement, beginning on May 24, 2003 and continuing
until the end of the consulting arrangement, Mr. Levit will provide certain
services to us, in exchange for which we will pay him an annual retainer of
$100,000 and provide him with other standard benefits. Additionally, we have
agreed to pay Mr. Levit or his spouse, beginning on May 23, 2003 and continuing
until the later of Mr. Levit's death or the death of his spouse, a retirement
benefit of $100,000 per year. If Penn Treaty merges into another entity or
ownership of the voting control of Penn Treaty otherwise changes, the consulting
arrangement between Penn Treaty and Mr. Levit will terminate automatically. Upon
such termination, Mr. Levit will receive what he would have received under his
Change of Control Agreement if he had been employed by Penn Treaty at the time
of a change of control with a base salary equal to the amount of his annual
retainer under the Consulting Agreement. Penn Treaty also will make a single
lump sum payment to Mr. Levit equal to the actuarial present value of the
remaining retirement annual payments. Penn Treaty has also agreed to provide Mr.
Levit with health and welfare benefits comparable to those the Company offers to
its executives from time to time until the later of Mr. Levit's death or the
death of his spouse. In connection with Mr. Levit's resignation as a member of
the Board of Directors of Penn Treaty, the Compensation Committee has determined
that his outstanding options shall survive and remain exercisable until the
tenth anniversary of their respective grant dates and that he will continue to
be compensated for attendance meetings of the Board of Directors as an observer.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The members of the Compensation Committee of the Board of Directors
during 2004 were Mr. Falconio, Mr. Grebe and Mr. Ross, who are non-employee
directors.
Until February 2004, Mr. Grebe was a partner at the investment
counseling firm of Davidson Investment Counselors, an affiliate of Davidson
Capital Management. Davidson Capital Management manages a portion of our
investment portfolio, for which it received fees of $34,000 for the year ended
December 31, 2004. Mr. Grebe was not directly involved with any of Penn Treaty's
investment matters. Mr. Grebe also serves as a financial advisor to Irving Levit
on some of Mr. Levit's personal matters for which he is compensated by Mr.
Levit.
Mr. Clark is a Managing Director with Advest, Inc. Advest, Inc. has in
the past engaged in, and may in the future engage in, investment banking and
other commercial dealings in the ordinary course of business with Penn Treaty.
Advest, Inc. has received customary fees for these transactions.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
84
The following table sets forth, as of April 14, 2005, information with
respect to the beneficial ownership of our common stock by (i) each person known
to Penn Treaty to own more than 5% of the outstanding shares of our common stock
or notes convertible into more than 5% of the outstanding shares of our common
stock, (ii) each Director, the former Chief Executive Officer, the Chief
Executive Officer and the four most highly compensated Executive Officers and
(iii) all Directors and Executive Officers as a group. Except as set forth in
the table, we do not know of any person who beneficially owns 5% or more of the
outstanding shares of our common stock.
SHARES PERCENTAGE
------ ----------
NAME AND ADDRESS(1) BENEFICIALLY OWNERSHIP(3)
---------------- ------------- ---------
OWNED(2)
--------
(I) CERTAIN BENEFICIAL OWNERS(4):
Lampe, Conway & Co., LLC (5)........................................... 6,478,415 12.1%
Whitebox Advisors LLC (6).............................................. 9,423,464 16.7%
(II) DIRECTORS AND EXECUTIVE OFFICERS:
William W. Hunt, Jr. (7)............................................... 230,000 *
Alexander M. Clark (8)................................................. 64,429 *
Mark D. Cloutier (9)................................................... 21,000 *
Patrick E. Falconio (10)............................................... 30,000 *
Francis R. Grebe (11).................................................. 43,000 *
James M. Heyer (12).................................................... 85,410 *
Gary E. Hindes (13).................................................... 106,500 *
Matthew W. Kaplan (14)................................................. 40,000 *
Stephen R. La Pierre 325 *
Irving Levit (15)...................................................... 2,512,435 5.3%
Patrick D. Patterson (16).............................................. 529,571 *
Peter M. Ross (17)..................................................... 42,667 *
Bruce A. Stahl (18).................................................... 55,000 *
Domenic P. Stangherlin (19)............................................ 127,963 *
Cameron B. Waite (20).................................................. 165,200 *
All Directors and Executive Officers as a group (15 persons) (21)...... 4,053,500 8.4%
* Less than 1%
---------------------
(1) Unless otherwise noted, the address of each person named above is in
care of Penn Treaty American Corporation 3440 Lehigh Street, Allentown,
Pennsylvania 18103.
(2) Beneficial ownership is determined in accordance with rules of the
Securities and Exchange Commission. Shares of common stock issuable upon
exercise or conversion of options or convertible notes currently
exercisable or convertible or exercisable or convertible within 60 days
of April 14, 2005 are deemed outstanding for computing the percentage
beneficially owned by such holder but are not deemed outstanding for
purposes of computing the percentage beneficially owned by any other
person. Except as otherwise indicated, Penn Treaty believes that the
beneficial owners of the common stock listed above, based on information
furnished by such owners, have sole investment and voting power with
respect to such shares, subject to community
85
property laws where applicable, and that there are no other affiliations
among the shareholders listed in the table.
(3) Based on 46,936,098 shares outstanding on April 14, 2005.
(4) Other investors who have purchased significant portions of the 6 1/4%
convertible subordinated notes due 2008 ("2008 Notes") may beneficially
own 5% or more of the outstanding shares of common stock.
(5) Consists of shares issuable upon conversion of 2008 Notes. According to
the Schedule 13G executed by LC Capital Master Fund, LTD and filed with
the Securities and Exchange Commission on November 4, 2004, its address
is c/o Lampe Conway & Co LLC, 680 5th Avenue, Suite 1202, New York, New
York 10019.
(6) Consists of shares issuable upon conversion of 2008 Notes. According to
the Schedule 13G/A executed by Whitebox Advisors LLC and filed with the
Securities and Exchange Commission on March 17, 2005, its address is
3033 Excelsior Boulevard, Suite 300, Minneapolis, Minnesota 55416.
(7) Includes exercisable options to purchase 180,000 shares of common stock.
(8) Includes exercisable options to purchase 40,000 shares of common stock
and 3,429 shares issuable upon conversion of 2008 Notes.
(9) Includes exercisable options to purchase 20,000 shares of common stock.
(10) Includes exercisable options to purchase 20,000 shares of common stock.
(11) Includes exercisable options to purchase 40,000 shares of common stock.
(12) Includes exercisable options to purchase 82,500 shares of common stock.
(13) Includes 59,500 shares owned by Fallen Angels Fund, L.P., a limited
partnership of which Mr. Hindes has sole voting power as the managing
member of the general partner, exercisable options to purchase 40,000
shares of common stock, 1,500 shares held by Mr. Hindes' wife as to
which he disclaims beneficial ownership and 1,700 shares held by Mr.
Hindes' children as to which he disclaims beneficial ownership.
(14) Consists of exercisable options to purchase shares of common stock.
(15) Includes 43,000 shares held by a private foundation of which Mr. Levit
is an officer and director, 45,007 shares held by Mr. Levit as trustee
of a retirement account, 147,167 shares held by Mr. Levit as co-trustee
of an irrevocable trust for Mr. Levit's children and exercisable options
to purchase 281,455 shares of common stock. Also includes 46,000 shares
held by Mr. Levit's wife as to which he disclaims beneficial ownership.
Excludes 63,073 shares held by other family members as to which he also
disclaims beneficial ownership.
(16) Includes exercisable options to purchase 80,000 shares of common stock
and 228,571 shares issuable upon conversion of 2008 Notes.
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(17) Includes shares held in trust, for which Mr. Ross is settlor and
trustee, and exercisable options to purchase 31,667 shares of common
stock.
(18) Includes exercisable options to purchase 30,000 shares of common stock.
(19) Includes exercisable options to purchase 40,000 shares of common stock.
(20) Includes exercisable options to purchase 128,000 shares of common stock.
(21) Includes exercisable options held by members of the group to purchase
1,053,622 shares of common stock.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
IMC, an insurance agency which is owned by Irving Levit, produced
approximately $21,000 of renewal premiums for PTNA for the year ended December
31, 2004, for which it received commissions of approximately $4,000. While IMC
has only been minimally involved in the sale of insurance products since 1979
and IMC'S operations since that time have not been significant, IMC continues to
receive overriding commissions from Penn Treaty of 5% on business written for
PTNA by any IMC general agents who were appointed prior to 1979 and any of their
sub-agents hired prior and subsequent to January 1979 and one agent appointed in
1981. For the year ended December 31, 2004, these override commissions totaled
approximately $452,000.
The terms on which commissions have been paid to IMC are consistent with
(i) the terms on which commissions have been paid by Penn Treaty to comparable
unaffiliated agencies in the past and are currently paid by Penn Treaty to an
unaffiliated agency performing similar services, and (ii) the terms on which
commissions are paid in the industry in general, and were no more favorable than
would have been obtained from unrelated third parties.
Until February 2004, Mr. Grebe was a partner at the investment
counseling firm of Davidson Investment Counselors, an affiliate of Davidson
Capital Management. Davidson Capital Management manages a portion of our
investment portfolio for which it received fees of $34,000 for the year ended
December 31, 2004. Mr. Grebe was not directly involved with any of Penn Treaty's
investment matters. Mr. Grebe also serves as a financial advisor to Irving Levit
on some of Mr. Levit's personal matters for which he is compensated by Mr.
Levit.
Mr. Clark is a Managing Director with Advest, Inc. Advest, Inc. has in
the past engaged in, and may in the future engage in, investment banking and
other commercial dealings in the ordinary course of business with Penn Treaty.
Advest, Inc. has received customary fees for these transactions.
Mr. Kaplan has in the past (from 1996 to 2000) been a principal and has
an ownership interest in U.S. Care, Inc., a marketing organization to which Penn
Treaty paid commissions of $170,000 in 2004. Penn Treaty also made a loan of
$100,000 with an interest rate of 9% to U.S. Care, Inc. in 2001, which is
guaranteed by renewal commissions payable to Penn Treaty in future periods.
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DESCRIPTION OF NOTES
Each series of the Notes is an entirely separate issue and has been
issued under a separate indenture between Penn Treaty and Wells Fargo Bank,
National Association, as trustee. The indentures under which the Series 1 Notes,
the Series 2 Notes and the Series 3 Notes were issued contain substantially the
same terms and provisions and the Series 1 Notes, the Series 2 Notes and the
Series 3 Notes have substantially the same terms. The occurrence of an event of
default with respect to one series of Notes will not constitute an event of
default with respect to any other series of Notes. Conversion or redemption of
one series of Notes may be effected without the conversion or redemption of the
other series of Notes. All references in this summary to the Notes, the
indenture, the trustee and other defined terms should be read as referring to
each series of the Notes and to the related indenture, trustee and other defined
terms.
The following summaries of certain provisions of the Notes and the
indentures do not purport to be complete and are subject to, and are qualified
in their entirety by reference to, all of the provisions of the Notes and the
indentures, including the definitions therein of certain terms which are not
otherwise defined in this prospectus. Wherever particular provisions or defined
terms of the indentures (or of the form of Notes which is a part thereof) are
referred to, such provisions or defined terms are incorporated herein by
reference in their entirety.
GENERAL
The Notes represent general unsecured subordinated obligations of Penn
Treaty and are convertible into common stock as described below under the
subheadings "- Conversion of the Notes" and "- Mandatory Conversion of the
Notes." The Notes were issued in fully registered form only in denominations of
$1,000 in principal amount or any integral multiple thereof, and will mature on
October 15, 2008, unless earlier redeemed at the option of Penn Treaty,
repurchased at the option of the Note holder or converted to common stock.
The indenture does not contain any financial covenants or any
restrictions on the payment of dividends, the repurchase of securities of Penn
Treaty or the incurrence of debt by Penn Treaty or any of its subsidiaries.
The Notes bear interest at the annual rate of 6.25%, payable
semi-annually on April 15 and October 15, to holders of record at the close of
business on the preceding April 1 and October 1, respectively. Interest is
computed on the basis of a 360-day year composed of twelve 30-day months.
Interest may, at the option of Penn Treaty, be paid by check mailed to
the address of such holder as it appears in the Note register. Principal will be
payable, and the Notes may be presented for conversion, registration of transfer
and exchange, without service charge, at the office of the trustee in the
Borough of Manhattan, New York, New York. Reference is made to the information
set forth below under the subheading "- Delivery and Form."
DELIVERY AND FORM
The Notes are currently in fully registered certificated form, without
coupons, in denominations of $1,000 and any integral multiple thereof. Penn
Treaty will use its best efforts to cause the Notes to be eligible for deposit
with and registration in the name of the Depository Trust Company ("DTC") upon
the effectiveness of the registration statement of which this prospectus is a
part or upon the resale of Notes pursuant to this prospectus.
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If the Notes become eligible for deposit with and registration in the
name of DTC, DTC will act as securities depository for the Notes. The Notes will
be issued as fully-registered securities registered in the name of Cede & Co.
(DTC's partnership nominee) or such other name as may be requested by an
authorized representative of DTC. One fully-registered Note certificate will be
issued for each series of Notes, each in the aggregate principal amount of such
issue, and will be deposited with DTC.
DTC, the world's largest depository, is a limited-purpose trust company
organized under the New York Banking Law, a "banking organization" within the
meaning of the New York Banking Law, a member of the Federal Reserve System, a
"clearing corporation" within the meaning of the New York Uniform Commercial
Code, and a "clearing agency" registered pursuant to the provisions of Section
17A of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). DTC
holds and provides asset servicing for over 2 million issues of U.S. and
non-U.S. equity, corporate and municipal debt issues, and money market
instruments from over 85 countries that DTC's participants ("Direct
Participants") deposit with DTC. DTC also facilitates the post-trade settlement
among Direct Participants of sales and other securities transactions in
deposited securities through electronic computerized book-entry transfers and
pledges between Direct Participants' accounts. This eliminates the need for
physical movement of securities certificates. Direct Participants include both
U.S. and non-U.S. securities brokers and dealers, banks, trust companies,
clearing corporations, and certain other organizations. DTC is a wholly-owned
subsidiary of The Depository Trust & Clearing Corporation ("DTCC"). DTCC, in
turn, is owned by a number of Direct Participants of DTC and Members of the
National Securities Clearing Corporation Government Securities Clearing
Corporation, MBS Clearing Corporation, and Emerging Markets Clearing Corporation
(NSCC, GSCC, MBSCC, and EMCC, also subsidiaries of DTCC), as well as by the New
York Stock Exchange, Inc., the American Stock Exchange LLC, and the National
Association of Securities Dealers, Inc. Access to the DTC system is also
available to others such as both U.S. and non-U.S. securities brokers and
dealers, banks, trust companies, and clearing corporations that clear through or
maintain a custodial relationship with a Direct Participant, either directly or
indirectly ("Indirect Participants"). DTC has Standard & Poor's highest rating:
AAA. The DTC Rules applicable to its Participants are on file with the
Securities and Exchange Commission. More information about DTC can be found at
www.dtcc.com.
Purchases of Notes under the DTC system must be made by or through
Direct Participants, which will receive a credit for the Notes on DTC's records.
The ownership interest of each actual purchaser of each Note ("Beneficial
Owner") is in turn to be recorded on the Direct and Indirect Participants'
records. Beneficial Owners will not receive written confirmation from DTC of
their purchase. Beneficial Owners are, however, expected to receive written
confirmations providing details of the transaction, as well as periodic
statements of their holdings, from the Direct or Indirect Participant through
which the Beneficial Owner entered into the transaction. Transfers of ownership
interests in the Notes are to be accomplished by entries made on the books of
Direct and Indirect Participants acting on behalf of Beneficial Owners.
Beneficial Owners will not receive certificates representing their ownership
interests in Notes, except in the event that use of the book-entry system for
the Notes is discontinued.
To facilitate subsequent transfers, all Notes deposited by Direct
Participants with DTC are registered in the name of DTC's partnership nominee,
Cede & Co. or such other name as may be requested by an authorized
representative of DTC. The deposit of Notes with DTC and their registration in
the name of Cede & Co. or such other nominee do not effect any change in
beneficial ownership. DTC has no knowledge of the actual Beneficial Owners of
the Notes; DTC's records reflect only the identity of the Direct Participants to
whose accounts such Notes are credited, which may or may not be the Beneficial
Owners. The Direct and Indirect Participants will remain responsible for keeping
account of their holdings on behalf of their customers.
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Conveyance of notices and other communications by DTC to Direct
Participants, by Direct Participants to Indirect Participants, and by Direct
Participants and Indirect Participants to Beneficial Owners will be governed by
arrangements among them, subject to any statutory or regulatory requirements as
may be in effect from time to time. Beneficial Owners of Notes may wish to take
certain steps to facilitate transmission of notices of significant events with
respect to the Notes, such as redemptions, tenders, defaults, and proposed
amendments to the security documents, to them. For example, Beneficial Owners of
Notes may wish to ascertain that the nominee holding the Notes for their benefit
has agreed to obtain and transmit notices to Beneficial Owners, in the
alternative, Beneficial Owners may wish to provide their names and addresses to
the registrar and request that copies of the notices be provided directly to
them.
Redemption notices shall be sent to DTC. If less than all of the Notes
within an issue are being redeemed, DTC's practice is to determine by lot the
amount of the interest of each Direct Participant in such issue to be redeemed.
Neither DTC nor Cede & Co. (nor any other DTC nominee) will consent or
vote with respect to the Notes unless authorized by a Direct Participant in
accordance with DTC's procedures. Under its usual procedures, DTC mails an
Omnibus Proxy to Penn Treaty as soon as possible after the record date. The
Omnibus Proxy assigns Cede & Co.'s consenting or voting rights to those Direct
Participants to whose accounts the Notes are credited on the record date
(identified in a listing attached to the Omnibus Proxy).
Redemption proceeds, distributions, and dividend payments on the Notes
will be made to Cede & Co., or such other nominee as may be requested by an
authorized representative of DTC. DTC's practice is to credit Direct
Participants' accounts, upon DTC's receipt of funds and corresponding detail
information from Penn Treaty or its agent on the payable date in accordance with
their respective holdings shown on DTC's records. Payments by Participants to
Beneficial Owners will be governed by standing instructions and customary
practices, as is the case with securities held for the accounts of customers in
bearer form or registered in "street name," and will be the responsibility of
such Participant and not of DTC or its nominee, any agent or Penn Treaty,
subject to any statutory or regulatory requirements as may be in effect from
time to time. Payment of redemption proceeds, distributions, and dividend
payments to Cede & Co. (or such other nominee as may be requested by an
authorized representative of DTC) is the responsibility of Penn Treaty or its
agent, disbursement of such payments to Direct Participants will be the
responsibility of DTC, and disbursement of such payments to the Beneficial
Owners will be the responsibility of Direct and Indirect Participants.
A Beneficial Owner shall give notice to elect to have its Notes
purchased or tendered, through its Participant, to an agent, and shall effect
delivery of such Securities by causing the Direct Participant to transfer the
Participant's interest in the Notes, on DTC's records, to the agent. The
requirement for physical delivery of Notes in connection with an optional tender
or a mandatory purchase will be deemed satisfied when the ownership rights in
the Notes are transferred by Direct Participants on DTC's records and followed
by a book-entry credit of tendered Notes to the agent's DTC account.
DTC may discontinue providing its services as securities depository with
respect to the Notes at any time by giving reasonable notice to Penn Treaty or
its agent. Under such circumstances, in the event that a successor securities
depository is not obtained, Note certificates are required to be printed and
delivered.
Penn Treaty may decide to discontinue use of the system of
book-entry-only transfers through DTC (or a successor securities depository). In
that event, Note certificates will be printed and delivered to DTC.
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The information in this section concerning DTC and DTC's book-entry
system has been obtained from sources that Penn Treaty believes to be reliable,
but Penn Treaty takes no responsibility for the accuracy thereof.
CONVERSION OF THE NOTES
Holders may convert their Notes or portions thereof (in denominations of
$1,000 in principal amount or integral multiples thereof) into common stock
(subject to the next paragraph) until the close of business on October 14, 2008.
The conversion price is $1.75 per share, subject to adjustment as described
below; provided, that in the case of Notes called for redemption, conversion
rights will expire at the close of business on the business day immediately
preceding the date fixed for redemption, unless Penn Treaty defaults in payment
of the redemption price. A Note (or portion thereof) in respect of which a
holder is exercising its option to require repurchase upon a Change of Control
(as defined below) may be converted only if such holder withdraws its election
to exercise such repurchase option in accordance with the terms of the
indenture.
In the event a holder desires to convert all, or any portion, of its
Notes into shares of common stock and Penn Treaty does not have a sufficient
number of shares of common stock available for such conversion, in lieu of
delivering shares of common stock upon conversion of that portion of such
holder's Notes for which there is an insufficient number of shares of common
stock, Penn Treaty will cancel such holder's Note and pay such holder an amount
in cash equal to the market price of the shares of common stock into which the
Notes are then convertible. "Market price" means the average of the last
reported closing prices of the common stock for the ten trading day period
(appropriately adjusted to take into account the occurrence during such period
of certain events that would result in an adjustment of the conversion price),
commencing on the first trading day after delivery of written notice to such
holder that Penn Treaty must pay cash in lieu of delivering shares of common
stock. Any cash paid to the holder in lieu of shares of common stock will
generally result in taxable gain or loss to the holder converting such Notes.
See "Certain Federal Income Tax Considerations." The ability of Penn Treaty to
pay cash to holders of Notes in lieu of delivering common stock will be limited
by our then existing financial resources. There can be no assurance that
sufficient funds will be available when necessary to make any required cash
payments in lieu of delivering common stock to Note holders seeking to convert
their Notes into shares of common stock. See "Risk Factors."
Except as described below, no adjustment will be made on conversion of
any Notes for interest accrued thereon or for dividends paid on any common stock
issued. A holder of Notes at the close of business on a record date will be
entitled to receive the interest payable on such Notes on the corresponding
interest payment date. Any unpaid interest on any Note or portion thereof as of
the date such Note or portion thereof is surrendered for conversion shall
(unless such Note or portion thereof being converted shall have been called for
redemption on a redemption date during the period from the close of business on
or after any record date for the payment of interest to the close of business on
the business day following the corresponding interest payment date) be paid in
cash to the former holder of such Note or portion thereof on the next succeeding
interest payment date. We are not required to issue fractional shares of common
stock upon conversion of Notes and, in lieu thereof, will pay a cash adjustment
based upon the closing price of the common stock on the last business day prior
to the date of conversion.
The conversion price is subject to adjustment (under formulae set forth
in the indenture) upon the occurrence of certain events, including: (i) the
issuance of common stock as a dividend or distribution on the outstanding common
stock, (ii) the issuance to all holders of common stock of certain rights,
options or warrants to purchase common stock at less than the Current Market
Price (as defined in the indenture), (iii) certain subdivisions, combinations
and reclassifications of common stock, (iv) distributions to all holders of
common stock of Penn Treaty of any class of capital stock of Penn Treaty (other
than
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distributions of common stock as a dividend or distribution) or evidences of
indebtedness of Penn Treaty or assets (including securities, but excluding those
rights, options and warrants referred to in clause (ii) above and dividends and
distributions in connection with the liquidation, dissolution or winding up of
Penn Treaty and dividends and distributions paid exclusively in cash), (v)
distributions consisting exclusively of cash (excluding any cash portion of
distributions referred to in clause (iv) or in connection with a consolidation,
merger or sale of assets of Penn Treaty as referred to in clause (ii) of the
third paragraph below) to all holders of common stock in an aggregate amount
that, together with (x) all other such all-cash distributions made within the
preceding 12 months in respect of which no adjustment has been made and (y) any
cash and the fair market value of other consideration payable in respect of any
tender offers by Penn Treaty or any of its subsidiaries for common stock
concluded within the preceding 12 months in respect of which no adjustment has
been made, exceeds 20% of Penn Treaty's market capitalization (being the product
of the then current market price of the common stock times the number of shares
of common stock then outstanding) on the record date for such distribution and
(vi) the purchase of common stock pursuant to a tender offer made by Penn Treaty
or any of its subsidiaries which involves an aggregate consideration that,
together with (x) any cash and the fair market value of any other consideration
payable in any other tender offer by Penn Treaty or any of its subsidiaries for
common stock expiring within the 12 months preceding such tender offer in
respect of which no adjustment has been made and (y) the aggregate amount of any
such all-cash distributions referred to in clause (v) above to all holders of
common stock within the 12 months preceding the expiration of such tender offer
in respect of which no adjustments have been made, exceeds 20% of Penn Treaty's
market capitalization on the expiration of such tender offer. No adjustment of
the conversion price will be made for shares issued pursuant to a plan for
reinvestment of dividends or interest.
No adjustment will be made pursuant to clause (iv) of the preceding
paragraph if Penn Treaty makes proper provision for each holder of Notes who
converts a Note (or portion thereof) to receive, in addition to the common stock
issuable upon such conversion, the kind and amount of assets (including
securities) that such holder would have been entitled to receive if such holder
had been a holder of the common stock at the time of the distribution of such
assets or securities. Rights, options or warrants distributed by Penn Treaty to
all holders of the common stock that entitle the holders thereof to purchase
shares of Penn Treaty's capital stock and that, until the occurrence of an event
(a "Triggering Event"), (i) are deemed to be transferred with the common stock,
(ii) are not exercisable and (iii) are also issued in respect of future
issuances of common stock, shall not be deemed to be distributed (and no
adjustment in the conversion price shall be required) until the occurrence of
the Triggering Event.
Except as stated above, the conversion price will not be adjusted for
the issuance of common stock or any securities convertible into or exchangeable
for common stock or carrying the right to purchase any of the foregoing. No
adjustment in the conversion price will be required unless such adjustment would
require a change of at least 1% in the conversion price then in effect;
provided, that any adjustment that would otherwise be required to be made shall
be carried forward and taken into account in any subsequent adjustment.
In the event that a holder of Notes desires to convert all or any
portion of its Notes into shares of our common stock prior to October 15, 2005,
we will pay such holder of Notes an amount equal to the interest that would have
been otherwise earned on such Notes between the date of such conversion and
October 15, 2005, discounted from October 15, 2005 to present value utilizing a
rate of 6.25% with simple interest over a 360 day year. In the event that a
holder of Notes elects to convert prior to October 15, 2005 and we are required
to pay this interest, we may, in our sole discretion, elect to make such
interest payment in cash or in shares of our common stock based on 90% of the
average closing prices of our common stock for the five trading days immediately
preceding the conversion date.
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In the case of (i) any reclassification or change of the common stock
(other than changes in par value or from par value to no par value as a result
of a subdivision or a combination) or (ii) a consolidation, merger or
combination involving Penn Treaty or a sale or conveyance to another entity of
the property and assets of Penn Treaty as an entirety or substantially as an
entirety (determined on a consolidated basis), in each case as a result of which
holders of common stock shall be entitled to receive stock, other securities,
other property or assets (including cash) with respect to or in exchange for
such common stock, the holders of the Notes then outstanding will be entitled
thereafter to convert such Notes into the kind and amount of shares of stock,
other securities or other property or assets which they would have owned or been
entitled to receive upon such reclassification, change, consolidation, merger,
sale or conveyance had such Notes been converted into common stock immediately
prior to such reclassification, change, consolidation, merger, sale or
conveyance assuming that a holder of Notes did not exercise any rights of
election, if any, as to the stock, other securities or other property or assets
receivable in connection therewith.
In the event of a taxable distribution to holders of common stock (or
other transaction) which results in any adjustment of the conversion price, the
holders of Notes may, in certain circumstances, be deemed to have received a
distribution subject to the U.S. income tax as a dividend; in certain other
circumstances, the absence of such an adjustment may result in a taxable
dividend to the holders of common stock. See "Certain Federal Income Tax
Considerations - Adjustments to Conversion Price."
We may from time to time to the extent permitted by law, reduce the
conversion price by any amount for any period of at least 20 days, in which case
Penn Treaty shall give at least 15 days' notice of such decrease, if the Board
of Directors has made a determination that such decrease would be in the best
interests of Penn Treaty, which determination shall be conclusive. We may, at
our option, make such reductions in the conversion price, in addition to those
set forth above, as we deem advisable to avoid or diminish any income tax to
Penn Treaty's shareholders resulting from any dividend or distribution of stock
(or rights to acquire stock) or from any event treated as such for income tax
purposes. See "Certain Federal Income Tax Considerations."
MANDATORY CONVERSION OF THE NOTES
If the average closing share price of our common stock for any 15
consecutive trading days beginning on or after October 15, 2005 is at least 10%
greater than the conversion price of the Notes (i.e., $1.93) and we have a
sufficient number of shares of our common stock authorized for issuance, then
holders of the Notes are required to convert their Notes into common stock at
the conversion price of $1.75.
RANKING; SUBORDINATION
The payment of principal of, premium, if any, and interest on the Notes,
to the extent set forth in the indenture, ranks PARI PASSU with our two other
series of 6 1/4% convertible subordinated Notes due 2008, but is subordinated in
right of payment to the prior payment in full of all Senior Indebtedness
(defined below). Upon any distribution to creditors of Penn Treaty in a
liquidation or dissolution of Penn Treaty or in a bankruptcy, reorganization,
insolvency, receivership or similar proceeding related to Penn Treaty or its
property, in an assignment for the benefit of creditors or any marshaling of
Penn Treaty's assets and liabilities, the holders of all Senior Indebtedness
will first be entitled to receive payment in full of all amounts due or to
become due thereon before the holders of the Notes will be entitled to receive
any payment in respect of the principal of, premium, if any, or interest on the
Notes (except that holders of Notes may receive securities that are subordinated
at least to the same extent as the Notes to Senior Indebtedness and any
securities issued in exchange for Senior Indebtedness).
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Penn Treaty also may not make any payment upon or in respect of the
Notes (except in such subordinated securities) and may not acquire from the
trustee or the holder of any Note for cash or property (other than securities
subordinated to at least the same extent as the Note to (i) Senior Indebtedness
and (ii) any securities issued in exchange for all Senior Indebtedness) until
Senior Indebtedness has been paid in full if (i) a default in the payment of the
principal of, premium, if any, or interest on Senior Indebtedness occurs and is
continuing beyond any applicable period of grace or (ii) any other default
occurs and is continuing with respect to Senior Indebtedness that permits
holders of the Senior Indebtedness as to which such default relates to
accelerate its maturity and the trustee receives a notice of such default (a
"Payment Blockage Notice") from the representative or representatives of holders
of at least a majority in principal amount of Senior Indebtedness then
outstanding. Payments on the Notes may and shall be resumed (i) in the case of a
payment default, upon the date on which such default is cured or waived, or (ii)
in the case of a default other than a non-payment default, 179 days after the
date on which the applicable Payment Blockage Notice is received, unless the
maturity of any Senior Indebtedness has been accelerated. No new period of
payment blockage may be commenced within 360 days after the receipt by the
trustee of any prior Payment Blockage Notice. No default, other than a
nonpayment default, that existed or was continuing on the date of delivery of
any Payment Blockage Notice to the trustee shall be, or be made, the basis for a
subsequent Payment Blockage Notice, unless such default shall have been cured or
waived for a period of not less than 180 days.
"Senior Indebtedness" with respect to the Notes means the principal of,
premium, if any, and interest on, and any fees, costs, expenses and any other
amounts (including indemnity payments) related to the following, whether
outstanding on the date of the indenture or thereafter incurred or created: (i)
indebtedness, matured or unmatured, whether or not contingent, of Penn Treaty
for money borrowed evidenced by notes or other written obligations, (ii) any
interest rate contract, interest rate swap agreement or other similar agreement
or arrangement designed to protect Penn Treaty or any of its subsidiaries
against fluctuations in interest rates, (iii) indebtedness, matured or
unmatured, whether or not contingent, of Penn Treaty evidenced by notes,
debentures, bonds or similar instruments or Letters of Credit (or reimbursement
agreements in respect thereof), (iv) obligations of Penn Treaty as lessee under
capitalized leases and under leases of property made as part of any sale and
leaseback transactions, (v) indebtedness of others of any of the kinds described
in the preceding clauses (i) through (iv) assumed or guaranteed by Penn Treaty,
and (vi) renewals, extensions, modifications, amendments and refundings of, and
indebtedness and obligations of a successor person issued in exchange for or in
replacement of, indebtedness or obligations of the kinds described in the
preceding clauses (i) through (iv), unless the agreement pursuant to which any
such indebtedness described in clauses (i) through (vi) is created, issued,
assumed or guaranteed expressly provides that such indebtedness is not senior or
superior in right of payment to the Notes; provided, however, that the following
shall not constitute Senior Indebtedness: (w) any indebtedness or obligation of
Penn Treaty in respect of the Notes or the two other series of 6 1/4%
convertible subordinated Notes due 2008; (x) any indebtedness of Penn Treaty to
any of its subsidiaries or other affiliates; (y) any indebtedness that is
subordinated or junior in any respect to any other indebtedness of Penn Treaty
other than Senior Indebtedness; and (z) any indebtedness incurred for the
purchase of goods or materials in the ordinary course of business.
In the event that the trustee (or paying agent if other than the
trustee) or any holder receives any payment of principal or interest with
respect to the Notes at a time when such payment is prohibited under the
indenture, such payment shall be held in trust for the benefit of, and
immediately shall be paid over and delivered to, the holders of Senior
Indebtedness or their representative as their respective interests may appear.
After all Senior Indebtedness is paid in full and until the Notes are paid in
full, holders shall be subrogated (equally and ratably with all other
indebtedness PARI PASSU with the Notes) to the rights of holders of Senior
Indebtedness to receive distributions applicable to Senior Indebtedness to the
extent that distributions otherwise payable to the holders have been applied to
the payment of Senior Indebtedness.
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As of the date of this prospectus, we have no outstanding Senior
Indebtedness; however, the indenture does not prohibit or limit the incurrence
of Senior Indebtedness in the future. As of May 6, 2005, Penn Treaty had
approximately $77,334,000 million in aggregate principal amount of 6 1/4%
convertible subordinated notes due 2008 outstanding, including the Series 1
Notes, the Series 2 Notes and the Series 3 Notes.
In addition, because our operations are conducted primarily through our
subsidiaries, claims of holders of indebtedness of such subsidiaries, as well as
claims of regulators and creditors of such subsidiaries, will have priority with
respect to the assets and earnings of such subsidiaries over the claims of
creditors of Penn Treaty, including holders of the Notes. The indenture does not
limit the amount of additional indebtedness that any of our subsidiaries can
create, incur, assume or guarantee.
Because of these subordination provisions, in the event of a liquidation
or insolvency of Penn Treaty or any of its subsidiaries, holders of Notes may
recover less, ratably, than the holders of Senior Indebtedness.
OPTIONAL REDEMPTION BY PENN TREATY
The Notes are not redeemable at the option of Penn Treaty prior to
October 15, 2005. At any time on or after that date, the Notes may be redeemed
at Penn Treaty's option on at least 30 but not more than 60 days' notice, in
whole at any time or in part from time to time, at a price equal to the
principal amount of the Notes, together with accrued interest to the date fixed
for redemption.
If fewer than all the Notes are to be redeemed, the trustee will select
the Notes to be redeemed in principal amounts of $1,000 or integral multiples
thereof by lot or, in its discretion, on a pro rata basis. If any Note is to be
redeemed in part only, a new Note or Notes in principal amount equal to the
unredeemed principal portion thereof will be issued. If a portion of a holder's
Notes is selected for partial redemption and such holder converts a portion of
such Notes, such converted portion shall be deemed to be taken from the portion
selected for redemption.
No sinking fund is provided for the Notes.
MANDATORY REDEMPTION
Upon the occurrence of a Change of Control (as defined below), each
holder of Notes shall have the right to require that Penn Treaty repurchase such
holder's Notes in whole or in part in integral multiples of $1,000, at a
purchase price in cash in an amount equal to 101% of the principal amount
thereof, together with accrued and unpaid interest to the date of repurchase,
pursuant to an offer (the "Change of Control Offer") made in accordance with the
procedures described below and the other provisions in the indenture.
A "Change of Control" means an event or series of events in which (i)
any "person" or "group" (as such terms are used in Sections 13(d) and 14(d) of
the Exchange Act) acquires "beneficial ownership" (as determined in accordance
with Rule 13d-3 promulgated under the Exchange Act), directly or indirectly, of
more than 50% of the total Voting Stock (as defined below) of Penn Treaty at an
Acquisition Price (as defined below) less than the conversion price then in
effect with respect to the Notes and (ii) the holders of the common stock
receive consideration which is not all or substantially all common stock that is
(or upon consummation of or immediately following such event or events will be)
listed on a United States national securities exchange or approved for quotation
on the Nasdaq Stock Market or any similar United States system of automated
dissemination of quotations of securities' prices; provided, however, that any
such person or group shall not be deemed to be the beneficial owner of, or to
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beneficially own, any Voting Stock tendered in a tender offer until such
tendered Voting Stock is accepted for purchase under the tender offer. "Voting
Stock" means stock of the class or classes pursuant to which the holders thereof
have the general voting power under ordinary circumstances to elect at least a
majority of the board of directors, managers or trustees of a corporation
(irrespective whether or not at the time stock of any other class or classes
shall have or might have voting power by reason of the happening of any
contingency). "Acquisition Price" means the weighted average price paid by the
person or group in acquiring the Voting Stock.
Within 30 days following any Change of Control, we shall send by
first-class mail, postage prepaid, to the trustee and to each holder of Notes,
at such holder's address appearing in the Note register, a notice stating, among
other things, that a Change of Control has occurred, the repurchase price, the
repurchase date, which shall be a business day no earlier than 30 days nor later
than 60 days from the date such notice is mailed, and certain other procedures
that a holder of Notes must follow to accept a Change of Control Offer or to
withdraw such acceptance.
We will comply, to the extent applicable, with the requirements of Rule
13e-4 and Rule 14e-1 promulgated under the Exchange Act and other securities
laws or regulations, to the extent such laws are applicable, in connection with
the repurchase of the Notes as described above.
Future indebtedness of Penn Treaty may contain prohibitions of certain
events that would constitute a Change of Control or require Penn Treaty to offer
to repurchase such indebtedness upon a Change of Control. Moreover, the exercise
by the holders of Notes of their right to require Penn Treaty to purchase the
Notes could cause a default under such indebtedness, even if the Change of
Control itself does not, due to the financial effect of such purchase on Penn
Treaty. Finally, our ability to pay cash to holders of Notes upon a purchase may
be limited by Penn Treaty's then existing financial resources. There can be no
assurance that sufficient funds will be available when necessary to make any
required purchases. See "Risk Factors." Furthermore, the Change of Control
provisions may in certain circumstances make more difficult or discourage a
takeover of Penn Treaty and the removal of incumbent management.
MERGER, CONSOLIDATION AND SALE OF ASSETS
The indenture prohibits Penn Treaty from consolidating with or merging
with or into, or conveying, transferring or leasing all or substantially all of
its assets (determined on a consolidated basis), to any person unless: (i)
either Penn Treaty is the resulting, surviving or transferee person (the
"Successor Company") or the Successor Company is a person organized and existing
under the laws of the United States or any state thereof or the District of
Columbia, and the Successor Company (if not Penn Treaty) expressly assumes by a
supplemental indenture, executed and delivered to the trustee, in form
satisfactory to the trustee, all the obligations of Penn Treaty under the
indenture and the Notes, including the conversion rights described above under
"- Conversion of the Notes," (ii) immediately after giving effect to such
transaction no Event of Default (as defined below) has occurred and is
continuing, and (iii) Penn Treaty has delivered to the trustee an officers'
certificate and an opinion of counsel, each stating that such consolidation,
merger or transfer and such supplemental indenture (if any) comply with the
indenture.
EVENTS OF DEFAULT AND REMEDIES
An Event of Default is defined in the indenture as being, among other
things: default in payment of the principal of or premium, if any, on the Notes
when due at maturity, upon redemption or otherwise, including failure by Penn
Treaty to purchase the Notes when required as described under "- Mandatory
Redemption" (whether or not such payment shall be prohibited by the
subordination provisions of the
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indenture); default for 30 days in payment of any installment of interest on the
Notes (whether or not such payment shall be prohibited by the subordination
provisions of the indenture); default by Penn Treaty for 90 days after notice in
the observance or performance of any other covenants in the indenture; final
judgments or decrees entered into by a court of competent jurisdiction against
Penn Treaty or any subsidiary involving liabilities of $25 million or more after
deducting the portion of such liabilities accepted by an insurance company; or
certain events involving bankruptcy, insolvency or reorganization of Penn
Treaty. The indenture provides that the trustee may withhold notice to the
holders of Notes of any default (except in payment of principal, premium, if
any, or interest with respect to the Notes) if the trustee, in good faith,
considers it in the interest of the holders of the Notes to do so.
The indenture provides that if an Event of Default (other than an Event
of Default with respect to certain events, including bankruptcy, insolvency or
reorganization of Penn Treaty) shall have occurred and be continuing, the
trustee or the holders of not less than 25% in principal amount of the Notes
then outstanding may declare the principal of and premium, if any, on the Notes
to be due and payable immediately, but if Penn Treaty shall pay or deposit with
the trustee a sum sufficient to pay all matured installments of interest on all
Notes and the principal and premiums, if any, on all Notes that have become due
other than by acceleration and certain expenses and fees of the trustee and if
all defaults (except the nonpayment of interest on, premium, if any, and
principal of any Notes which shall have become due by acceleration) shall have
been cured or waived and certain other conditions are met, such declaration may
be canceled and past defaults may be waived by the holders of a majority in
principal amount of the Notes then outstanding.
The holders of a majority in principal amount of the Notes then
outstanding shall have the right to direct the time, method and place of
conducting any proceedings for any remedy available to the trustee, subject to
certain limitations specified in the indenture. The indenture provides that,
subject to the duty of the trustee following an Event of Default to act with the
required standard of care, the trustee will not be under an obligation to
exercise any of its rights or powers under the indenture at the request or
direction of any of the holders, unless the trustee receives satisfactory
indemnity against any associated costs, liability or expense.
SATISFACTION AND DISCHARGE; DEFEASANCE
The indenture will cease to be of further effect as to all outstanding
Notes (except as to (i) rights of the holders of Notes to receive payments of
principal of, premium, if any, and interest on, the Notes, (ii) rights of
holders of Notes to convert to common stock or, in certain circumstances, cash,
(iii) Penn Treaty's right of optional redemption, (iv) rights of registration of
transfer and exchange, (v) substitution of apparently mutilated, defaced,
destroyed, lost or stolen Notes, (vi) rights, obligations and immunities of the
trustee under the indenture and (vii) rights of the holders of Notes as
beneficiaries of the indenture with respect to the property so deposited with
the trustee payable to all or any of them) if (A) Penn Treaty will have paid or
caused to be paid the principal of, premium, if any, and interest on the Notes
as and when the same will have become due and payable or (B) all outstanding
Notes (except lost, stolen or destroyed Notes which have been replaced or paid)
have been delivered to the trustee for cancellation or (C) (x) the Notes not
previously delivered to the trustee for cancellation will have become due and
payable or are by their terms to become due and payable within one year or are
to be called for redemption under arrangements satisfactory to the trustee upon
delivery of notice and (y) Penn Treaty will have irrevocably deposited with the
trustee, as trust funds, cash, in an amount sufficient to pay principal of and
interest on the outstanding Notes, to maturity or redemption, as the case may
be. Such trust may only be established if such deposit will not result in a
breach or violation of, or constitute a default under, any agreement or
instrument pursuant to which Penn Treaty is a party or by which it is bound and
Penn Treaty has delivered to the trustee an officers' certificate and an opinion
of counsel, each stating that all conditions related to such defeasance have
been complied with.
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The indenture will also cease to be in effect (except as described in
clauses (i) through (vii) in the immediately preceding paragraph) and the
indebtedness on all outstanding Notes will be discharged on the 123rd day after
the irrevocable deposit by Penn Treaty with the trustee, in trust, specifically
pledged as security for, and dedicated solely to, the benefit of the holders of
the Notes, of cash, U.S. Government Obligations (as defined in the indenture) or
a combination thereof, in an amount sufficient, in the opinion of a nationally
recognized firm of independent public accountants expressed in a written
certification thereof delivered to the trustee, to pay the principal of,
premium, if any, and interest on the Notes then outstanding in accordance with
the terms of the indenture and the Notes ("legal defeasance"). Such legal
defeasance may only be effected if (i) no Event of Default has occurred or is
continuing, (ii) such deposit will not result in a breach or violation of, or
constitute a default under, any agreement or instrument to which Penn Treaty is
a party or by which it is bound, (iii) Penn Treaty has delivered to the trustee
an opinion of counsel stating that (A) Penn Treaty has received from, or there
has been published by, the Internal Revenue Service (the "Service") a ruling or
(B) since the date of the indenture, there has been a change in the applicable
Federal income tax law, in either case to the effect that, based thereon, the
holders of the Notes will not recognize income, gain or loss for Federal income
tax purposes as a result of such deposit, defeasance and discharge by Penn
Treaty and will be subject to Federal income tax on the same amount and in the
same manner and at the same times as would have been the case if such deposit,
defeasance and discharge had not occurred, (iv) Penn Treaty has delivered to the
trustee an opinion of counsel to the effect that after the 123rd day following
the deposit, the trust funds will not be subject to the effect of any applicable
bankruptcy, insolvency, reorganization or similar laws affecting creditors'
rights generally and (v) Penn Treaty has delivered to the trustee an officers'
certificate and an opinion of counsel stating that all conditions related to the
defeasance have been complied with.
Penn Treaty may also be released from its obligations under the
covenants described above captioned "- Mandatory Redemption" and "- Merger,
Consolidation and Sale of Assets" with respect to the Notes outstanding on the
123rd day after the irrevocable deposit by Penn Treaty with the trustee, in
trust, specifically pledged as security for, and dedicated solely to, the
benefit of the holders of the Notes, of cash, U.S. Government Obligations or a
combination thereof, in an amount sufficient in the opinion of a nationally
recognized firm of independent public accountants expressed in a written
certification thereof delivered to the trustee, to pay the principal of,
premium, if any, and interest on the Notes then outstanding in accordance with
the terms of the indenture and the Notes ("covenant defeasance"). Such covenant
defeasance may only be effected if (i) no Event of Default has occurred or is
continuing, (ii) such deposit will not result in a breach or violation of, or
constitute a default under, any agreement or instrument to which Penn Treaty is
a party or by which it is bound, (iii) Penn Treaty has delivered to the trustee
an officers' certificate and an opinion of counsel to the effect that the
holders of the Notes will not recognize income, gain or loss for federal income
tax purposes as a result of such deposit and covenant defeasance by Penn Treaty
and will be subject to federal income tax on the same amount, in the same manner
and at the same times as would have been the case if such deposit and covenant
defeasance had not occurred, (iv) Penn Treaty has delivered to the trustee an
opinion of counsel to the effect that after the 123rd day following the deposit,
the trust funds will not be subject to the effect of any applicable bankruptcy,
insolvency, reorganization or similar laws affecting creditors' rights generally
and (v) Penn Treaty has delivered to the trustee an officers' certificate and an
opinion of counsel stating that all conditions related to the covenant
defeasance have been complied with. Following such covenant defeasance, Penn
Treaty will no longer be required to comply with the obligations described above
under "Merger, Consolidation and Sale of Assets" and will have no obligation to
repurchase the Notes pursuant to the provisions described under "- Mandatory
Redemption."
Notwithstanding any satisfaction and discharge or defeasance of the
indenture, the obligations of Penn Treaty described under "- Conversion of the
Notes" will survive to the extent provided in the indenture until the Notes
cease to be outstanding.
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MODIFICATIONS OF THE INDENTURE
The indenture contains provisions permitting Penn Treaty and the
trustee, with the consent of the holders of not less than a majority in
principal amount of the Notes at the time outstanding, to modify the indenture
or any supplemental indenture or the rights of the holders of the Notes, except
that no such modification shall (i) extend the fixed maturity of any Note,
reduce the rate or extend the time of payment of interest thereon, reduce the
principal amount thereof or premium, if any, thereon, reduce any amount payable
upon redemption thereof, change the obligation of Penn Treaty to repurchase the
Notes, at the option of the holder, upon the happening of a Change of Control,
impair or affect the right of a holder to institute suit for the payment
thereof, change the currency in which the Notes are payable, modify the
subordination provisions of the indenture in a manner adverse to the holders of
the Notes or impair the right to convert the Notes into common stock subject to
the terms set forth in the indenture, without the consent of the holder of each
Note so affected or (ii) without the consent of holders of all the Notes then
outstanding, reduce the aforesaid percentage of Notes, the holders of which are
required to consent to any such modification or supplemental indenture. The
trustee may modify or supplement the indenture without notice to or consent of
any holder in certain events, such as to make provision for certain conversion
rights, to provide for the issuance of Notes in coupon form, to correct or
supplement any inconsistent or deficient provision in the indenture, to comply
with the provisions of the Trust Indenture Act of 1939 or to appoint a successor
trustee.
CONCERNING THE TRUSTEE
Wells Fargo Bank, National Association, the trustee under the indenture,
has been appointed by Penn Treaty as the paying agent, conversion agent,
registrar and custodian with regard to the Notes. The trustee and/or its
affiliates may in the future provide banking and other services to us in the
ordinary course of their respective businesses. Under the indenture, each holder
or former holder of a Note agrees to indemnify Penn Treaty and the trustee
against any liability that may result from the transfer, exchange or assignment
of such holder's or former holder's Note in violation of any provision of the
indenture or applicable United States federal or state securities laws.
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DESCRIPTION OF COMMON STOCK
We are currently authorized to issue 150,000,000 shares of common stock,
par value $.10 per share, and 5,000,000 shares of preferred stock, par value
$1.00 per share. As of May 6, 2005, 48,643,824 shares of common stock and no
shares of our preferred stock were outstanding.
The following summary description of our common stock is qualified in
its entirety by reference to our Restated and Amended Articles of Incorporation,
as amended, and our Amended and Restated By-Laws, as amended, copies of which
are filed as exhibits to our Registration Statement on Form S-1 (File No.
33-92690), our Registration Statement on Form S-3 (File No. 333-22125), our
Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, our Annual
Report on Form 10-K for the year ended December 31, 2002 and our Registration
Statement on From S-1 (333-119966).
DIVIDENDS
Subject to the rights of the holders of preferred stock, if any, the
holders of our common stock are entitled to receive dividends and other
distributions in cash, stock or property when, as and if declared by the Board
of Directors out of our assets or funds legally available therefor and shall
share equally on a per share basis in all such dividends and other
distributions.
VOTING RIGHTS
At every meeting of shareholders, every holder of our common stock is
entitled to one vote per share. Subject to any voting rights which may be
granted to holders of preferred stock, any action submitted to shareholders is
approved if the number of votes cast in favor of such action exceeds the number
of votes required by the provisions of our Articles of Incorporation or by
applicable law, subject to applicable quorum requirements. Our Articles of
Incorporation require the affirmative vote of at least 67% of the voting power
of all of our shareholders with respect to fundamental corporate transactions
including mergers, consolidations and sales of all or substantially all assets.
Our Bylaws provide for action by written consent.
MISCELLANEOUS
The holders of common stock have no cumulative voting rights or
preemptive rights and the common stock is not subject to conversion or
redemption.
The transfer agent and registrar with respect to the common stock is
Wachovia Bank, National Association.
All shares of common stock issuable upon conversion of the Notes or as
payment of discounted interest on any Notes converted prior to October 15, 2005
from the date of conversion to October 15, 2008 will, when issued, be fully paid
and non-assessable. The common stock is traded on the New York Stock Exchange
under the symbol "PTA."
The rights evidenced by, and amounts payable with respect to, our common
stock may be materially limited or qualified by the rights of any preferred
stock issued by us in the future. Our preferred stock may be issued from time to
time in one or more series with such designations, preferences and rights of the
shares of such series and the qualifications, limitations or restrictions
thereon, including, but not limited to, dividend rights, dividend rate or rates,
conversion rights, voting rights, rights and terms of redemption and the
liquidation preference established by our Board of Directors, without approval
of the shareholders, pursuant to the provisions of our Restated and Amended
Articles of Incorporation, as
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amended. The issuance of preferred stock may have the effect of delaying,
deferring or preventing a change in control without further action by our
shareholders.
ANTI-TAKEOVER PROVISIONS
Our Board of Directors is divided into three classes, each of which is
comprised of three directors elected for a three-year term, with one class being
elected each year. Directors may be removed without cause only with the approval
of 67% of the voting power of our shareholders entitled to vote in the election
of directors. Any director elected to fill a vacancy, however created, serves
for the remainder of the term of the director which he or she replaces.
Our Restated and Amended Articles of Incorporation, as amended, require
the affirmative vote of shareholders owning at least 67% of the outstanding
shares of our common stock in order for us to: amend or repeal any provision of
or to add any provision to the Restated and Amended Articles of Incorporation,
as amended; merge or consolidate with another corporation, other than a
wholly-owned subsidiary; exchange shares of our common stock in such a manner
that a corporation, person or entity acquires the issued or outstanding shares
of our common stock pursuant to a vote of shareholders; sell, lease, convey,
encumber or otherwise dispose of all or substantially all of our property or
business; or dissolve or liquidate.
In addition, the Restated and Amended Articles of Incorporation, as
amended, permit the Board of Directors to oppose a tender offer or other offer
for our securities, and allow the Board to consider any pertinent issue in
determining whether to oppose any such offer.
Pursuant to our Amended and Restated By-Laws, as amended, shareholder
nominations for election to the Board of Directors must be made in writing and
delivered or mailed to our President not less than fifty days nor more than
seventy-five days prior to any meeting of shareholders called for the election
of directors; provided, however, that if less than fifty days' notice of the
meeting is given to shareholders, such nominations shall be mailed or delivered
to the President not later than the close of business on the seventh day
following the day on which the notice of the meeting was mailed.
The Pennsylvania Business Corporation Law of 1988, as amended (the "1988
BCL"), includes certain shareholder protection provisions, some of which apply
to us and two of which, relating to "Disgorgement by Certain Controlling
Shareholders" and "Control Share Acquisitions," we have specifically opted out
of pursuant to our Amended and Restated By-Laws, as amended. The following is a
description of those provisions of the 1988 BCL that still apply to us and that
may have an anti-takeover effect. This description of the 1988 BCL is only a
summary, does not purport to be complete and is qualified in its entirety by
reference to the full text of the 1988 BCL.
(i) The control transaction provisions allow holders of voting
shares of a corporation to "put" their stock to an acquirer for
fair value in the event of a control transaction (the
acquisition of twenty percent of the voting stock of the
corporation). Fair value is defined as not less than the highest
price paid by the acquirer during a certain 90-day period.
(ii) An interested shareholder (the beneficial owner of twenty
percent of the voting stock either of a corporation or an
affiliate of the corporation who was at any time within the
five-year period immediately prior to the date in question the
beneficial owner of twenty percent of the voting stock of the
corporation) cannot engage in a business combination with the
corporation for a period of five years unless: (a) the board
approves the business combination or the acquisition of shares
in advance, (b) if the interested shareholder owns
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eighty percent of such stock, the business combination is
approved by a majority of the disinterested shareholders and the
transaction satisfies certain "fair price" provisions or (c) the
business combination is approved by all shareholders. After the
five-year period, the same restrictions apply, unless the
transaction either is approved by a majority of the
disinterested shareholders or is approved by a majority of all
shareholders and satisfies the fair price provisions.
(iii) Corporations may adopt shareholders' rights plans with
discriminatory provisions (sometimes referred to as poison
pills) whereby certain options to acquire shares or corporate
assets are created and issued. These options contain terms that
limit persons owning or offering to acquire a specified
percentage of outstanding shares from exercising, converting,
transferring or receiving the options and allows the exercise of
the options to be limited to shareholders or triggered based
upon control transactions. Such poison pills take effect only in
the event of a control transaction. Such poison pills may be
adopted by the Board without shareholder approval.
(iv) In taking action with respect to tender offers or takeover
proposals (as for any other action), directors may, in
considering the best interests of the corporation, consider the
effects of any action upon shareholders, employees, suppliers,
customers, creditors, communities where offices or other
establishments of the corporation are located and all other
pertinent factors.
(v) Shareholders of a corporation no longer have a statutory right
to call special meetings of shareholders or to propose
amendments to the articles.
The foregoing provisions may discourage certain types of transactions
that involve a change of control and ensure a measure of continuity in the
management of our business and affairs. While we do not currently have a
shareholder rights plan or poison pill, the effect of the above-described
provisions may be to deter hostile takeovers at a price higher than the
prevailing market price for our common stock and to permit our current
management to remain in control. In some circumstances, certain shareholders may
consider these anti-takeover provisions to have disadvantageous effects. Tender
offers or other non-open market acquisitions of stock are frequently made at
prices above the prevailing market price of the target's stock. In addition,
acquisitions of stock by persons attempting to acquire control through market
purchases may cause the market price of the stock to reach levels that are
higher than would otherwise be the case. Anti-takeover provisions may discourage
any or all of such acquisitions, particularly those of less than all of our
shares, and may thereby deprive certain holders of our common stock of any
opportunity to sell their stock at a temporarily higher market price.
Pursuant to an amendment to our Amended and Restated By-laws, we opted
out of two additional statutory anti-takeover provisions. The first, titled
"Disgorgement by Certain Controlling Shareholders Following Attempts to Acquire
Control," would otherwise allow us to recover all profits derived by any person
or group that acquired or disclosed an intention to acquire voting power over
twenty percent of our equity securities on certain dispositions of any of our
securities acquired within two years prior or eighteen months after acquiring
such control or announcing an intention to that effect. The second, titled
"Control-Share Acquisitions," would otherwise suspend certain voting rights of a
shareholder when his or her ownership of our securities crossed any of three
thresholds (20%, 33 1/3% or 50%). The voting rights are held in abeyance until
the shareholders holding a majority of disinterested shares vote to restore
them. The inapplicability of these provisions mitigates somewhat the deterrence
of hostile anti-takeover attempts at prices in excess of the prevailing market
prices and lessens the ability of current management to retain control.
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In addition to provisions of the 1988 BCL, the Pennsylvania Insurance
Code provides that no person may acquire control of us unless such person has
given prior written notice to us and received the prior approval of the
Pennsylvania Insurance Commissioner. Any purchaser or holder of shares is
presumed to have acquired such control unless the Pennsylvania Insurance
Commissioner, upon receipt of an application, has determined otherwise.
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CERTAIN FEDERAL INCOME TAX CONSEQUENCES
The following is a general summary of the principal federal income tax
considerations relevant to holders of the Securities. This summary is qualified
in its entirety by reference to, and is based upon, the Internal Revenue Code of
1986 (the "Code"), and other laws, regulations, rulings and decisions in effect
on the date of this offering memorandum as those laws, regulations, rulings and
decisions were interpreted on such date. This summary does not discuss all
aspects of federal income taxation that may be relevant to a particular investor
or to certain types of investors subject to special treatment under the federal
income tax laws (for example, banks, dealers in securities, life insurance
companies, tax-exempt organizations and non-U.S. holders (as defined below)), or
any aspect of state, local or foreign tax laws.
As used herein, a "U.S. holder" means a beneficial owner of Securities
that is a citizen or resident (within the meaning of Section 7701(b) of the
Code) of the United States, a corporation (including a non-corporate entity
taxable as a corporation) formed under the laws of the United States or any
political subdivision thereof, an estate the income of which is subject to
United States federal income taxation regardless of its source and a trust
subject to the primary supervision of a court within the United States and the
control of a United States fiduciary as described in Section 7701(a)(30) of the
Code or any other person whose income or gain with respect to a Security is
effectively connected with the conduct of a United States trade or business. If
an entity treated as a partnership for federal income tax purposes holds
Securities, the tax treatment of a partner depends upon the status of the
partner and the activities of the partnership. A "non-U.S. holder" is any
beneficial owner of Securities other than a U.S. holder.
We intend to treat the Notes as indebtedness for federal income tax
purposes. Such characterization is binding on us (but not the Internal Revenue
Service or a court). Each holder of a Note also must treat the Notes as
indebtedness unless the holder makes adequate disclosure on its income tax
return.
Prospective investors are urged to consult their own tax advisors to
determine the potential tax consequences of acquisition, ownership and
disposition of the Securities that are relevant to their particular situations.
STATED INTEREST AND PREMIUM ON THE NOTES
The stated interest on the Notes will be includable in a holder's gross
income as ordinary income for federal income tax purposes at the time it is paid
or accrued in accordance with the holder's regular method of tax accounting,
regardless of whether such interest is paid in cash or shares of common stock.
The Notes will be issued at a "premium" if a holder's tax basis in the
Notes immediately after their acquisition (reduced by the value of the
conversion option as discussed below) exceeds the sum of all amounts payable on
the Note after the acquisition date (other than payments of qualified stated
interest). The stated interest on the Notes will constitute "qualified stated
interest" and will therefore not be taken into account in determining the amount
of "premium" on the Notes. A holder's basis in the Notes is reduced by an amount
equal to the value of the conversion option. The value of the conversion option
may be determined under any reasonable method. A holder may, for example,
determine the value of the conversion option by comparing the market price of
the Notes to the market prices of Notes with similar credit ratings that do not
have conversion options.
A holder may elect to amortize premium as an offset to interest income
(and not as a separate deduction item) as it accrues under a constant yield
method. A holder's tax basis in the Note will be reduced by the amount of the
amortized premium. Any such election shall apply to all debt instruments, other
than instruments the interest on which is excludable from gross income, held by
the holder at the
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beginning of the first taxable year for which the election applies or thereafter
acquired and is irrevocable without the consent of the Internal Revenue Service.
Premium on a Note held by a holder who has not elected to amortize the premium
will decrease the gain or increase the loss otherwise recognized on the
disposition of the Note.
MARKET DISCOUNT
The Notes may be subject to the "market discount" rules of the Code if
held in the hands of a holder not acquiring them at original issue. In general,
these rules apply if the holder purchases a Note at a discount from its stated
redemption price at maturity that is equal to or greater than 1/4 of 1 percent
of the stated redemption price at maturity of the debt instrument multiplied by
the number of complete years to maturity after the holder has acquired the Note.
If the holder acquires a Note at a market discount and (a) recognizes gain upon
a disposition, or (b) receives payments that do not constitute qualified stated
interest, the lesser of (i) such gain or payment or (ii) the accrued market
discount that has not previously been included in income will be taxed as
ordinary income.
Generally, market discount accrues in the ratio of the number of days
the holder has held the Note to the number of days after the holder acquired the
Note up to (and including) the date of its maturity. A holder may elect,
however, to determine accrued market discount for any Note under the constant
yield method.
Limitations imposed by the Code which are intended to match deductions
with the taxation of income may defer deductions for interest on indebtedness
incurred or continued, or short-sale expenses incurred, to purchase or carry a
security with accrued market discount. A holder may elect to include market
discount in gross income as its accrues. If it makes this election, the holder
will not be required to defer deductions. Any such election will apply to all
debt instruments acquired by the holder on or after the first day of the first
taxable year to which such election applies. The adjusted basis of a security
subject to such election will be increased to reflect market discount included
in gross income, thereby reducing any gain or increasing any loss on a sale or
taxable disposition.
SALE, EXCHANGE OR RETIREMENT OF THE NOTES
A holder generally will recognize gain or loss on the sale, exchange or
retirement of Notes equal to the difference between the amount realized on the
sale, exchange or retirement of the Notes (other than amounts attributable to
accrued interest but including any redemption premium) and the holder's adjusted
tax basis in the Notes. Any gain or loss recognized on the sale, exchange or
retirement of Notes will generally be long-term capital gain or loss if the
holder has held the Notes as capital assets for more than one year, except that
any gain attributable to accrued market discount will (as described above) be
taxable as ordinary income.
CONSTRUCTIVE DIVIDEND
If at any time we make a distribution of property to shareholders that
would be taxable to such shareholders as a dividend for federal income tax
purposes and, pursuant to the anti-dilution provisions of the indenture, the
conversion price of the Notes is reduced, such reduction may be deemed to be the
payment of a taxable dividend to holders of Notes. If the conversion rate is
increased at our discretion, this increase may be deemed to be the payment of a
taxable dividend to holders of Notes.
105
CONVERSION OF NOTES INTO COMMON STOCK
A holder's conversion of a Note into common stock generally will not be
a taxable event. The holder's tax basis in the common stock received on
conversion of Notes will be the same as the holder's adjusted tax basis in the
Notes at the time of conversion, exclusive of any tax basis allocable to a
fractional share for which the holder receives cash. The holding period for the
common stock received on conversion will include the holding period of the Notes
converted. The receipt of cash in lieu of fractional shares of common stock
should generally result in capital gain or loss. This capital gain or loss will
be measured by the difference between the cash received for the fractional share
interest and the holder's tax basis in the fractional share interest.
If any Notes are converted prior to October 15, 2005, we will be
required to pay the holders of those Notes an amount equal to the interest that
would have been otherwise earned on those Notes between the date of conversion
and October 15, 2005, discounted from October 15, 2005 to present value using a
rate of 6.25% (the "Prepaid Interest.") We may, in our sole discretion, pay the
Prepaid Interest in cash or in shares of common stock. If we elect to pay the
Prepaid Interest in common stock, we will determine the number of shares to be
issued based on a per share value equal to 90% of the average closing prices of
the common stock for the five trading days immediately preceding the conversion
date. The amount of cash or the value of common stock received as Prepaid
Interest will be includable in a holder's gross income as ordinary income for
federal income tax purposes at the time of receipt.
DISTRIBUTIONS MADE ON COMMON STOCK
Distributions, if any, paid on the common stock after a conversion, to
the extent made from our current or accumulated earnings and profits, will be
included in a holder's income as ordinary income as they are paid. Distributions
in excess of our current and accumulated earnings and profits will reduce a
holder's basis for the common stock until the basis is zero and any additional
distributions in excess of our current and accumulated earnings and profits will
be short term or long term gain, depending upon whether the holder's holding
period for the common stock exceeds one year.
Any distribution on our common stock qualifying as a dividend: (i) will
be eligible for the dividends received deduction if the holder is an otherwise
qualifying corporate U.S. Holder that meets the holding period and other
requirements for the dividends received deduction, and (ii) if received by a
non-corporate U.S. Holder in tax years beginning on or before December 31, 2008,
will be taxed at the preferential rates applicable to net capital gain (15% or
5%) if it qualifies as "qualified dividend income" and the holder meets certain
holding period and other applicable requirements.
SALE OR EXCHANGE OF COMMON STOCK
Gain or loss realized on a sale or exchange of common stock will equal
the difference between the amount realized on such sale or exchange and the
holder's adjusted tax basis in such stock. Such gain or loss will generally be
long-term capital gain or loss if the holder's holding period in the common
stock is more than one year. However, under the market discount rules described
above, any gain recognized by a holder will be ordinary income to the extent of
the accrued market discount that had not been included in income prior to the
conversion of the Note into common stock.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Payments on the Notes, and payments of dividends on the Common Stock to
certain non-corporate holders generally will be subject to information reporting
and possibly to "backup withholding" at a rate of 28%.
106
Any amounts withheld from a payment to a holder under the backup
withholding rules will be allowed as a credit against such holder's federal
income tax, and may entitle such holder to a refund, provided that the required
information is furnished to the Internal Revenue Service.
107
ERISA CONSIDERATIONS
The following is a summary of certain considerations associated with the
acquisition of the Securities by employee benefit plans that are subject to the
fiduciary responsibility provisions of the Employee Retirement Income Security
Act of 1974, as amended ("ERISA"), and the prohibited transaction provisions of
ERISA and the Code, that should be considered when using plan assets to acquire
the Securities. The following is merely a summary of those issues, however, and
should not be construed as legal advice or as complete in any respect. We urge
you to consult your own legal advisers before investing plan assets in the
Securities and to make your own independent decision.
ERISA and the Code impose certain requirements on employee benefit
plans, and certain other retirement plans and arrangements, including individual
retirement accounts and annuities, Keogh plans, and any entity that, under the
Department of Labor's plan asset regulation, is deemed to hold the assets of any
such plan, account or annuity (such as a bank collective investment fund, an
insurance company general or separate account and certain other commingled
funds) (collectively, "Plans"), and on persons who are fiduciaries with respect
to Plans, in connection with the investment of the assets of any Plan ("Plan
Assets"). Generally, a person who exercises discretionary authority or control
with respect to Plan Assets will be considered a fiduciary of the Plan under
ERISA. Before investing in the Securities, a Plan fiduciary or other Plan
investor should determine whether such investment and the holding of the
Securities is permitted under the Plan document and the instruments governing
the Plan and is appropriate for the Plan in view of its overall investment
policy and the composition and diversification of its portfolio.
In addition, ERISA and the Code prohibit a wide range of transactions
between Plans and persons who have certain specified relationships to those
Plans. These persons are referred to as "parties in interest" under ERISA and
"disqualified persons" under the Code and we refer to them collectively herein
as "Parties in Interest." Parties in Interest that participate in a prohibited
transaction and the fiduciaries that allow them may be subject to a penalty
imposed under ERISA and/or an excise tax imposed pursuant to Section 4975 of the
Code, unless a statutory or administrative exemption is available. These
prohibited transactions generally are set forth in Section 406 of ERISA and
Section 4975 of the Code. Thus, a Plan fiduciary or other Plan investor
considering an investment in the Securities should also consider whether such
investment might constitute or give rise to a prohibited transaction under ERISA
or the Code for which no statutory or administrative exemption (as discussed
below) is available.
The acquisition of Notes by a Plan could result in a prohibited
transaction if the seller, any of the seller's affiliates, we or any of our
affiliates is a Party in Interest with respect to the Plan at the time of the
acquisition. The acquisition of shares of Common Stock by a Plan could result in
a prohibited transaction if the seller or any of the seller's affiliates is a
Party in Interest with respect to the Plan at the time of the acquisition. The
holding of Notes by a Plan could result in a prohibited transaction if we or any
of our affiliates is a Party in Interest with respect to the Plan during the
time the Notes are held. The subsequent sale of the Securities by a Plan could
result in a prohibited transaction if the purchaser or an affiliate is a Party
in Interest with respect to the Plan.
A transaction would be treated as exempt from some of the prohibited
transaction rules of ERISA and the Code if the Securities were acquired, held or
disposed of pursuant to and in accordance with one or more statutory or
administrative exemptions. Among the administrative exemptions (each, a
"Prohibited Transaction Class Exemption," or "PTCE") are PTCE 75-1 (an exemption
for certain transactions involving employee benefit plans and registered broker
dealers, such as the initial purchasers, reporting dealers and banks), PTCE
84-14 (an exemption for certain transactions determined by an independent
qualified professional asset manager), PTCE 90-1 (an exemption for certain
transactions involving insurance company pooled separate accounts), PTCE 91-38
(an exemption for certain transactions involving bank collective investment
funds), PTCE 95-60 (an exemption for certain
108
transactions involving insurance company general accounts) and PTC 96-23 (an
exemption for certain transactions determined by a qualified in-house asset
manager). Certain of the exemptions, however, do not afford relief from the
prohibitions on self-dealing contained in Section 406(b) of ERISA and Section
4975(c)(1)(E)-(F) of the Code. In addition, there can be no assurance that any
of these administrative exemptions will be available with respect to any
particular transaction involving the Securities. Thus, a Plan fiduciary
considering an investment in the Securities should consider whether the
acquisition, the continued holding or the ultimate disposition of the Securities
might constitute or give rise to a nonexempt prohibited transaction.
Governmental plans (as defined in Section 3(32) of ERISA) and certain
church plans (as defined in Section 3(33) of ERISA), while not subject to the
fiduciary responsibility provisions or the prohibited transactions provisions of
ERISA or the Code, may nevertheless be subject to state, local or other federal
laws that are substantially similar to the foregoing provisions of ERISA and the
Code. Furthermore, any such plan that is qualified and exempt from taxation
under Sections 401(a) and 501(a) of the Code is subject to the prohibited
transaction rules set forth in Section 503 of the Code.
Based on the reasoning of the United States Supreme Court in John
Hancock Mutual Life Ins. Co. v. Harris Trust and Sav. Bank, 114 S. Ct. 517
(1993), an insurance company's general account may be deemed to include assets
of the Plans investing in the general account (e.g. through the purchase of an
annuity contract), and the insurance company may be treated as a fiduciary of
and a Party in Interest with respect to a Plan by virtue of such investment. Any
purchaser of the Securities that is an insurance company using the assets of an
insurance company general account should consider the implications of Section
401(c) of ERISA, as interpreted by final regulations issued by the Department of
Labor effective as of January 5, 2000, (the "General Account Regulations") that
provide a safe harbor for certain insurance policies issued on or before
December 31, 1998, to employee benefit plans that are supported by an insurer's
general account. As a result of the General Account Regulations, effective as of
July 5, 2001, assets of an insurance company's general account will not be
treated as "plan assets" for purposes of the fiduciary responsibility provisions
of ERISA and Section 4975 of the Code to the extent such assets relate to
contracts issued to employee benefit plans on or before December 31, 1998 and
the insurer satisfies various conditions.
Due to the complexity of these rules and the penalties that may be
imposed upon fiduciaries and Parties in Interest in non-exempt prohibited
transactions, it is particularly important that a Plan fiduciary (and each
fiduciary of a governmental or church plan subject to rules similar to those
imposed on plans subject to ERISA) and other persons considering purchasing
Securities on behalf of, or with Plan Assets of, any Plan consult their tax
and/or legal advisers regarding the availability, if any, of exemptive relief
from any potential prohibited transaction and other fiduciary issues and
potential consequences related to the acquisition of Securities.
109
SELLING SECURITYHOLDERS
SERIES 1 NOTES
We are registering a total of $14,000,000 Series 1 Notes and 8,191,329
shares of Common Stock issuable upon or in connection with the conversion of the
Series 1 Notes on behalf of the selling securityholders named in the table
below. The Series 1 Notes were issued on February 2, 2004 pursuant to an
indenture between Penn Treaty and Wells Fargo Bank Minnesota, N.A., as trustee,
in a private placement transaction. We undertook to register the Series 1 Notes
and the Common Stock in the offering memorandum pursuant to which the Series 1
Notes were offered.
We are registering all of the Series 1 Notes and the related shares of
Common Stock covered by this prospectus on behalf of the selling
securityholders. We are registering the Series 1 Notes and the related shares of
Common Stock to permit the selling securityholders and their pledgees, donees,
transferees or other successors-in-interest that receive Series 1 Notes or
shares of Common Stock from the selling securityholders as a gift, partnership
distribution or another non-sale related transfer after the date of this
prospectus to resell the Series 1 Notes or shares of Common Stock when they deem
appropriate.
The table below sets forth, as of May 6, 2005, information regarding the
amount and percentage of 6 1/4% convertible subordinated notes due 2008 and
Series 1 Notes and the number and percentage of shares of Common Stock that each
selling securityholder beneficially owns. We have prepared the table based upon
information furnished to us by or on behalf of the selling securityholders.
Based on the information provided to us by the selling securityholders, none of
the selling securityholders beneficially owns any Series 1 Notes or shares of
Common Stock other than as listed below.
The selling securityholders confirmed at the time they acquired the
Series 1 Notes listed below that they were acquiring the Series 1 Notes for
investment purposes only and not with a view toward resale, and acknowledged the
existence of restrictions on resale applicable to the Series 1 Notes and the
related shares of Common Stock. The offering relates only to the sale of Series
1 Notes or related shares of Common Stock held or to be held by the selling
securityholders named in the table below. Since the date on which the selling
securityholders provided us with the information below, they may have sold,
transferred or otherwise disposed of some or all of their Series 1 Notes or
shares of Common Stock in transactions exempt from the registration requirements
of the Securities Act of 1933, as amended (the "Securities Act").
110
PERCENT
PRINCIPAL PRINCIPAL OF 6 1/4% PERCENT OF
AMOUNT OF 6 1/4% AMOUNT OF CONVERTIBLE SHARES OF COMMON
CONVERTIBLE SERIES 1 SUBORDINATED COMMON STOCK SHARES OF STOCK
SUBORDINATED NOTES OWNED NOTES DUE BENEFICIALLY COMMON BENEFICIALLY
NOTES DUE 2008 PRIOR TO THE 2008 OWNED OWNED STOCK OWNED AFTER
OWNED PRIOR TO OFFERING AND AFTER THE PRIOR TO THE OFFERED THE
THE OFFERING OFFERED HEREBY OFFERING(1) OFFERING(2) HEREBY(3) OFFERING(1)
------------ -------------- ----------- ----------- --------- -----------
Broadfield Capital LP................ $ 400,000 $ 300,000 * 434,037(4) 175,527 *
East Hudson Inc...................... 100,000 100,000 - 58,508 58,508 -
Elkhorn Partners, LP................. 6,415,000 600,000 7.5% 4,940,783(5) 351,056 8.8%
JMG Capital Partners LP.............. 1,500,000 500,000 1.3% 877,641 292,547 1.2%
JMG Triton Offshore Fund, Ltd........ 1,500,000 500,000 1.3% 877,641 292,547 1.2%
LC Capital Master Fund, Ltd.......... 11,094,000 4,000,000 9.2% 6,515,742(6) 2,340,379 7.9%
Libertyview Funds LP................. 660,000 210,000 * 386,161 122,869 *
Libertyview Special Opportunities
Fund LP............................ 1,540,000 490,000 1.4% 901,046 286,696 1.2%
Pandora Select Partners LP........... 3,220,000 500,000 3.5% 1,866,022(7) 292,547 3.1%
Perseus Capital Appreciation
Fund LP............................ 3,000,000 3,000,000 - 1,755,284 1,755,284 -
The Conus Fund LP.................... 676,000 676,000 - 395,523 395,523 -
The Conus Fund Offshore LTD.......... 119,000 119,000 - 69,626 69,626 -
The Conus Fund QP LP................. 105,000 105,000 - 61,434 61,434 -
Whitebox Convertible Arbitrage
Partners, LP....................... 5,400,000 1,300,000 5.3% 3,159,512 760,623 4.7%
Whitebox Diversified Convertible
Arbitrage Partners LP................ 800,000 100,000 * 468,075 58,508 *
Whitebox Hedged High Yield
Partners LP........................ 5,400,000 1,500,000 5.0% 3,159,512 877,641 4.5%
------------ -------------- -----------
TOTAL...................... $ 41,929,000 $ 14,000,000 36.1% 25,946,562(8) 8,191,329 27.3%
* Less than 1%.
(1) Percentage ownership is based on $77,334,000 in aggregate principal
amount of 6 1/4% Convertible Subordinated Notes dues 2008 and 48,643,824
shares of Common Stock outstanding on May 6, 2005 and assumes all Series
1 Notes or shares of Common Stock issuable upon or in connection with
conversion of Series 1 Notes that may be offered hereunder are sold.
Shares of Common Stock issuable upon or in connection with conversion of
a holder's Series 1 Notes are deemed outstanding in computing the
percentage beneficially owned by such holder but are not deemed
outstanding for purposes of computing the percentage beneficially owned
by any other person.
(2) Assumes conversion of all of the holder's 6 1/4% Convertible
Subordinated Notes due 2008 at a conversion price of $1.75 per share of
common stock on May 6, 2005, and includes, for each holder, shares of
common stock representing the maximum additional shares of common stock
that could have been issued, at the option of Penn Treaty, as payment of
discounted interest if such holder's 6 1/4% Convertible Subordinated
Notes due 2008 were converted on May 6, 2005. The number of shares
issuable as payment of discounted interest will vary based on Penn
Treaty's stock price and the number of days remaining until October 15,
2005.
(3) Includes shares of common stock issuable upon or in connection with
conversion of Series 1 Notes only.
(4) Includes 200,000 outstanding shares of Common Stock.
(5) Includes 1,187,400 outstanding shares of Common Stock.
(6) Includes 24,700 outstanding shares of Common Stock.
(7) Includes 2,017 outstanding shares of Common Stock.
(8) Includes 1,414,117 outstanding shares of Common Stock.
SERIES 2 NOTES
We are registering a total of $2,000,000 Series 2 Notes and 1,170,189
shares of Common Stock issuable upon or in connection with the conversion of the
Series 2 Notes on behalf of the selling securityholders named in the table
below. The Series 2 Notes were issued on February 19, 2004 pursuant to an
indenture between Penn Treaty and Wells Fargo Bank Minnesota, N.A., as trustee,
in a private placement transaction. We undertook to register the Series 2 Notes
and the Common Stock in the offering circular pursuant to which the Series 2
Notes were offered.
111
We are registering all of the Series 2 Notes and the related shares of
Common Stock covered by this prospectus on behalf of the selling
securityholders. We are registering the Series 2 Notes and the related shares of
Common Stock to permit the selling securityholders and their pledgees, donees,
transferees or other successors-in-interest that receive Series 2 Notes or
shares of Common Stock from the selling securityholders as a gift, partnership
distribution or another non-sale related transfer after the date of this
prospectus to resell the Series 2 Notes or shares of Common Stock when they deem
appropriate.
The table below sets forth, as of May 6, 2005, information regarding the
amount and percentage of 6 1/4% convertible subordinated notes due 2008 and
Series 2 Notes and the number and percentage of shares of Common Stock that each
selling securityholder beneficially owns. We have prepared the table based upon
information furnished to us by or on behalf of the selling securityholders.
Based on the information provided to us by the selling securityholders, none of
the selling securityholders beneficially owns any Series 2 Notes other than as
listed below.
The selling securityholders confirmed at the time they acquired the
Series 2 Notes listed below that they were acquiring the Series 2 Notes for
investment purposes only and not with a view toward resale, and acknowledged the
existence of restrictions on resale applicable to the Series 2 Notes and the
related shares of Common Stock. The offering relates only to the sale of Series
2 Notes or related shares of Common Stock held or to be held by the selling
securityholders named in the following table. Since the date on which the
selling securityholders provided us with the information below, they may have
sold, transferred or otherwise disposed of some or all of their Series 2 Notes
or shares of Common Stock in transactions exempt from the registration
requirements of the Securities Act.
PERCENT SHARES OF
PRINCIPAL PRINCIPAL OF 6 1/4% COMMON PERCENT OF
AMOUNT OF AMOUNT OF CONVERTIBLE STOCK COMMON
6 1/4% CONVERTIBLE SERIES 2 SUBORDINATED BENEFICIALLY STOCK
SUBORDINATED NOTES OWNED NOTES DUE OWNED SHARES OF BENEFICIALLY
NOTES DUE 2008 PRIOR TO THE 2008 OWNED PRIOR TO COMMON STOCK OWNED
OWNED PRIOR TO OFFERING AND AFTER THE THE OFFERED AFTER THE
THE OFFERING OFFERED HEREBY OFFERING (1) OFFERING (2) HEREBY(3) OFFERING(1)
------------ -------------- ------------ ------------ --------- -----------
Riggs Qualified Partners.............. $1,000,000 $1,000,000 - 585,094 585,094 -
Whitebox Convertible Arbitrage
Partners LP......................... 5,400,000 900,000 5.8% 3,159,512 526,584 5.1%
Whitebox Diversified Convertible
Arbitrage Partners, LP................ 800,000 100,000 * 468,075 58,508 *
------------ -------------- ------------
TOTAL....................... 7,200,000 $2,000,000 6.7% 4,212,682 1,170,189 5.9%
* Less than 1%.
(1) Percentage ownership is based on $77,334,000 in aggregate principal
amount of 6 1/4% Convertible Subordinated Notes due 2008 and 48,643,824
shares of Common Stock outstanding on May 6, 2005 and assumes all Series
2 Notes or shares of common stock issuable upon or in connection with
conversion of Series 2 Notes that may be offered hereunder are sold.
Shares of Common Stock issuable upon or in connection with conversion of
a holder's Series 2 Notes are deemed outstanding in computing the
percentage beneficially owned by such holder but are not deemed
outstanding for purposes of computing the percentage beneficially owned
by any other person.
(2) Assumes conversion of all of the holder's 6 1/4% Convertible
Subordinated Notes due 2008 at a conversion price of $1.75 per share of
common stock on May 6, 2005, and includes, for each holder, shares of
common stock representing the maximum additional shares of common stock
that could have been issued, at the option of Penn Treaty, as payment of
discounted
112
interest if such holder's 6 1/4% Convertible Subordinated Notes due 2008
were converted on May 6, 2005. The number of shares issuable as payment
of discounted interest will vary based on Penn Treaty's stock price and
the number of days remaining until October 15, 2005.
(3) Includes shares of common stock issuable upon or in connection with
conversion of Series 2 Notes only.
SERIES 3 NOTES
We are registering a total of $10,000,000 Series 3 Notes and 5,850,948
shares of Common Stock issuable upon or in connection with the conversion of the
Series 3 Notes on behalf of the selling securityholders named in the table
below. The Series 3 Notes were issued on November 24, 2004 pursuant to an
indenture between Penn Treaty and Wells Fargo Bank, National Association, as
trustee, in a private placement transaction. We undertook to register the Series
3 Notes and the Common Stock in the offering memorandum pursuant to which the
Series 3 Notes were offered.
We are registering all of the Series 3 Notes and the related shares of
Common Stock covered by this prospectus on behalf of the selling
securityholders. We are registering the Series 3 Notes and the related shares of
Common Stock to permit the selling securityholders and their pledgees, donees,
transferees or other successors-in-interest that receive Series 3 Notes or
shares of Common Stock from the selling securityholders as a gift, partnership
distribution or another non-sale related transfer after the date of this
prospectus to resell the Series 3 Notes or shares of Common Stock when they deem
appropriate.
The table below sets forth, as of May 6, 2005, information regarding the
amount and percentage of 6 1/4% convertible subordinated notes due 2008 and
Series 3 Notes and the number and percentage of shares of Common Stock that each
selling securityholder beneficially owns. We have prepared the table based upon
information furnished to us by or on behalf of the selling securityholders.
Based on the information provided to us by the selling securityholders, none of
the selling securityholders beneficially owns any Series 3 Notes or shares of
Common Stock other than as listed below.
The selling securityholders confirmed at the time they acquired the
Series 3 Notes listed below that they were acquiring the Series 3 Notes for
investment purposes only and not with a view toward resale, and acknowledged the
existence of restrictions on resale applicable to the Series 3 Notes and the
related shares of Common Stock. The offering relates only to the sale of Series
3 Notes or related shares of Common Stock held or to be held by the selling
securityholders named in the table below. Since the date on which the selling
securityholders provided us with the information below, they may have sold,
transferred or otherwise disposed of some or all of their Series 3 Notes or
shares of Common Stock in transactions exempt from the registration requirements
of the Securities Act.
113
PERCENT
PRINCIPAL PRINCIPAL OF 6 1/4% PERCENT OF
AMOUNT OF 6 1/4% AMOUNT OF CONVERTIBLE SHARES OF COMMON
CONVERTIBLE SERIES 3 SUBORDINATED COMMON STOCK SHARES OF STOCK
SUBORDINATED NOTES OWNED NOTES DUE BENEFICIALLY COMMON BENEFICIALLY
NOTES DUE 2008 PRIOR TO THE 2008 OWNED OWNED STOCK OWNED AFTER
OWNED PRIOR TO OFFERING AND AFTER THE PRIOR TO THE OFFERED THE
THE OFFERING OFFERED HEREBY OFFERING(1) OFFERING(2) HEREBY(3) OFFERING(1)
------------ -------------- ----------- ----------- --------- -----------
AK Steel Master Pension Trust......... $ 2,500,000 $ 2,500,000 - 1,462,736 1,462,736 -
Arthur E. Byrnes...................... 150,000 150,000 - 87,763 87,763 -
Citigroup Global Markets Inc.......... 500,000 500,000 - 292,547 292,547 -
Elkhorn Partners LP................... 6,415,000 2,350,000 5.3% 4,940,783(4) 1,374,973 7.0%
JMG Capital Partners LP............... 1,500,000 1,000,000 * 877,641 585,094 *
JMG Triton Offshore Fund Ltd.......... 1,500,000 1,000,000 * 877,641 585,094 *
Libertyview Funds LP.................. 660,000 450,000 * 386,161 263,291 *
Libertyview Special Opportunities
Fund LP............................. 1,540,000 1,050,000 * 901,046 614,349 *
Pandora Select Partners LP............ 3,220,000 100,000 4.0% 1,886,022(5) 58,508 3.6%
Whitebox Convertible Arbitrage
Partners, LP........................ 5,400,000 400,000 6.5% 3,159,512 234,037 5.7%
Whitebox Hedged High Yield Partners
LP.................................. 5,400,000 400,000 6.5% 3,159,512 234,037 5.7%
Whitebox Intermarket Partners LP..... 1,400,000 100,000 1.7% 819,132 58,508 1.5%
------------ -------------- -----------
TOTAL....................... $ 30,185,000 $ 10,000,000 26.1% 18,850,507(6) 5,850,948 21.5%
* Less than 1%.
(1) Percentage ownership is based on $77,334,000 in aggregate principal
amount of 6 1/4% Convertible Subordinated Notes dues 2008 and 48,643,824
shares of Common Stock outstanding on May 6, 2005 and assumes all Series
3 Notes or shares of Common Stock issuable upon or in connection with
conversion of Series 3 Notes that may be offered hereunder are sold.
Shares of Common Stock issuable upon or in connection with conversion of
a holder's Series 3 Notes are deemed outstanding in computing the
percentage beneficially owned by such holder but are not deemed
outstanding for purposes of computing the percentage beneficially owned
by any other person.
(2) Assumes conversion of all of the holder's 6 1/4% Convertible
Subordinated Notes due 2008 at a conversion price of $1.75 per share of
common stock on May 6, 2005, and includes, for each holder, shares of
common stock representing the maximum additional shares of common stock
that could have been issued, at the option of Penn Treaty, as payment of
discounted interest if such holder's 6 1/4% Convertible Subordinated
Notes due 2008 were converted on May 6, 2005. The number of shares
issuable as payment of discounted interest will vary based on Penn
Treaty's stock price and the number of days remaining until October 15,
2005.
(3) Includes shares of common stock issuable upon or in connection with
conversion of Series 3 Notes only.
(4) Includes 1,187,400 outstanding shares of Common Stock.
(5) Includes 2,017 outstanding shares of Common Stock.
(6) Includes 1,189,417 outstanding shares of Common Stock.
COMMON STOCK
We are registering a total of 100,000 shares of Common Stock on behalf
of the selling securityholders named in the table below. The shares of Common
Stock were issued on May 8, 2003 and May 28, 2004 in private placement
transactions.
We are registering the shares of Common Stock to permit the selling
securityholders and their pledgees, donees, transferees or other
successors-in-interest that receive Common Stock from the selling
securityholders as a gift, partnership distribution or another non-sale related
transfer after the date of this prospectus to resell the Common Stock when they
deem appropriate.
The table below sets forth, as of May 6, 2005, the number and percentage
of shares of Common Stock that each selling securityholder beneficially owns. We
have prepared the table based upon information furnished to us by or on behalf
of the selling securityholders. Based on the information
114
provided to us by the selling securityholders, none of the selling
securityholders beneficially owns any Common Stock other than as listed below.
The selling securityholders confirmed at the time they acquired the
shares of Common Stock listed below that they were acquiring the shares of
Common Stock for investment purposes only and not with a view toward resale, and
acknowledged the existence of restrictions on resale applicable to these shares
of Common Stock. The offering relates only to the sale of shares of Common Stock
held by the selling securityholders named in the table below. Since the date on
which the selling securityholders provided us with the information below, they
may have sold, transferred or otherwise disposed of some or all of their shares
of Common Stock in transactions exempt from the registration requirements of the
Securities Act.
SHARES OWNED AFTER
NUMBER OF NUMBER OF THE OFFERING (1)
SHARES OWNED PRIOR SHARES BEING ----------------
NAME TO THE OFFERING OFFERED NUMBER PERCENT
---- --------------- ------- ------ -------
Robert Fisk............. 84,600 84,600 0 -
Kevin Hamilton.......... 6,700 6,700 0 -
Sean McDermott.......... 6,700 6,700 0 -
Bernadette Pucillo...... 2,000 2,000 0 -
-------- ------- ------------- ----------
TOTAL............ 100,000 100,000 0 -
* Less than 1%.
(1) Assumes all the shares of Common Stock that may be offered hereunder are
sold.
The selling securityholders are affiliated with Philadelphia Brokerage
Corporation. Philadelphia Brokerage Corporation acted as a placement agent in
the private placement we completed in March 2002, the public offering we
completed in March 2003 and the private placements we completed in February 2004
and November 2004 and received commissions for its services. In addition, we
have retained Philadelphia Brokerage Corporation to provide us with certain
professional services. As compensation for such services, Philadelphia Brokerage
Corporation receives $5,000 a month and has received 300,000 shares of our
common stock, 100,000 of which are covered by this prospectus.
The information regarding the selling securityholders may change from
time to time. If required, we will set forth these changes in one or more
prospectus supplements.
115
PLAN OF DISTRIBUTION
We are registering the Securities on behalf of the selling
securityholders. As used herein, "selling securityholders" includes donees,
pledgees, transferees or other successors-in-interest selling Securities
received after the date of this prospectus from a named selling securityholder
as a gift, pledge, partnership distribution or other non-sale related transfer.
All costs, expenses and fees in connection with the registration of the
Securities offered hereby will be borne by us. Brokerage commissions and similar
selling expenses, if any, attributable to the sale of Securities will be borne
by the selling securityholders. Sales of Securities may be effected by selling
securityholders from time to time in one or more types of transactions (which
may include block transactions) on the New York Stock Exchange, in the
over-the-counter market, in negotiated transactions, through put or call options
transactions, through short sales or a combination of such methods of sale, at
market prices prevailing at the time of sale, or at negotiated prices. Such
transactions may or may not involve brokers or dealers. The selling
securityholders have advised us that they have not entered into any agreements,
understandings or arrangements with any underwriters or broker-dealers regarding
the sale of their securities, nor is there an underwriter or coordinating broker
acting in connection with the proposed sale of Securities by the selling
securityholders. Any such arrangements with broker-dealers entered into
subsequent to the effective date of the registration statement of which this
prospectus is a part will be disclosed in a supplement to this prospectus.
The selling securityholders may effect such transactions by selling
Securities directly to purchasers or to or through broker-dealers, which may act
as agents or principals. Such broker-dealers may receive compensation in the
form of discounts, concessions or commissions from the selling securityholders
and/or the purchasers of Securities for whom such broker-dealers may act as
agents or to whom they sell as principal, or both (which compensation as to a
particular broker-dealer might be in excess of customary commissions).
The selling securityholders and any broker-dealers that act in
connection with the sale of Securities might be deemed to be "underwriters"
within the meaning of Section 2(a)(11) of the Securities Act, and any
commissions received by such broker-dealers and any profit on the resale of the
Securities sold by them while acting as principals might be deemed to be
underwriting discounts or commissions under the Securities Act. The selling
securityholders may agree to indemnify any agent, dealer or broker-dealer that
participates in transactions involving sales of the Securities against certain
liabilities, including liabilities arising under the Securities Act.
Because selling securityholders may be deemed to be "underwriters"
within the meaning of Section 2(a)(11) of the Securities Act, the selling
securityholders will be subject to the prospectus delivery requirements of the
Securities Act, which may include delivery through the facilities of the New
York Stock Exchange pursuant to Rule 153 under the Securities Act. We have
informed the selling securityholders that the anti-manipulative provisions of
Regulation M promulgated under the Exchange Act may apply to their sales in the
market.
Selling securityholders also may resell all or a portion of the
Securities in open market transactions in reliance upon Rule 144 under the
Securities Act, provided they meet the criteria and conform to the requirements
of such Rule.
Upon our being notified by a selling securityholder that any material
arrangement has been entered into with a broker-dealer for the sale of
Securities through a block trade, special offering, exchange distribution or
secondary distribution or a purchase by a broker or dealer, a supplement to this
prospectus will be filed, if required, pursuant to Rule 424(b) under the Act,
disclosing (i) the name of each such selling shareholder and of the
participating broker-dealer(s), (ii) the amount of Notes or the
116
number of shares of Common Stock involved, (iii) the price at which such
Securities were sold, (iv) the commissions paid or discounts or concessions
allowed to such broker-dealer(s), where applicable, (v) that such
broker-dealer(s) did not conduct any investigation to verify the information set
out or incorporated by reference in this prospectus and (vi) other facts
material to the transaction. In addition, upon our being notified by a selling
securityholder that a donee, pledgee, transferee or other successor-in-interest
intends to sell more than 500 shares, a supplement to this prospectus will be
filed.
117
LEGAL MATTERS
Ballard Spahr Andrews & Ingersoll, LLP, Philadelphia, Pennsylvania will
pass upon the validity of the Securities.
EXPERTS
The financial statements included in this prospectus have been so
included in reliance on the report of PricewaterhouseCoopers LLP, an independent
registered public accounting firm, given on the authority of said firm as
experts in auditing and accounting.
WHERE YOU CAN FIND MORE INFORMATION
We are subject to the informational requirements of the Exchange Act
and, in accordance with these requirements, we file reports, proxy statements
and other information relating to our business, financial condition and other
matters with the SEC. We are required to disclose in such reports certain
information, as of particular dates, concerning our operating results and
financial condition, officers and directors, principal holders of securities,
any material interests of such persons in transactions with us and other
matters. Reports, proxy statements and other information filed by us can be
inspected and copied at the public reference facilities maintained by the SEC at
450 Fifth Street, N.W., Washington, D.C. 20549 and at the SEC's regional
offices. Information on the operation of the public reference facilities may be
obtained by calling the SEC at 1-800-SEC-0330.
The SEC also maintains a website that contains reports, proxy and
information statements and other information regarding registrants like us that
file electronically with the SEC. The address of such site is:
HTTP://WWW.SEC.GOV. Reports, proxy statements and other information concerning
our business may also be inspected at the offices of the New York Stock Exchange
at 20 Broad Street, New York, New York 10005. This information may also be
obtained from us as described below.
You may request a copy of these filings, at no cost, by writing to or
telephoning us at the address and telephone number below. However, we will not
provide copies of the exhibits to these filings unless we specifically
incorporated by reference the exhibits in these filings.
Penn Treaty American Corporation
Attention: Mark D. Cloutier
Senior Vice President and Chief Financial Officer
3440 Lehigh Street
Allentown, PA 18103
(610) 965-2222
118
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Pages
-----
Report of Independent Registered Public Accounting Firm F-2
Financial Statements:
Consolidated Balance Sheets as of December 31,
2004 and 2003 F-3
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2004, 2003 and 2002 F-4
Consolidated Statements of Shareholders' Equity
for the Years Ended December 31, 2004,
2003 and 2002 F-5
Consolidated Statements of Cash Flows for the
Years Ended December 31, 2004, 2003 and 2002 F-6
Notes to Consolidated Financial Statements F-7
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Penn Treaty American Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income and comprehensive income, of shareholders'
equity and of cash flows after the restatement described in Note 2, present
fairly, in all material respects, the financial position of Penn Treaty American
Corporation and Subsidiaries at December 31, 2004 and 2003, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2004 in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
April 29, 2005
Cleveland, Ohio
F-2
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(amounts in thousands, except per share information)
December 31,
December 31, 2003
2004 Restated (1)
----------- -----------
ASSETS
Investments:
Bonds, available for sale at market (cost of $58,945 and $42,933 respectively(2) $ 59,171 $ 43,853
Policy loans 338 288
----------- -----------
Total investments 59,509 44,141
Cash and cash equivalents (2) 15,296 12,808
Property and equipment, at cost, less accumulated depreciation of
$10,727 and $9,635 respectively 16,925 16,149
Unamortized deferred policy acquisition costs 149,180 160,758
Receivables from agents, less allowance for
uncollectible amounts of $474 and $404 respectively 1,007 1,407
Accrued investment income 888 604
Goodwill 6,985 20,360
Receivable from reinsurers 23,418 23,934
Corporate owned life insurance 51,228 53,220
Notional experience account due from reinsurer 901,368 784,778
Other assets 18,873 27,335
----------- -----------
Total assets $ 1,244,677 $ 1,145,494
=========== ===========
LIABILITIES
Policy reserves:
Accident and health $ 568,928 $ 518,600
Life 12,947 12,871
Claim reserves 324,138 340,981
Accounts payable and other liabilities 24,590 21,747
Federal income tax payable 545 -
Preferred interest on early conversion 1,403 3,018
Long-term debt, less discount of $1,426 and $1,625, respectively 85,167 88,467
Deferred income taxes 29,589 15,731
----------- -----------
Total liabilities 1,047,307 1,001,415
----------- -----------
Commitments and contingencies (Note 14) - -
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none
outstanding - -
Common stock, par value $.10; 150,000 and 40,000 shares authorized,
respectively; 44,091 and 25,645 shares issued, respectively 4,409 2,565
Additional paid-in capital 137,288 105,926
Accumulated other comprehensive income 147 598
Retained earnings 62,231 41,695
----------- -----------
204,075 150,784
Less 915 common shares held in treasury, at cost (6,705) (6,705)
----------- -----------
Total shareholders' equity 197,370 144,079
----------- -----------
Total liabilities and shareholders' equity $ 1,244,677 $ 1,145,494
=========== ===========
(1) Restated to reflect impact of previously unreserved policy riders. See Note
2 - "Restatement"
(2) Cash and investments of $31,497 and $28,490, are restricted as to use as of
December 31, 2004 and 2003, respectively.
See accompanying notes to consolidated financial statements.
F-3
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2004, 2003 and 2002
(amounts in thousands, except per share information)
2003 2002
2004 Restated (1) Restated (1)
--------- ------------ ------------
Revenues:
Premium revenue $ 319,885 $ 321,946 $ 333,643
Net investment income 46,839 43,273 40,107
Net realized capital gain 167 237 15,663
Market gain (loss) on notional experience account 39,749 (9,494) 56,555
Change in preferred interest on early conversion liability 2,237 (981) -
Other income 5,864 9,082 11,585
--------- --------- ---------
414,741 364,063 457,553
--------- --------- ---------
Benefits and expenses:
Benefits to policyholders 232,698 247,822 374,085
Commissions 39,115 40,800 45,741
Net policy acquisition costs amortized 11,578 10,243 7,515
Impairment of unamortized policy acquisition costs - - 1,100
General and administrative expense 52,970 59,110 46,472
Impairment of goodwill 13,376 - -
Litigation accrual expense 4,150 - -
Expense and risk charges on reinsurance 11,230 11,073 14,308
Excise tax expense 2,969 3,065 2,919
Interest expense 10,443 8,112 5,733
--------- --------- ---------
378,529 380,225 497,873
--------- --------- ---------
Income (loss) before federal income taxes 36,212 (16,162) (40,320)
Federal income tax (provision) benefit (15,676) 2,992 13,728
--------- --------- ---------
Net income (loss) before cumulative effect of
change in accounting principle 20,536 (13,170) (26,592)
Cumulative effect of change in accounting principle - - (5,151)
--------- --------- ---------
Net income (loss) $ 20,536 $ (13,170) $ (31,743)
========= ========= =========
Other comprehensive income (loss):
Unrealized holding (loss) gain arising during period (527) (522) 1,310
Income tax (benefit) provision from unrealized holdings 185 184 (465)
Reclassification of gains included in net income (167) (237) (15,663)
Income tax provision from reclassification 58 83 5,325
--------- --------- ---------
Comprehensive income (loss) $ 20,085 $ (13,662) $ (41,236)
========= ========= =========
Basic earnings per share from net income (loss) before
cumulative effect of change in accounting principle $ 0.54 $ (0.63) $ (1.38)
========= ========= =========
Basic earnings per share from net income (loss) $ 0.54 $ (0.63) $ (1.65)
========= ========= =========
Diluted earnings per share from net income (loss) before
cumulative effect of change in accounting principle $ 0.30 $ (0.63) $ (1.38)
========= ========= =========
Diluted earnings per share from net income (loss) $ 0.30 $ (0.63) $ (1.65)
========= ========= =========
Weighted average number of shares outstanding 37,720 20,970 19,240
Weighted average number of shares and share equivalents 86,306 20,970 19,240
(1) Restated to reflect impact of previously unreserved policy riders. See
Note 2 - "Restatement"
See accompanying notes to consolidated financial statements.
F-4
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity for the Years Ended
December 31, 2004, 2003 and 2002 (amounts in thousands)
Accumulated
Common Stock Additional Other Total
--------------------- Paid-In Comprehensive Retained Treasury Shareholders'
SHARES AMOUNT CAPITAL INCOME (LOSS) EARNINGS STOCK EQUITY
--------- --------- --------- ------------- --------- --------- ---------
Previously reported balance,
December 31, 2001 19,750 $ 1,975 $ 94,802 $ 10,583 $ 92,141 $ (6,705) $ 192,796
Restatement - - - - (5,533) - (5,533)
--------- --------- --------- --------- --------- --------- ---------
Restated balance at December 31, 2001 (1) 19,750 1,975 94,802 10,583 86,608 (6,705) 187,263
Net loss - - - - (31,743) - (31,743)
Change in unrealized gain (loss) - - - (9,493) - - (9,493)
Option-based compensation - - (430) - - - (430)
Private placement proceeds 510 51 2,301 - - - 2,352
Shares issued to financial advisor 80 8 385 - - - 393
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 2002, restated (1) 20,340 2,034 97,058 1,090 54,865 (6,705) 148,342
Net loss - - - - (13,170) - (13,170)
Change in unrealized gain (loss) - - - (492) - - (492)
Shares issued to financial advisor 120 13 196 - - - 209
Shares issued for conversion and interest 5,185 518 8,672 - - - 9,190
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 2003, restated (1) 25,645 2,565 105,926 598 41,695 (6,705) 144,079
--------- --------- --------- --------- --------- --------- ---------
Net income - - - - 20,536 - 20,536
Change in unrealized gain (loss) - - - (451) - - (451)
Shares issued to financial advisor 100 10 203 - - - 213
Interest expense for debt issued with
beneficial conversion feature - - 686 - - - 686
Shares issued for conversion and interest 18,346 1,834 30,473 - - - 32,307
--------- --------- --------- --------- --------- --------- ---------
Balance, December 31, 2004 44,091 $ 4,409 $ 137,288 $ 147 $ 62,231 $ (6,705) $ 197,370
========= ========= ========= ========= ========= ========= =========
(1) Restated to reflect impact of previously unreserved policy riders. See Note
2 - "Restatement"
See accompanying notes to consolidated financial statements.
F-5
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Years Ended December 31,2004, 2003 and 2002
(amounts in thousands)
2003 2002
2004 Restated (1) Restated (1)
--------- ------------ ------------
Net cash flow from operating activities:
Net income (loss) $ 20,536 $ (13,170) $ (31,743)
Adjustments to reconcile net income (loss) to cash
provided by operations:
Depreciation and amortization expense 6,461 5,540 3,476
Cumulative effect of change in accounting principle - - 5,151
Change in preferred interest on early conversion liability (2,237) 981 -
Impairment of long-lived assets - (522) -
Net realized capital gains (167) (237) (15,663)
Investment credit on corporate owned life insurance (321) (2,036) (3,295)
Impairment of goodwill 13,376 - -
Equity issued for interest expense from long-term debt
conversions 2,809 1,069 -
Increase (decrease) due to change in:
Policy acquisition costs, net 11,578 10,243 8,615
Receivables from agents 330 (38) 536
Federal income taxes payable 545 - 4,406
Accrued investment income (284) (190) 7,493
Receivable from reinsurers 122 3,123 (624)
Notional experience account due from reinsurer (73,236) (17,686) (85,955)
Policy reserves 50,797 43,598 82,912
Claim reserves (16,843) 11,037 115,478
Accounts payable and other liabilities 2,843 2,888 3,670
Deferred income taxes 14,101 (3,427) (11,180)
Other, net (334) (1,103) (3,735)
--------- --------- ---------
Cash provided by operations 30,076 40,070 79,542
--------- --------- ---------
Cash flow from investing activities:
Proceeds from sales of bonds 34,177 38,987 475,473
Proceeds from sales of equity securities - - 9,547
Maturities of investments 960 4,277 3,892
Purchases of bonds (51,469) (59,817) (27,621)
Purchases of equity securities - - (20)
Change in policy loans (50) (50) (57)
Death benefits received from corporate owned life insurance 8,564 - -
Deposits to notional experience account due from reinsurer (43,354) (58,110) (623,027)
Disposal of property and equipment 308 - -
Acquisition of property and equipment (2,724) (3,726) (2,530)
--------- --------- ---------
Cash used in investing (53,588) (78,439) (164,343)
--------- --------- ---------
Cash flow from financing activities:
Net proceeds from stock offering - - 2,352
Issuance of long-term debt 26,000 32,421 -
Repayments of long-term debt - (10,450) (2,945)
--------- --------- ---------
Cash provided by (used in) financing 26,000 21,971 (593)
--------- --------- ---------
Increase (decrease) in cash and cash equivalents 2,488 (16,398) (85,394)
Cash balances:
Beginning of period 12,808 29,206 114,600
--------- --------- ---------
End of period $ 15,296 $ 12,808 $ 29,206
========= ========= =========
Non-cash transactions:
Equity issued for long-term debt conversions $ 29,499 $ 8,122 $ -
Equity issued for financial advisor fees 213 209 393
Exchange of long-term debt - 3,450 63,343
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $ 5,393 $ 5,751 $ 5,365
Cash (paid) received during the year for federal income taxes (1,055) 431 (6,950)
(1) Restated to reflect impact of previously unreserved policy riders. See Note
2 - "Restatement" Total cash provided by operations, cash used in investing
and cash provided by or used in financing were not impacted by the
restatement.
See accompanying notes to consolidated financial statements.
F-6
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(amounts in thousands, except per share information)
1. BASIS OF PRESENTATION AND NATURE OF OPERATIONS:
BASIS OF PRESENTATION:
The accompanying consolidated financial statements of Penn Treaty American
Corporation and its Subsidiaries (the "Company") have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP") and include Penn Treaty Network America Insurance Company
("PTNA"), American Network Insurance Company ("ANIC"), American Independent
Network Insurance Company of New York ("AIN"), Penn Treaty (Bermuda), Ltd.
("PTB"), United Insurance Group Agency, Inc. ("UIG"), Network Insurance Senior
Health Division ("NISHD") and Senior Financial Consultants Company ("SFCC"). PTB
was liquidated with no material impact on the financial statements during the
year ended December 31, 2003. Intercompany transactions and balances have been
eliminated in consolidation.
USE OF ESTIMATES:
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent liabilities and the reported
amounts of revenues and expenses. Actual results could differ from those
estimates. The Company's principal estimates include:
o Policy reserves
o Claim reserves
o Unamortized deferred policy acquisition costs
o Valuation of goodwill
o The value of preferred interest on early conversion liability
o The value of our notional experience account
o The valuation allowance for deferred income taxes
o Commitments and contingencies
NATURE OF OPERATIONS:
The Company currently sells accident and health insurance through its wholly
owned subsidiaries. The Company's principal lines of business are long-term care
products including facility care and home health care products. The Company
distributes its products principally through independent agents, independent
field marketing organizations and agents employed by UIG. The Company operates
its home office in Allentown, Pennsylvania, with subsidiary agency offices
throughout the country, whose principal functions include marketing new
business.
The Company is licensed in all states and receives renewal premiums from
policyholders, but is currently restricted from issuing new policies in 9
states. The Company is approved for sales in Florida, California and
Pennsylvania (subject to Corrective Action Plans), which accounted for
approximately 16%, 15% and 12%, respectively, of the Company's direct premium
revenue for the year ended December 31, 2004. No other state's sales accounted
for more than 10% of the Company's direct premium revenue for the year ended
December 31, 2004.
2. RESTATEMENT:
In March 2005, in conjunction with the preparation of the financial statements
for the year ended December 31, 2004, management concluded that certain policy
riders were not properly reserved for in prior years. The policy riders are
options chosen by the policyholders and the previously unreserved policy riders
include inflation, restoration of benefit and return of premium benefit. A
significant majority of these policy riders were inflation riders. The premiums
associated with the policies were properly billed and any claims incurred on
these policies were properly paid. However, the policy riders were not properly
identified in the data utilized to calculate policy reserves. As a result of
this conclusion, the Company has restated its previously issued financial
statements for the years ended December 31, 2003 and 2002 to reflect the
inclusion of the policy riders.
F-7
The total cumulative impact of the restatement that affected shareholders'
equity as of December 31, 2003 was a decrease in shareholders' equity of $6,655,
which includes a decrease in beginning shareholders' equity as of January 1,
2002 of $5,533. The overall financial decrease on shareholders' equity of the
restatement as of each year end was as follows:
December 31, 2001 (1) $ (5,533)
December 31, 2002 (2) (1,305)
December 31, 2003 (2) 183
(1) The adjustment as of December 31, 2001 represents an opening
retained earnings adjustment on January 1, 2002.
(2) The adjustment represents the retained earning impact of the
restatement to net income in the respective period.
The consolidated financial statements for the years ended December 31, 2003 and
2002, reflect the effects of the restatement on (i) net policy acquisition costs
amortized and its effects on unamortized deferred policy acquisition costs, (ii)
benefits to policyholders expense and its effects on policy reserves, (iii) the
Federal income tax benefit and its effects of deferred income taxes and (iv)
basic and diluted earnings per share. A summary of the effects of the
restatement on reported amounts for the years ended December 31, 2003 and 2002
is presented below.
CONSOLIDATED BALANCE SHEETS
----------------------------------------------------------------------------------
DECEMBER 31, 2003 DECEMBER 31, 2002
------------------------------------- -------------------------------------
As Previously As As Previously As
Reported Adjustment Restated Reported Adjustment Restated
------------- ---------- -------- ------------- ---------- --------
Unamortized deferred policy acquisition costs $ 160,740 $ 18 $ 160,758 $ 171,357 $ (357) $ 171,000
Policy reserves (accident and health) (508,344) (10,256) (518,600) (464,318) (10,163) (474,481)
Deferred income tax liability (19,314) 3,583 (15,731) (23,101) 3,682 (19,419)
Total shareholders' equity 150,734 (6,655) 144,079 155,180 (6,838) 148,342
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME FOR THE YEARS ENDED
----------------------------------------------------------------------------------
DECEMBER 31, 2003 DECEMBER 31, 2002
------------------------------------- -------------------------------------
As Previously As As Previously As
Reported Adjustment Restated Reported Adjustment Restated
------------- ---------- -------- ------------- ---------- --------
Benefits to policyholders $ (247,730) $ (92) $(247,822) $ (371,998) $ (2,087) $(374,085)
Net policy acquisition costs amortized (10,617) 374 (10,243) (7,595) 80 (7,515)
Federal income tax benefit 3,091 (99) 2,992 13,026 702 13,728
Net loss (13,353) 183 (13,170) (30,438) (1,305) (31,743)
Basic earnings per share from net loss $ (0.64) $ 0.01 $ (0.63) $ (1.58) $ (0.07) $ (1.65)
Diluted earnings per share from net loss $ (0.64) $ 0.01 $ (0.63) $ (1.58) $ (0.07) $ (1.65)
The restatement did not have any impact on total cash flows from operations,
investing or financing activities.
3. SUMMARY OF SIGNIFICANT AND NEW ACCOUNTING POLICIES:
INVESTMENTS:
The Company categorizes its investment securities as available for sale since
they may be sold in response to changes in interest rates, prepayments and
similar factors. Investments in this classification are reported at the current
market value with net unrealized gains or losses, net of the applicable deferred
income tax effect, as components of other comprehensive income.
Realized investment gains and losses, including provisions for market declines
considered to be other than temporary, are included in income. Gains and losses
on sales of investment securities are computed on the specific identification
method. Debt and equity securities are regularly evaluated to determine if
market values below amortized cost are as a result of credit quality,
performance or general market decline. If market value declines are determined
to be other than temporary, the amortized cost is adjusted to the market value
of the security, with the loss recognized in the current
F-8
period. Any future increases to the market value of a security that has been
written down due to an other than temporary impairment is recorded as an
unrealized gain in other comprehensive income. Purchases and sales of securities
are recorded on the trade-date basis. Interest income is recorded on the accrual
basis. Dividends are recorded on the ex-dividend date.
The Company is subject to interest rate and credit risk to the extent that its
investment portfolio cash flows are not matched to its insurance liabilities.
Management believes it manages this risk through monitoring cash flows and
actuarial assumptions regarding the timing of future insurance liabilities.
Management further believes that, while not currently under its direction, the
benchmark indices supporting the total return of its notional experience account
asset are appropriately matched to the duration of its ceded reserve
liabilities.
POLICY LOANS:
Policy loans are stated at the aggregate unpaid principal balance.
CASH AND CASH EQUIVALENTS:
Cash and cash equivalents include highly liquid debt instruments with an
original maturity of three months or less.
PROPERTY AND EQUIPMENT:
Property and equipment are stated at cost, less accumulated depreciation and
amortization. Expenditures for improvements, which materially increase the
estimated useful life of the asset, are capitalized. Expenditures for repairs
and maintenance are charged to operations as incurred. Depreciation is provided
principally on a straight-line basis over the related asset's estimated life.
Upon sale or retirement, the cost of the asset and the related accumulated
depreciation are removed from the accounts and the resulting gain or loss, if
any, is included in operations.
The Company accounts for its internally developed software in accordance with
Statement of Position 98-1 "Accounting for the Costs of Computer Software
Developed or obtained for Internal Use." All costs incurred during the
preliminary project stage are expensed as they are incurred. Costs incurred to
develop the internal-use software during the application development stage are
capitalized with the exception of certain data conversion costs, which are
expensed as incurred. Training costs and maintenance costs are expensed as
incurred.
UNAMORTIZED DEFERRED POLICY ACQUISITION COSTS ("DAC"):
The costs primarily related to and varying with the acquisition of new business,
principally commissions, underwriting and policy issue expenses, have been
deferred. These deferred costs are amortized over the related premium-paying
periods utilizing the same projected premium assumptions used in computing
reserves for future policy benefits.
The Company regularly assesses the recoverability of DAC through actuarial
analysis. To determine recoverability, the present value of future premiums less
future costs and claims are added to current reserve balances. If this amount is
greater than current DAC, the unamortized amount is deemed recoverable. In the
event recoverability is not demonstrated, the Company reassesses the calculation
using justifiable premium rate increases. If rate increases are not received or
are deemed unjustified, the Company will expense, as impaired, the attributed
portion of the DAC in the current period. If the Company concludes that the DAC
are impaired, the Company will record an impairment loss and a reduction in the
DAC. In the event of an impairment, the Company will also evaluate its
historical assumptions utilized in establishing the policy reserves and DAC and
may update those assumptions to reflect current experience (referred to as
"unlocking"). The primary assumptions include persistency, morbidity (claims
expectations), investment yields and premium rate increases. Recoverability of
DAC is highly dependent upon the Company's ability to obtain future premium rate
increases. While the Company has been successful in obtaining premium rate
increases on existing policies in the past, the ability to obtain these
increases is subject to regulatory approval, and is not guaranteed. Management
believes the current assumptions and other considerations used to estimate and
evaluate the recoverability of DAC are appropriate
F-9
During 2002, the Company recognized an impairment of its DAC of approximately
$1,100 due to its anticipation of reduced future investment earnings rates and
accelerated claims costs, substantially offset by increased premium rate
expectations.
GOODWILL:
The goodwill on the Company's Consolidated Balance Sheets at December 31, 2004
and 2003 relates to the purchase of the Company's insurance agencies, UIG and
NISHD. The Company tests for impairment of goodwill on an annual basis unless an
event occurs or circumstances change that would more likely than not indicate
that an impairment has occurred. The Company tested for impairment on a
quarterly basis during 2004 due to declining sales.
The test is done at a reporting unit level. UIG and NISHD are combined to form a
reporting unit. UIG and NISHD are both insurance agencies that sell senior
market insurance products, and therefore have similar economic characteristics.
OTHER ASSETS:
Other assets consist primarily of deferred reinsurance premiums, premiums due
but not yet collected, deferred offering costs, prepaid assets and a deposit
account related to a reinsurance agreement.
The deferred reinsurance premiums represent the warrants granted as part of
entering into a reinsurance agreement in 2002. The warrants are part of the
consideration for the reinsurance contract and are recognized as reinsurance
premiums over the anticipated life of the contract, which is six years.
Premiums due but not collected are recorded as premium revenue when due.
Deferred offering costs are amortized on a straight-line basis over the maturity
period of the related convertible debt, which matures in 2008. A pro-rata
portion is expensed at the time of any early conversions. Prepaid assets are
expensed over the period to which the related services are provided.
The deposit account relates to a 50% quota share reinsurance agreement for
policies issued between January 1, 2002 and July 31, 2004. The net cash flows
relating to premiums paid to the reinsurer, claim payments collected from the
reinsurer, investment income earned on the cash flows, less a finance charge are
recoded to the deposit account.
CORPORATE OWNED LIFE INSURANCE:
The Company purchased corporate owned life insurance ("COLI") to fund the future
payment of employee benefit expenses. The Company has purchased $50,000 of COLI.
No additional purchases were made in 2004 or 2003. The COLI, which is invested
in investment grade corporate bonds and equity indexes is recorded at cash
surrender value. Increases in the cash surrender value are recorded as other
income. When a covered employee dies, the Company receives cash equal to the
death benefit. No income or expense is recorded as a result.
NOTIONAL EXPERIENCE ACCOUNT DUE FROM REINSURER:
The 2001 reinsurance agreement with Centre Solutions (Bermuda) Limited
("Centre") (as described in Note 15) includes a provision for the maintenance of
a notional experience account for the Company's benefit in the event of future
commutation of the agreement.
The initial premium and future cash flows from the reinsured policies, less
claims payments, ceding commissions, risk charges and certain other charges, is
credited to a notional experience account, which is held by the reinsurer for
the Company's benefit in the event of commutation and recapture on or after
December 31, 2007. The notional experience account balance receives an
investment credit based upon the total return from a series of benchmark indices
and derivative hedges that are intended to match the duration of the reserve
liability.
The notional experience account represents a hybrid instrument, containing both
a fixed debt host contract and an embedded derivative. The economic
characteristics and risks of the embedded derivative instrument are not clearly
and closely related to the economic characteristics and risks of the fixed debt
host contract. In accordance with SFAS No. 133, the Company is accounting for
the investment credit received on the notional experience account as follows:
F-10
o The fixed debt host yields a fixed return based on the yield to
maturity of the underlying benchmark indices. The return on the
fixed debt host is reported as investment income in the
Consolidated Statement of Income and Comprehensive Income.
o The change in fair value of the embedded derivative represents
the percentage change in the underlying indices applied to the
notional experience account, similar to that of an unrealized
gain/loss on a bond. The change in the fair value of the
embedded derivative is reported as market (loss) gain on
notional experience account in the Consolidated Statement of
Income and Comprehensive Income.
The benchmark indices are comprised of US treasury strips, agencies and
investment grade corporate bonds, with weightings of approximately 25%, 15% and
60%, respectively, and have a duration of approximately 14 years. The hybrid
instrument subjects the Company to significant volatility as the estimated value
of the embedded derivative is highly sensitive to changes in interest rates.
POLICY RESERVES AND CLAIM RESERVES:
There are two components to the Company's policyholder liabilities. The first is
a policy reserve for future policy benefits and the second is a claim reserve
for incurred claims, either reported or unreported.
POLICY RESERVES --
The policy reserve liability is determined using the present value of estimated
future policy benefits to be paid to, or on behalf of policyholders, less the
present value of estimated future premiums to be collected from policyholders,
including anticipated premium rate increases. This liability is recognized
concurrent with and as a portion of premium revenue. Policy reserves are
computed based on assumptions, including estimates of expected investment yield,
mortality, morbidity (claims expectations), withdrawals and expenses, applicable
at the time insurance contracts are effective. The assumptions utilized to
determine the policy reserves are established at year of policy issuance and are
"locked in" for the future development of reserves (See "Unamortized Deferred
Policy Acquisition Costs").
The Company reviews its policy reserves and the recoverability of its deferred
acquisition costs on a quarterly basis, utilizing assumptions for future
expected claims, premium rate increases and interest rates. If the Company
determines that the future gross profits of its in-force policies are not
sufficient to recover its deferred acquisition costs, the Company recognizes a
premium deficiency and "unlocks" (or changes) historical assumptions to match
current expectations. These assumptions include interest rates, premium rate
increases, shock lapses and anti-selection of policyholder persistence. When
original assumptions are unlocked, the Company employs its new expectations in
the establishment of future reserves.
CLAIM RESERVES -
Claim reserves are recognized when insured events occur and include amounts
comprising:
o An estimate, based upon prior experience, for accident and
health claims reported, and incurred but unreported claims;
o the actual in-force amounts for reported life claims; and,
o an estimate of future administrative expenses, which would be
incurred to process existing claims.
This is consistent with the long duration of claims and industry practice for
long-term care policies. Benefits are payable over periods ranging from six
months to five years, and are also available for lifetime coverage. The Company
discounts all claims, which involve fixed periodic payments extending beyond one
year. The methods for making estimates and establishing claim reserves are
periodically reviewed and updated and any resulting adjustments are reflected in
earnings currently.
The establishment of appropriate policy and claim reserves is an inherently
uncertain process that requires management to make critical accounting
estimates. Management believes the current assumptions and other considerations
used to estimate policy reserves and claim reserve liabilities are appropriate.
However, if the actual experience differs from the
F-11
assumptions and other considerations (including mortality, morbidity (claims
experience), withdrawals, expenses, premium rate increases and investment
yields) used in estimating the Company's policy reserves and claim reserves, the
resulting change could have a material adverse effect on the Company's results
of operations and financial condition. Due to the inherent uncertainty of
estimating reserves, it has been necessary, and may over time continue to be
necessary, to revise estimated future liabilities as reflected in the Company's
policy reserves and claim reserves.
REINSURANCE:
The Company reports all reserve amounts gross of reinsurance. The amounts
receivable from unaffiliated reinsurers are reported as receivables from
reinsurers. An allowance is established for any amounts the Company believes may
be uncollectible.
The Company applies deposit accounting for reinsurance agreements that do not
meet the risk transfer criteria in Statement of Financial Accounting Standards
No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts."
ACCOUNTS PAYABLE AND OTHER LIABILITIES:
Accounts payable and other liabilities consist primarily of amounts payable to
agents, reinsurers and vendors, as well as deferred income items. During 2001,
the Company reinsured the majority of its disability policies with an
unaffiliated insurer under an assumption reinsurance agreement, for which it
received a ceding commission of approximately $5,000. The gain relating to the
assumptions of these policies by the reinsurer is deferred and will be
recognized as income when the Company's policy liability is novated through
policyholder or state approval, as may be required. The Company recognized
income of $317 in 2004, $896 in 2003 and $1,593 in 2002. The deferred ceding
commission balance is $1,714 and $2,031 at December 31, 2004 and 2003,
respectively.
PREFERRED INTEREST ON EARLY CONVERSION:
Holders of the 2008 Notes (as described in Note 9) are entitled to convert their
notes into shares of common stock before October 2005 and receive a discounted
amount of interest that they would have otherwise received until that date. This
feature is an embedded derivative as defined in Statement of Financial
Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging
Activities." This embedded derivative is not clearly and closely related to the
host contract, the convertible subordinated notes, because it could at least
double the investor's initial rate of return on the host contract and could also
result in a rate of return that is at least twice what otherwise would be the
market return for a contract that has the same terms as the host contract and
that involves a debtor with a similar credit quality.
The Company has valued and bifurcated the embedded derivative from the host
contract. At each balance sheet date, the embedded derivative is recorded at
fair value, with any change in fair value recognized in current operations. The
fair value of the embedded derivative is determined based on a number of
assumptions including the liquidity and volatility of the Company's common
stock. The amount of time remaining between the date of early conversion and
October 15, 2005 also has a significant impact on the fair value of the embedded
derivative. As the date gets closer to October 15, 2005, the amount of interest
to be paid at the time of early conversion is reduced.
LONG-TERM DEBT:
Long-term debt is carried at face value less the remaining related unamortized
discount. The discount on long-term debt is equal to the fair value of the
preferred interest on early conversion at the time of issuance. The discount is
recorded as interest expense over the maturity of the long-term debt, which is
2008, using the effective interest method. A pro-rata portion of the discount is
charged immediately to interest expense at the time of any early conversion.
INCOME TAXES:
Income taxes consist of amounts currently due plus deferred tax expense or
benefits. Deferred tax assets and liabilities result from temporary differences
between the amounts recorded in the consolidated financial statements and the
tax bases of the Company's assets and liabilities. Such temporary differences
are primarily due to the difference in allowable deductions for deferred
acquisition costs, the deposit accounting for our 2001 Centre Agreement, the
warrants issued as compensation for the 2001 Centre Agreement and tax benefits
of net operating loss carryforwards. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date. A
F-12
valuation allowance against deferred tax assets is recorded if it is more likely
than not that all, or some portion, of the benefits related to deferred tax
assets will not be realized.
REVENUE RECOGNITION:
Premiums on long duration accident and health insurance, the majority of which
is guaranteed renewable, and life insurance are recognized when due. Estimates
of premiums due but not yet collected are accrued.
Commission revenue that the Company's agencies receive from unaffiliated
insurers is included in other income when the commission from the underlying
policy premium is due, net of an allowance for unissued or cancelled policies.
EXCISE TAXES:
The Company pays excise taxes related to reinsurance agreements with a foreign
reinsurer. The amount recorded each year is equal to one percent of the premiums
ceded to the reinsurer. The Company recorded an expense of $2,969, $3,065 and
$2,919 for the years ended December 31, 2004, 2003 and 2002, respectively.
EARNINGS PER SHARE:
A reconciliation of the numerator and denominator of the basic earnings per
share computation to the numerator and denominator of the diluted earnings per
share computation follows. Basic earnings per share excludes dilution and is
computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per share reflect the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into common
stock. Anti-dilutive effects are not included. As such, the Company has not
included securities of 17,143, 66,260 and 12,338 for 2004, 2003 and 2002,
respectively that could potentially dilute basic earnings per share in the
future.
FOR THE PERIODS ENDED DECEMBER 31,
----------------------------------
2003 2002
2004 RESTATED (1) RESTATED (1)
-------- ------------ -----------
Net income (loss) before cumulative
effect of change in accounting
principles $ 20,536 $(13,170) $(26,592)
Weighted average common shares
outstanding 37,720 20,970 19,240
-------- -------- --------
Basic earnings per share from net
income (loss) before cumulative
effect of change in accounting
principles $ 0.54 $ (0.63) $ (1.38)
======== ======== ========
Net income (loss) before cumulative
effect of accounting change $ 20,536 $(13,170) $(26,592)
Cumulative effect of change in
accounting principles - - (5,151)
-------- -------- --------
Net income (loss) $ 20,536 $(13,170) $(31,743)
======== ======== ========
Basic earnings per share from net
income (loss) $ 0.54 $ (0.63) $ (1.65)
======== ======== ========
Adjustments net of tax:
Interest expense on convertible
debts (2) $ 6,514 $ - $ -
Amortization of debt offering
costs (2) 607 - -
(Gain) loss on preferred
interest (2) (1,454) - -
-------- -------- --------
Diluted net income (loss) before
cumulative effect of change in
accounting principles $ 26,203 $(13,170) $(26,592)
======== ======== ========
Diluted net income (loss) $ 26,203 $(13,170) $(31,743)
======== ======== ========
Weighted average common shares
outstanding 37,720 20,970 19,240
Common stock equivalents due to
dilutive effect of stock options
(2) 81 - -
Shares converted from convertible
debt (2) 48,505 - -
-------- -------- --------
Total outstanding shares for fully
diluted earnings per share
computation 86,306 20,970 19,240
-------- -------- --------
Diluted earnings per share from net
income (loss) before cumulative
effect of accounting change $ 0.30 $ (0.63) $ (1.38)
======== ======== ========
Diluted earnings per share $ 0.30 $ (0.63) $ (1.65)
======== ======== ========
(1) Restated to reflect impact of previously unreserved policy riders. See Note
2 - "Restatement"
(2) Amounts not included in 2003 and 2002 because they are anti-dilutive
F-13
STOCK BASED COMPENSATION PLANS:
The Company continues to maintain its accounting for stock-based compensation in
accordance with APB No. 25, but has adopted the disclosure provisions of SFAS
No. 148.
The following table reflects net income, basic and diluted earnings per share as
reported and pro-forma as if the Company had adopted the fair value based method
of accounting for its stock-based employee compensation awards:
2003 2002
2004 RESTATED (1) RESTATED (1)
--------- ------------ -----------
Net income (loss), as reported $ 20,536 $ (13,170) $ (31,743)
Add: Stock-based employee compensation
income included in reported net income,
net of related tax effects - - 286
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (369) (248) (258)
--------- ------------ -----------
Pro forma net income (loss) $ 20,167 $ (13,418) $ (31,715)
========= ============ ===========
Earnings per share:
Basic - as reported $ 0.54 $ (0.63) $ (1.65)
Basic - pro forma $ 0.53 $ (0.64) $ (1.65)
Diluted - as reported $ 0.30 $ (0.63) $ (1.65)
Diluted - pro forma $ 0.30 $ (0.64) $ (1.65)
(1) Restated to reflect impact of previously unreserved policy riders. See Note
2 - "Restatement"
NEW ACCOUNTING PRONOUNCEMENTS:
In December 2004, the Financial Accounting Standards Board ("FASB") issued FASB
Statement No. 123R ("SFAS 123R") "Share-Based Payment". SFAS 123R replaces SFAS
123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion 25,
"Accounting for Stock Issued to Employees." SFAS 123R requires that the cost of
share-based payment transactions (including those with employees and
non-employees) be recognized in the financial statements. SFAS 123R applies to
all share-based payment transactions in which an entity acquires goods or
services by issuing (or offering to issue) its shares, share options, or other
equity instruments (except for those held by an ESOP) or by incurring
liabilities (1) in amounts based (even in part) on the price of the entity's
shares or other equity instruments, or (2) that require (or may require)
settlement by the issuance of an entity's shares or other equity instruments.
SFAS 123R is effective for public companies for annual periods beginning after
June 15, 2005. The Company will adopt the provisions of SFAS 123R on January 1,
2006 and has not yet determined the impact on its financial position or results
of operations.
F-14
4. INVESTMENTS AND FINANCIAL INSTRUMENTS
DEBT SECURITIES -
The amortized cost and estimated market values of debt securities at
December 31, 2004 and 2003 are shown below.
DECEMBER 31, 2004
---------------------------------------------------------------------
Amortized Gross Unrealized Grossd Unrealized Estimated
Cost Gains Losses Market Value
----------- ------------------ ------------------- --------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 34,795 $ 298 $ (237) $ 34,856
Mortgage backed securities 1,874 21 (16) 1,879
Debt securities issued by
foreign governments 384 20 (2) 402
Corporate securities 21,892 245 (103) 22,034
----------- ------------------ ------------------- --------------
$ 58,945 $ 584 $ (358) $ 59,171
=========== ================== =================== ==============
DECEMBER 31, 2003
---------------------------------------------------------------------
Amortized Gross Unrealized Grossd Unrealized Estimated
Cost Gains Losses Market Value
----------- ------------------ ------------------- --------------
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 20,699 $ 624 $ (38) $ 21,285
Mortgage backed securities 2,020 39 (3) 2,056
Debt securities issued by
foreign governments 236 11 (2) 245
Corporate securities 19,978 375 (86) 20,267
----------- ------------------ ------------------- --------------
$ 42,933 $ 1,049 $ (129) $ 43,853
=========== ================== =================== ==============
The amortized cost and estimated market values of debt securities at
December 31, 2004, by contractual maturity, are shown below. Expected
maturities may differ from contractual maturities because borrowers may
have the right to call or prepay obligations with or without call or
prepayment penalties.
Amortized Estimated
Cost Market Value
--------- ------------
Due in one year or less $ 5,113 $ 5,154
Due after one year through five years 35,236 35,322
Due after five years through ten years 16,722 16,816
Collateralized Mortgage Obligations 1,874 1,879
--------- ------------
$ 58,945 $ 59,171
========= ============
F-15
Gross proceeds and realized gains and losses on debt securities,
including impairment losses for declines deemed other than temporary and
excluding calls, were as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- ----- ------
2004 $ 34,177 $ 314 $ 147
2003 43,264 493 256
2002 478,808 18,728 3,822
Gross proceeds and realized gains and losses on equity securities,
including impairment losses for declines deemed other than temporary,
were as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- ----- ------
2004 $ - $ - $ -
2003 - - -
2002 9,547 1,861 1,094
IMPAIRMENTS -
The Company assesses whether declines in market value, whether for its
debt securities or its equity securities, are other than temporary. Upon
such determination, the Company will impair the security's amortized
cost and record an impairment charge in its results of operations.
The Company reduced its cost basis on bonds in 2002 by $12 due to
differences deemed other than temporary. There were no differences
deemed to be other than temporary during 2004 or 2003. The following
table describes the Company's debt securities at December 31, 2004,
which had a market value below cost:
Less Than 12 Months Greater Than 12 Months Total
------------------- ---------------------- -----
Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss
---------- --------------- ---------- --------------- ---------- ---------------
DEBT SECURITIES
---------------
U.S. Treasury securities and
obligation of U.S. Government
authorities and agencies $ 24,138 $ (228) $ 150 $ (9) $ 24,288 $ (237)
Mortgage backed securities 1,369 (16) - - 1,369 (16)
Debt securities issued by foreign
governments - - 29 (2) 29 (2)
Corporate securities 9,578 (92) 380 (11) 9,958 (103)
---------- --------------- ---------- --------------- ---------- ---------------
TOTAL $ 35,085 $ (336) $ 559 $ (22) $ 35,644 $ (358)
========== =============== ========== =============== ========== ===============
The above table includes $336 of unrealized losses related to fixed
income securities that have been in an unrealized loss situation for
less than twelve months and $22 of unrealized losses related to fixed
income securities that have been in an unrealized loss situation for
greater than twelve months. All of the fixed income securities are
investment grade and have a fair value of greater than 94% of amortized
cost. Investment grade is defined as a security having a rating from the
NAIC of 1 or 2; a Moody's equivalent rating of Aaa, Aa, A, or Baa; a
Standard & Poor's equivalent rating of AAA, AA, A, or BBB; or a
comparable internal rating. Unrealized losses on investment grade
securities are principally related to changes in interest rates or
changes in issuer or sector related credit spreads since the securities
were acquired.
F-16
All of the securities were evaluated considering factors such as
financial conditions, near-term, and long-term prospects of the issuer
and were determined to have adequate resources to fulfill contractual
obligations. As of December 31, 2004, the Company had the intent and
ability to hold these investments for a period of time sufficient for
them to recover in value.
NET INVESTMENT INCOME -
Net investment income is applicable to the following types of
investments:
2004 2003 2002
-------- -------- --------
Bonds $ 2,052 $ 2,173 $ 1,327
Notional experience account 46,162 41,426 38,375
Other 242 302 647
-------- -------- --------
Investment income 48,456 43,901 40,349
Investment expense (1,617) (628) (242)
-------- -------- --------
Net investment income $ 46,839 $ 43,273 $ 40,107
======== ======== ========
RESTRICTED INVESTMENTS AND CASH
Pursuant to certain statutory licensing requirements, as of December 31,
2004 and 2003, the Company had on deposit bonds with an estimated market
value aggregating $12,264 and $12,585, respectively, in Insurance
Department special deposit accounts. The Company is not permitted to
remove the bonds from these accounts without approval of the regulatory
authority.
The Company maintains assets in a trust account under a reinsurance
agreement with an unaffiliated insurer. The Company is required to hold
assets equal to at least 102% of the reserves for the policies assumed
under this agreement. At December 31, 2004 and 2003, the Company was
required to hold $18,869 and $15,905, respectively.
5. PROPERTY AND EQUIPMENT:
The following table lists the range of lives, cost and accumulated
depreciation for various asset classes:
December 31, 2004
-----------------------------------------------------
Accumulated Carrying
Class Years Cost Depreciation Value
----- ----------- -------- ------------ ---------
Automobiles 5 $ 271 $ 213 $ 58
Equipment 5 - 10 4,702 4,390 312
Software 3 - 10 13,306 2,790 10,516
Furniture 10 2,813 1,624 1,189
Buildings 40 6,560 1,710 4,850
-------- ------------ ---------
$ 27,652 $ 10,727 $ 16,925
======== ============ =========
December 31, 2003
-----------------------------------------------------
Accumulated Carrying
Class Years Cost Depreciation Value
----- ----------- -------- ------------ ---------
Automobiles 5 $ 313 $ 273 $ 40
Equipment 5 - 10 4,616 4,231 385
Software 3 - 10 11,746 1,853 9,893
Furniture 10 2,646 1,709 937
Buildings 40 6,463 1,569 4,894
-------- ------------ ---------
$ 25,784 $ 9,635 $ 16,149
======== ============ =========
The Company amortized $849, $631 and $607 of its cost related to
software in 2004, 2003 and 2002, respectively. Depreciation expense on
other property and equipment was $792, $1,079 and $1,024 for the years
ended December 31, 2004, 2003 and 2002, respectively.
F-17
At December 31, 2003, the Company concluded that its system replacement
project would be more expensive and take longer to implement than it had
originally intended. As a result of this conclusion and the availability
of alternative vendor solutions that had become available since the
start of its project, the Company determined to evaluate additional
vendors for a portion of its system replacement project, which if
selected would not utilize certain components of the programming
completed and capitalized in prior periods. As a result of its decision
to select another vendor and discontinue the use of a portion of its
current software, the Company impaired the capitalized value of the
unused software by $522 at December 31, 2003. No impairment losses were
recorded in 2004 or 2002.
6. NOTIONAL EXPERIENCE ACCOUNT:
During 2004 and 2003, the notional experience account activity was as
follows:
Twelve Months Ended December 31,
--------------------------------------
2004 2003
---- ----
Beginning balance $ 784,778 $ 708,982
Premiums, net of claims and
ceding allowance: 43,418 55,512
Investment credit:
Investment income 46,162 41,426
Market gain(loss) 39,749 (9,494)
Expense and risk charges (11,230) 11,074)
Broker/custodian/trustee fees (1,509) (574)
---------------- ---------------
Ending balance $ 901,368 $ 784,778
================ ===============
7. IMPAIRMENT OF GOODWILL:
During the second quarter 2002, the Company completed an impairment
analysis of goodwill, in accordance with SFAS No. 142 "Goodwill and
Other Intangible Assets". 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 two 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. The deficiency of current market value to book
value was attributed to the insurance subsidiary values. As a result,
the Company determined that the goodwill associated with its insurance
subsidiaries was impaired and recognized an impairment loss of $5,151
from its transitional impairment test of goodwill, which it recorded as
a cumulative effect of change in accounting principle. The impairment
has been recorded effective January 1, 2002.
During the Company's quarterly impairment as of December 31, 2004, it
determined that the goodwill related to its agency reporting unit
consisting of UIG and NISHD was impaired. The test was done on a
quarterly basis during 2004 due to declining sales. This impairment was
a result of declining sales which led to lower than planned net income
at the reporting unit level. The fair value of the reporting unit is
determined utilizing the present value of cash flows, which includes
assumptions for future growth in sales. During the most recent
impairment test, the Company lowered the assumption related to future
sales growth and as a result has recognized an impairment of $13,376 in
2004.
F-18
8. POLICY AND CLAIM RESERVES:
Policy reserves have been computed principally by the net premium method
based upon estimated future investment yield, mortality, morbidity
(claims experience), withdrawals and other benefits. The Company employs
a prospective net premium methodology, which incorporates premium rate
increases expected to be implemented in the near term in the net premium
used to establish policy reserves. The composition of the policy
reserves at December 31, 2004 and 2003, and the assumptions pertinent
thereto are presented below:
Amount of Policy Reserves
as of December 31,
2003
2004 Restated (1)
---- ---------------
Accident and health $ 568,928 $ 518,600
Annuities and other 162 137
Ordinary life, individual 12,785 12,734
Years of Issue Discount Rate
------------------------------- ------------------------------
Accident and health 1976 to 2002 5.7%
2002 to 2004 4.5%
Annuities and other 1977 to 1983 6.5% & 7.0%
Ordinary life, individual 1962 to 2002 3.0% to 5.5%
(1) Restated to reflect impact of previously unreserved policy riders. See Note 2 -
"Restatement"
Accident and health: Morbidity and withdrawals based on
actual and projected experience.
Morbidity represents the claim costs we
expect to incur in the future. The
assumption for these future claim costs
is based on past company experience
modified for both industry experience
and recent trends, withdrawals represent
the lapsation of policies due to either
death or cancellation.
Annuities and other: Primarily funds on deposit inclusive of
accrued interest.
Ordinary life, individual: Mortality based on 1975-80 SOA Mortality
Table (Age Last Birthday).
The development of the Company's claim reserves and paid claims is
summarized as follows for claims incurred (the date of original claim)
in 2004 and prior.
2004 2003 2002
---- ---- ----
Claim reserve balance at January 1 $ 340,981 $ 329,944 $ 214,466
less reinsurance recoverable (7,698) (9,059) (8,888)
---------- ---------- ----------
Net claim reserve balance at January 1 333,283 320,885 205,578
---------- ---------- ----------
Incurred related to:
Current year 184,316 190,986 200,006
Prior years (18,082) (3,095) 80,948
Imputed prior year interest 14,922 14,136 10,225
---------- ---------- ----------
Total incurred 181,156 202,027 291,179
---------- ---------- ----------
Paid related to:
Current year 46,474 49,149 48,627
Prior years 152,033 140,480 127,245
---------- ---------- ----------
Total paid 198,507 189,629 175,872
---------- ---------- ----------
Net claim reserve balance at December 31 315,932 333,283 320,885
plus reinsurance recoverable 8,206 7,698 9,059
---------- ---------- ----------
Claim reserve balance at December 31 $ 324,138 $ 340,981 $ 329,944
========== ========== ==========
F-19
The Company establishes reserves for the future payment of all currently
incurred claims. The amount of reserves relating to reported and
unreported claims incurred is determined by periodically evaluating
historical claims experience and statistical information with respect to
the probable number and nature of such claims. Claim reserves reflect
actual experience through the most recent time period. Claim reserves
include current assumptions as to type and duration of care, remaining
policy benefits, and interest rates. The Company compares actual
experience with estimates and adjusts its reserves on the basis of such
comparisons.
The Company evaluates its prior year assumptions by reviewing the
development of reserves for the prior period (i.e. incurred from prior
years). This amount includes imputed interest from prior year-end
reserve balances plus adjustments to reflect actual versus estimated
claims experience. These adjustments (particularly when calculated as a
percentage of the prior year-end reserve balance) provide a relative
measure of deviation in actual performance as compared to its initial
assumptions. The adjustments to reserves for claims incurred in prior
periods are primarily attributable to claims incurred from our long-term
care insurance policies, which represent approximately 95% of our
premium in-force.
In 2004, prior year incurred claims developed favorably by $19,404
compared to prior period expectations. The favorable development is due
to:
(1) Refinements to the model utilized to calculate claim
reserves, including the addition of diagnosis code data,
payment frequency data, and further delineation of
policy forms for purposes of evaluation existing
continuance tables. As a result claims reserves were
reduced by approximately $6,000.
(2) An increase in the discount rate used for claims
reserves from 5.7% to 5.9%, reflecting improved
investment portfolio performance, which reduced claims
reserves by approximately $1,000.
(3) During 2004, fewer claims that were closed as of
December 31, 2003 reopened than we had estimated,
resulting in a reduction of approximately $4,500; and
(4) Claim reserve adjudication process improvements
implemented in the second half of 2003 and throughout
2004.
In 2003, prior year incurred claims developed favorably by $3,095
compared to prior period expectations. This development did not differ
materially from the amount reserved at December 31, 2003.
In 2002, the Company added approximately $80,948 to its claim reserves
for 2001 and prior period incurred claims. During 2002, the Company
completed an analysis of the adverse deviation recognized in the past
development of its reserves for current claims. The analysis included a
comparison of actual to expected experience. As a result of this
analysis, the Company refined its process and assumptions for developing
claims reserves. This included redefining certain "multiple" claims as a
single claim and employing new assumptions and processes for predicting
the continuance, or the likelihood of a claim continuing in the future.
Over time, it may continue to be necessary for the Company to increase
or decrease its reserves further as additional experience develops.
9. LONG-TERM DEBT:
At December 31, 2004 and 2003 our long-term debt consists entirely of
convertible subordinated debt issued in 2002, 2003 and 2004, all of
which matures in 2008 (the "Notes").
During 2004 and 2003 the activity in long-term debt was as follows:
December 31,
2004 2003
---- ----
Long-term debt at beginning of year $ 90,092 $ 74,750
Debt issued 26,000 32,421
Debt retired - (8,957)
Debt converted (29,499) (8,122)
----------- -----------
Long-term debt at end of year 86,593 90,092
Less discount on long-term debt (1,426) (1,625)
----------- -----------
Long-term debt less discount at end of year $ 85,167 $ 88,467
=========== ===========
F-20
The Notes pay a semi-annual coupon at a 6.25% annual percentage rate.
The Notes are callable after October 15, 2005, at the Company's option,
at a price equal to 100% of the principal amount of the Notes plus
accrued and unpaid interest. The Notes are general unsecured obligations
of the Company and are subordinated to all future senior indebtedness.
Prior to maturity, the Notes are convertible to shares of the Company's
stock at $1.75 per share. The Notes are mandatorily convertible if, at
any time after October 15, 2005, the 15-day average closing price of the
Company's common stock exceeds 110% of the conversion price.
The Notes also contain a provision that, upon conversion prior to
October 15, 2005, the Company will pay the holder additional interest
(referred to as "preferred interest on early conversion") equal to the
amount that would otherwise have been paid from the date of conversion
until October 15, 2005. The interest amount, which is discounted from
October 15, 2005 to the date of early conversion, is payable at the
Company's discretion in cash or in shares of common stock equal to 90%
of the average closing prices of the Company's common stock for the five
trading days immediately preceding the conversion date. The preferred
interest on early conversion is accounted for as an embedded derivative
with changes in its fair value recorded on the Consolidated Statements
of Income and Comprehensive Income.
As of December 31, 2004 and 2003, the fair value of the embedded
derivative was $1,403 and $3,018, respectively. In determining the fair
value of the embedded derivative, the Company makes certain assumptions,
including the future volatility and liquidity of the Company's common
stock, as well as recent trends in the number of holders converting.
During 2004 and 2003, the activity in the preferred interest on early
conversion was as follows:
December 31,
2004 2003
---- ----
Preferred interest on early conversion at beginning of year $ 3,018 $ -
Add fair value related to new debt issuances 622 2,037
Change in fair value (2,237) 981
---------- ----------
Preferred interest on early conversion at end of year $ 1,403 $ 3,018
========== ==========
The decrease in fair value during 2004 is due to the conversions that
occurred during 2004 and the decrease in the time period until October
15, 2005, the date that interest is paid through. The fair value
increased during 2003 due to the issuance in new debt, an increase in
the liquidity of the Company's common shares.
During 2004 and 2003, holders of $29,499 and $8,122 of the Notes elected
to convert their Notes into 16,857 and 4,641 shares of the Company's
common stock, respectively, and also received 1,490 and 543 shares,
respectively, as payment for preferred interest on early conversion. In
connection with these conversions, the Company recognized additional
interest expense of $2,809 and $1,069 for the years ended December 31,
2004 and 2003, respectively.
During November 2004, the Company issued $10,000 of additional Notes. At
the time of issuance the market price of the Company's common stock was
$1.87. As a result of the market price of the common stock exceeding the
conversion price, the Company recorded additional interest expense of
$686 related to this issuance.
The Company recorded interest expense of $820 and $412 in 2004 and 2003,
respectively related to the reduction in the discount on long-term debt.
F-21
At December 31, 2004, the Company's total debt and financing obligations
through 2009 were as follows:
Lease
Debt Obligations Total
--------- ----------- ----------
2005 $ - $ 460 $ 460
2006 - 349 349
2007 - 277 277
2008 86,593 214 86,807
2009 - 170 170
--------- ----------- ----------
Total $ 86,593 $ 1,470 $ 88,063
========= =========== ==========
10. FEDERAL INCOME TAXES:
The total (provision) benefit for federal income taxes for the years
ended December 31 consisted of:
2003 2002
2004 Restated (1) Restated (1)
---- ------------ ------------
Current $ (1,575) $ (435) $ 2,548
Deferred (14,101) 3,427 11,180
----------- ------------ ------------
$ (15,676) $ 2,992 $ 13,728
=========== ============ ============
(1) Restated to reflect impact of previously unreserved policy
riders. See Note 2 - "Restatement"
Deferred income tax assets and liabilities have been recorded for
temporary differences between the reported amounts of assets and
liabilities in the accompanying financial statements and those in the
Company's income tax return. Management believes the existing net
deductible temporary differences are realizable on a more likely than
not basis. The sources of these differences and the approximate tax
effect are as follows for the years ended December 31:
2003
2004 Restated (1)
----------- ------------
Net operating loss carryforward $ 23,443 $ 21,079
Pension and post-retirement accrual 558 597
Preferred interest on early conversion 491 1,056
Litigation accrual 1,523 -
Other 1,085 685
Valuation allowance (8,275) (8,275)
----------- ------------
Total deferred tax assets $ 18,825 $ 15,142
=========== ============
Deferred policy acquisition costs $ (10,961) $ (17,912)
Present value of future profits acquired (74) (140)
Premiums due and unpaid (878) (873)
Unrealized gains on investments (79) (322)
Policy reserves (33,087) (5,193)
Deferred reinsurance premium (2,775) (3,700)
Discount on long-term debt (499) (569)
Other (61) (2,164)
----------- ------------
Total deferred income liabilities $ (48,414) $ (30,873)
=========== ============
Net deferred income tax $ (29,589) $ (15,731)
=========== ============
(1) Restated to reflect impact of previously unreserved policy riders. See
Note 2 - "Restatement"
F-22
The Company has net operating loss carryforwards of $39,876, or $13,957
on a tax effected basis, which have been generated by taxable losses at
the parent company, and if unused will expire between 2012 and 2024. The
Company has net operating loss carryforwards of $27,102, or $9,486 on a
tax effected basis, which have been generated by taxable losses at the
Company's life subsidiaries, and if unused, will expire in 2016.
The parent company's net operating loss carryforwards can be utilized by
the Company's insurance subsidiaries subject to the lesser of 35% of the
insurance subsidiary taxable income or 35% of the current aggregate
carry forward amount. The Company has recorded a valuation allowance of
$8,275 against its net operating loss carryforwards.
The valuation allowances were recorded as a result of potential future
limitations on their use due to Internal Revenue Code Section 382. The
Internal Revenue Service has established rules that potentially limit a
company's use of prior period net operating loss carryforwards in the
event that a majority of the company's common stock ownership changes
within any consecutive three year period. Due to the issuance of
additional shares of the Company's common stock since May 2001 and
conversions of the Company's subordinated convertible notes during 2003
and the first quarter of 2004, the Company became subject to these
limitations and has established the valuation allowance at December 31,
2003 accordingly. There was no change to the valuation allowance in
2004.
A reconciliation of the income tax (provision) benefit computed using
the federal income tax rate to the (benefit) provision for federal
income taxes is as follows:
2003 2002
2004 RESTATED (1) RESTATED (1)
------------ ------------ ------------
Computed federal income tax (provision)
benefit provision at statutory rate $ (12,674) $ 5,656 $ 15,914
Valuation allowance - (2,500) -
Impairment of goodwill (3,801) - (1,803)
Interest expense on beneficial conversion feature (263)
Small life insurance company deduction 597 236 -
Tax-exempt income 113 713 1,225
Other 352 (1,113) (1,608)
------------ ------------ ------------
$ (15,676) $ 2,992 $ 13,728
============ ============ ============
(1) Restated to reflect impact of previously unreserved policy riders. See Note 2 -
"Restatement"
At December 31, 2004, the accumulated earnings of the Company for
Federal income tax purposes included $1,451 of "Policyholders' Surplus",
a special memorandum tax account. This memorandum account balance has
not been currently taxed, but income taxes computed at then-current
rates will become payable if surplus is distributed. Provisions of the
Deficit Reduction Act of 1984 do not permit further additions to the
"Policyholders' Surplus" account.
11. STATUTORY INFORMATION:
STATUTORY FINANCIAL RESULTS
The insurance subsidiaries prepare their statutory financial statements
in accordance with accounting practices prescribed or permitted by the
insurance department of the state of domicile. Net income and capital
and surplus for these subsidiaries as reported in accordance with
statutory accounting principles, are as follows:
2004
(UNAUDITED) 2003 2002
----------- ---- ----
Net (loss) income $ (5,319) $ (5,023) $ 7,288
Capital and surplus 29,902 30,638 34,234
F-23
Total reserves, including claim reserves, reported to regulatory
authorities were approximately $861,820 and $824,232 less than those
recorded for GAAP as of December 31, 2004 and 2003, respectively. This
difference is primarily attributable to reinsurance agreements in force
as of December 31, 2004 and 2003.
The differences in statutory net income (loss) compared to GAAP net
(loss) income are primarily due to the immediate expensing of
acquisition costs, as well as differing reserving methodologies and
treatment of reinsurance and deferred income taxes. Due to the
differences in expensing of acquisition costs and reserving
methodologies, under statutory accounting there is generally a net loss
and a corresponding decrease in surplus, referred to as surplus strain,
when new policies are issued.
PENNSYLVANIA CORRECTIVE ACTION PLAN
The Company's Pennsylvania 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 them under regulatory control, leading to
rehabilitation or liquidation. At December 31, 2000, the Company's
primary insurance subsidiary, Penn Treaty Network America Insurance
Company ("PTNA"), which represented 94% of the Company's direct premium
revenue, had statutory surplus which, while above the authorized control
level, was at an amount that required PTNA to file a Corrective Action
Plan (the "Plan") with the insurance commissioner. In addition, American
Network Insurance Company ("ANIC"), which is owned 100% by PTNA, is also
subject to the provisions of the Plan.
On February 12, 2002, the Department approved the Plan which, among
other things:
a) required the Company to enter into a reinsurance
agreement with Centre Solutions (Bermuda) Limited (the
"2001 Centre Agreement") for substantially all of its
existing business at December 31, 2001
b) limits new investments to those rated by the National
Association of Insurance Commissioners ("NAIC") as 1 or
2;
c) limits and requires Department approval for affiliated
transactions; and
d) required a $125,000 increase in statutory reserves over
a three-year period, which has been completed as of
December 31, 2004.
The 2001 Centre Agreement is accounted for as reinsurance for statutory
accounting purposes, but does not qualify as reinsurance under GAAP. As
the agreement is treated as reinsurance for statutory accounting
purposes, it results in the ceding (or removal) of substantially all of
PTNA's and ANIC's policy reserve and claim reserve liabilities for
statutory accounting purposes. Furthermore, subject to certain
limitations, any adverse development of the 2001 and prior policy and
claim reserves, is ceded to the reinsurer and is not reflected on PTNA's
or ANIC's statutory financial statements.
The agreement is subject to certain coverage limitations, including an
aggregate limit of liability that is a function of certain factors and
that may be reduced in the event that the premium rate increases that
the reinsurance agreement may require are not obtained. The Company is
required to perform annual comparisons of its actual to expected claims
experience. If the Company has reason to believe, whether from this
analysis or other available information, that at least a 5% premium rate
increase is necessary, the Company is obligated to file and obtain such
premium rate increases in order to comply with the requirements of the
agreement. If the Company does not file and obtain such premium rate
increases, the aggregate limit of liability would be reduced by 50% of
the premium amount that would have otherwise been received.
In the event the statutory policy and claim reserves for the reinsured
policies ultimately exceed the limit of liability established in the
reinsurance agreement, either as a result of additions to reserves or
reductions in the amount of the
F-24
reinsurer's limit of liability, PTNA or ANIC would have to retain any
reserve liabilities in excess of the limit of liability, which could
have a materially adverse impact upon their statutory surplus.
The estimation of policy reserves for statutory accounting purposes
differs from that utilized in GAAP. For statutory accounting purposes,
the assumptions utilized and the methodology applied may be at the
discretion of the Department in its interpretation of its regulations.
As noted above, as part of the Plan, the Department has provided the
Company with guidelines for establishing its statutory policy reserves.
Because PTNA and ANIC have limited statutory capital and the 2001 Centre
Agreement has a limit of liability, any changes in the Department's
interpretation or view of how the Company's insurance subsidiaries
determine their statutory policy reserves could have a material adverse
impact on PTNA or ANIC, possibly resulting in regulatory control or
liquidation.
Failure to comply with the Plan could result in the Department taking
control of the Company's insurance subsidiaries.
STATUTORY DIVIDEND RESTRICTIONS
States restrict the dividends the Company's insurance subsidiaries are
permitted to pay. Dividend payments will depend on profits arising from
the business of its insurance company subsidiaries, computed according
to statutory formulae. Under the insurance laws of Pennsylvania and New
York, where the Company's insurance subsidiaries are domiciled,
insurance companies can pay ordinary dividends only out of earned
surplus. In addition, under Pennsylvania law, PTNA and ANIC must give
the Department at least 30 days' advance notice of any proposed
"extraordinary dividend" and cannot pay such a dividend if the
Department disapproves the payment during that 30-day period. For
purposes of that provision, an extraordinary dividend is a dividend
that, together with all other dividends paid during the preceding twelve
months, exceeds the greater of 10% of the insurance company's surplus as
shown on the company's last annual statement filed with the 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 the parent, regardless of normal
statutory requirement for allowable dividends. The Company believes that
the Department is unlikely to consider any dividend request in the
foreseeable future, as a result of PTNA's statutory surplus position.
Although not stipulated in the Plan, this requirement is likely to
continue until such time as PTNA meets normal statutory requirements,
including reported net income and positive cumulative earned surplus.
Under New York law, AINIC must give the New York Insurance Department 30
days advance notice of any proposed dividend and cannot pay any dividend
if the regulator disapproves the payment during that 30-day period. In
addition, AINIC must obtain the prior approval of the New York Insurance
Department before paying any dividend that, together with all other
dividends paid during the preceding twelve months, exceeds the lesser of
10% of the insurance company's surplus as of the preceding December 31
or its adjusted net investment income for the year ended the preceding
December 31.
PTNA and ANIC have not paid any dividends to the parent company for the
past three years and are unlikely in the foreseeable future to be able
to make dividend payments due to insufficient statutory surplus and
anticipated earnings. However, AINIC is not subject to the Plan and was
permitted by New York statute to make a dividend payment in 2002 of
$651.
12. EMPLOYEE BENEFITS:
401(K) RETIREMENT PLAN:
The Company has a 401(k) retirement plan, covering substantially all
employees with at least one year of service. Under the plan,
participating employees may contribute up to 15% of their annual salary
on a pre-tax basis. The Company, under the plan, equally matches 100% of
employee contributions up to the first 3% of the employee's salary. The
Company and employee portion of the plan is vested immediately. The
Company's expense related to
F-25
this 401(k) plan was $269, $240 and $239 for the years ended December
31, 2004, 2003 and 2002, respectively. The Company may elect to make a
discretionary contribution to the plan, which will be contributed
proportionately to each eligible employee. The Company did not make a
discretionary contribution in 2004, 2003 or 2002.
RETIREMENT BENEFITS:
On April 29, 2003, the Company announced that its Board of Directors had
approved certain changes in the management of the Company to implement
the succession plan initiated in 2002. On May 23, 2003, in connection
with the succession plan, the Company's Founder stepped down as Chairman
of the Board of Directors and Chief Executive Officer but will continue
as a member of the Board of Directors. In addition, the Company and its
Founder entered into a consulting and retirement agreement. The
significant terms of the consulting and retirement agreement are as
follows:
a) The Company's Founder assumed the new position of
Founding Chairman.
b) The Company will pay the Founding Chairman or his
spouse, until the later of his death or the death of his
spouse, a retirement benefit of $100 per year and health
and welfare benefits comparable to those the Company
offers to its executives from time to time.
c) The Founding Chairman will continue to provide certain
services to the Company for a period of up to two years,
in exchange for which the Company pays him an annual
retainer of $100.
The Company uses December 31 as the measurement date for the plans and
the plans are unfunded. The following table provides the components of
the benefit obligation at December 31, 2004:
PENSION BENEFITS OTHER BENEFITS
---------------------- ----------------------
2004 2003 2004 2003
---- ---- ---- ----
Change in benefit obligation:
Benefit Obligation at Beginning of Year $ 1,492 $ - $ 215 $ -
Benefit Obligation at May 23, 2003 - 1,526 - 205
Interest Cost 83 83 12 16
Benefits Paid (200) (117) (8) (6)
Actuarial Loss/(Gain) - includes change in discount rate 12 - 37 -
--------- --------- --------- ---------
Benefit Obligation at End of Year $ 1,387 $ 1,492 $ 256 $ 215
========= ========= ========= =========
A 6.0% weighted average discount rate was assumed in determining both
the benefit obligation at December 31, 2004 and 2003 and to determine
the net periodic benefit cost for the years ended December 31, 2004 and
2003.
Amounts recognized in the Consolidated Balance Sheets consist of:
PENSION BENEFITS OTHER BENEFITS
----------------------- --------------------
2004 2003 2004 2003
---- ---- ---- ----
Accrued Benefit Cost $ 1,375 $ 1,492 $ 219 $ 215
The expense components of the net periodic pension and postretirement
benefit cost for the year ended December 31, 2004 consisted of only
interest expense and were $83 and $12 for Pension and Other Benefits,
respectively. The expense components of the net periodic pension and
postretirement for the year ended December 31, 2003 consisted of only
interest expense and was $83 and $16 for Pension and Other Benefits,
respectively.
F-26
The assumed health care cost trend rates at December 31, 2004 and 2003
are:
2004 2003
---- ----
Current Year Medical Trend Rate 12.00% 5.75%
Ultimate Medical Trend Rate 4.00% 5.75%
Assumed health care cost trend rates have an effect on the amounts
reported for the health care plans. A one-percentage point change in
assumed health care cost trend rates would have the following effects:
One - One-
Percentage- Percentage-
Point Point
Increase Decrease
----------- -----------
Effect on Total of Service and Interest Cost $1 ($1)
Effect on Postretirement Benefit Obligation 22 19
The following benefits are expected to be paid in the future:
PENSION BENEFITS OTHER BENEFITS
--------------------- -----------------
2005 $ 142 $ 12
2006 97 18
2007 94 19
2008 91 20
2009 87 21
2010-2014 381 103
13. STOCK OPTION PLANS:
At December 31, 2004, the Company had three stock-based compensation
plans, which are described below. The Company applies APB Opinion No. 25
in accounting for its plans. The Company issues options at the current
market value and does not record a charge to earnings upon the issuance
of options. While the Company continues to maintain its accounting for
stock-based compensation in accordance with APB Opinion No. 25, it has
adopted the disclosure provisions of SFAS No. 148.
The Company's 1987 Employee Incentive Stock Option Plan provided for the
granting of options to purchase up to 1,200 shares of common stock. This
plan expired in 1997 and was subsequently replaced by the 1998 Employee
Non-Qualified Incentive Stock Option Plan. The 1998 Plan allows for the
grant of options to purchase up to 600 shares of common stock. No new
options may be granted under the 1987 Plan. The term of each option
granted in 2004, 2003 and 2002 is ten years and each is vested one year
following the date of original grant.
Effective May 1995, the Company adopted a Participating Agent Stock
Option Plan which provides for the granting of options to purchase up to
300 shares of common stock. The exercise price of all options granted
under the plan may not be less than the fair market value of the shares
on the date of grant. The term of each option is ten years, and the
options become exercisable in four equal, annual installments commencing
one year from the option grant date. SFAS No. 123 requires that the fair
value of options granted to non-employees (agents) be recognized as
compensation expense over the estimated life of the option. Options were
granted to agents in 1997, 1996 and 1995. No agent options have been
granted since 1997. The Company did not have any compensation expense
related to this Plan in 2004, 2003 or 2002.
During 2001, the Company granted 566 replacement options to its
employees for all existing options granted under its existing fixed
option plans. As a result, these options are now subject to the variable
accounting provisions of APB Opinion No. 25 until exercised, forfeited
or cancelled. The Company recorded compensation income of $430
F-27
in 2002, related to these variable options, representing the change in
the intrinsic value of the stock options at the reporting date. In
addition, 4 options were granted to a new senior executive in 2002, 23
were granted to new executives in 2003, and none were granted to new
executives in 2004.
Had compensation cost for the Company's employee stock-based
compensation plans been determined based on the fair value at the grant
dates for awards under those plans consistent with the method of SFAS
No. 123, the Company's net loss and earnings per share would have been
reduced to the pro-forma amounts indicated in Note 1.
Pro-forma compensation cost is estimated using an option-pricing model
with the following assumptions for new options granted to employees in
2004, 2003 and 2002. In 2004, options were valued with an expected life
of 5.3 years, volatility of 67.7% and a risk free interest rate of 3.9%.
The weighted average fair value of options granted in 2004 was $1.11. In
2003 options were valued with an expected life of 5.3 years, volatility
of 70.9% and a risk free rate of 3.5%. The weighted average fair value
of options granted in 2003 was $.98. In 2002, options were valued with
an expected life of 5.3 years, volatility of 70.9% and a risk free rate
of 4.4%. The weighted average fair value of options granted in 2002 was
$2.37.
The following is a summary of the Company's option activity, including
grants, exercises, forfeitures and weighted average price information:
2004 2003 2002
---- ---- ----
Exercise Exercise Exercise
Price Price Price
Options Per Option Options Per Option Options Per Option
------------- ------------ ------------- ------------ ------------- ---------------
Outstanding at beginning of year 1,038 $ 5.85 652 $ 8.45 648 $ 8.48
Granted 518 $ 1.83 395 $ 1.60 4 $ 4.40
Exercised - $ - - $ - - $ -
Forfeitures 2 $ 8.39 9 $ 8.20 - $ -
------------- ------------- -------------
Outstanding at end of year 1,554 $ 4.51 1,038 $ 5.85 652 $ 8.45
============= ============= =============
Exercisable at end of year 1,036 $ 5.81 726 $ 7.26 648 $ 8.48
============= ============= =============
Outstanding Remaining Exercisable
at December Contractual at December
Range of Exercise Prices 31, 2004 Life (Yrs) 31, 2004
----------------------------- ------------- ------------- -------------
$1.52 -- $1.64 389 9 389
$1.70 358 10 -
$1.80 5 9 5
$2.13 160 10 -
$2.54 2 9 2
$3.40 -- $4.26 116 7 116
$4.40 4 8 4
$4.68 -- $12.30 437 7 437
$12.38 -- $12.63 7 1 7
$13.30 -- $13.53 29 7 29
$20.50 22 2 22
$32.25 25 3 25
------ ----- ------
1,554 8 1,036
====== ===== ======
F-28
14. COMMITMENTS AND CONTINGENCIES:
OPERATING LEASE COMMITMENTS:
The total net rental expenses under all leases amounted to approximately
$1,173, $928 and $1,059 for the years ended December 31, 2004, 2003 and
2002 respectively. The Company's required payments due under
non-cancelable leases in each of the next five years are as follows:
Years Amounts
----- -------
2005 $ 460
2006 349
2007 277
2008 214
2009 170
---------
$ 1,470
=========
During May 1987, the Company assigned its rights and interests in a land
lease to a third party for $175. The agreement indemnifies the Company
against any further liability with respect to future lease payments. The
Company remains contingently liable to the lessor under the original
deed of lease for rental payments of $16 per year, the amount being
adjustable based upon changes in the consumer price index since 1987,
through the year 2063.
LITIGATION
The Company and its subsidiaries are parties to various lawsuits
generally arising in the normal course of their business. The Company
does not believe that the eventual outcome of any of the suits to which
it is a 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 its subsidiary, PTNA, are defendants in an action in the
Fifth Judicial Circuit of the State of Florida in and for Marion County,
Civil Division. Plaintiffs filed this matter on January 10, 2003 in
Florida State Court, on behalf of themselves and a class of similarly
situated Florida long-term care policyholders. The Company removed this
case to United States District Court, Middle District of Florida, Ocala
Division for a second time in November 2003. Plaintiffs' motion to
remand the case to Florida State Court was granted in April 2004.
Plaintiffs claim wrongdoing in connection with the sale of long-term
care insurance policies to the Plaintiffs and the class. Plaintiffs
allege claims for reformation, breach of fiduciary duty, breach of the
implied duty of good faith and fair dealing, negligent
misrepresentation, fraudulent misrepresentation, and restitution and
pray for relief in the form of compensatory damages and restitution, an
order of reformation of the policies, and attorney fees and court costs.
No amounts were specified for compensatory damages and restitution. The
Company has filed motions to dismiss for failure to state a claim, lack
of personal jurisdiction against the Company, and to strike certain
allegations of the complaint as irrelevant and improper. While the
Company denies liability to Plaintiffs and intends to contest this
vigorously, the Company is continuing its negotiations in this matter.
The Company and its subsidiary, PTNA, are defendants in an action in the
Orange County Superior Court in the state of California. Plaintiffs
filed this matter in November 2003 on behalf of themselves, all other
persons similarly situated and the general public. Plaintiffs claim
wrongdoing in violation of the California Business & Professions Code in
connection with the sale of long term care insurance policies.
Plaintiffs allege unlawful business acts, claims for reformation, breach
of fiduciary duty, breach of the implied duty of good faith and fair
dealing, and negligent misrepresentation and pray for relief in the form
of compensatory damages and restitution, punitive damages, an order of
reformation of the policies, and attorney fees and court costs. No
amounts were specified for compensatory damages and restitution. After
review of the Company's motions related to the plaintiffs' complaint,
the court dismissed plaintiffs' claim for breach of fiduciary duty, and
the Company filed an answer to the plaintiffs' other
F-29
claims in the complaint. While the Company denies liability to
Plaintiffs and intend to contest this vigorously, the company is
continuing its negotiations in this matter.
The Company and two of its subsidiaries, PTNA and Senior Financial
Consultants Company, are defendants in an action instituted on June 5,
2002 in the United States District Court for the Eastern District of
Pennsylvania by National Healthcare Services, Inc. The complaint sought
compensatory damages for an alleged breach of contract and
misappropriation. The parties have settled the matter for value of $1.35
million to be paid in a combination of our common shares (at our option)
and cash. The Company denies liability to Plaintiffs but is entered into
the settlement to avoid the risks, uncertainties and costs inherent in
litigation. The case has now been dismissed with prejudice pursuant to
the settlement agreement.
The Company's subsidiary, PTNA, is a defendant in an action in the Los
Angeles County Superior Court in the state of California. Plaintiffs
filed this matter on May 28, 2004 on behalf of themselves and all other
persons similarly situated and the general public. The plaintiffs allege
wrongdoing in connection with the payment of long-term care insurance
claims. The Plaintiffs allege violations of the California Consumer
Legal Remedies Act, the California Business and Professions Code, breach
of the implied duty of good faith and fair dealing, financial elder
abuse and prays for relief in the form of compensatory damages and
restitution, punitive damages, any accounting, attorney fees and court
costs. No amounts were specified for compensatory damages and
restitution or punitive damages. The Company removed this case to United
States District Court for the Central District of California in March
2005. We have filed a motion to dismiss all counts of the Plaintiffs'
complaint, and a motion to strike allegations of the complaint,
including Plaintiffs' class allegations. While the Company cannot
predict the outcome of this case, it could have a material adverse
impact upon our financial condition and results of operations in the
event of an unfavorable outcome. However, the Company believes that the
complaint is without merit and intends to continue to defend the matter
vigorously.
15. REINSURANCE:
CENTRE SOLUTIONS (BERMUDA), LIMITED
2001 CENTRE AGREEMENT
Effective December 31, 2001, PTNA and ANIC entered a reinsurance
transaction to reinsure, on a quota share basis, substantially all of
the Company's long-term care insurance policies then in-force (the "2001
Agreement").
This agreement does not qualify for reinsurance treatment in accordance
with GAAP, because the agreement does not result in the reasonable
possibility that the reinsurer may realize a significant loss. This is
due to a number of factors related to the agreement, including
experience refund provisions, expense and risk charges credited to the
notional experience account and the aggregate limit of liability.
Accordingly, the contract is being accounted for in accordance with
deposit accounting for reinsurance contracts. This agreement meets the
requirements to qualify for reinsurance treatment under statutory
accounting rules.
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 the Company's reserve
liability.
The reinsurance agreement contains commutation provisions and allows the
Company to recapture the reserve liabilities and the current notional
experience account balance as of December 31, 2007, or on December 31 of
any year thereafter. The Company intends, but is not required, to
commute the agreement on December 31, 2007. In the event the Company
does not commute the agreement on December 31, 2007, the expense and
risk charges applied to
F-30
the experience account will increase significantly. Additionally, the
reinsurance provisions contain covenants and conditions that, if
breached, may result in the immediate commutation of the agreement and
the payment of $2,500 per quarter from the period of the breach through
December 31, 2007.
The Company's current modeling and actuarial projections suggest that it
is likely to be able to commute the agreement, as planned, on December
31, 2007. In order to commute the agreement, PTNA's and ANIC's statutory
surplus following commutation must be sufficient to support the
reacquired business in compliance with all statutory requirements. Upon
commutation, the Company will receive cash or other liquid assets
equaling the value of its notional experience account from the
reinsurer. The Company would also record the necessary reserves for the
business in its statutory financial statements. Accordingly, the
Company's ability to commute the agreement is highly dependent upon the
value of the notional experience account exceeding the level of required
statutory reserves to be established. As of December 31, 2004, the
statutory basis reserve liabilities of $1,026,341 exceeded the
combination of the notional experience account value and funds held due
to the reinsurer of $939,452. Management expects that the growth in the
notional experience account will exceed the growth in the reserve
liabilities such that the notional experience account value will exceed
the reserve liabilities at December 31, 2007. In addition to the
performance of the reinsured policies from now through 2007, the
notional experience account value is susceptible to market interest rate
changes. A market interest rate increase of 100 basis points could
reduce the value of the current notional experience account by
approximately $110,000 and jeopardize the Company's ability to commute
as planned. As the intended commutation date approaches, the sensitivity
of the notional experience account to market interest rate movement will
decline as the duration of the benchmark indices becomes shorter,
however the amount of assets susceptible to such interest sensitivity
will continue to grow as additional net cash flows are added to the
notional experience account balance prior to commutation.
As part of the reinsurance agreement, the reinsurer was granted four
tranches of warrants to purchase shares of non-voting convertible
preferred stock. The first three tranches of warrants are exercisable
through December 31, 2007 at common stock equivalent prices ranging from
$2.75 to $6.25 per share, which if exercised would represent 15% of the
Company's then outstanding common stock on a fully diluted basis. If the
agreement is not commuted on or after December 31, 2007, the reinsurer
may exercise the fourth tranche of convertible preferred stock purchase
warrants at a common stock equivalent price of $1.80 per share,
representing an additional 20% of the then outstanding common stock on a
fully diluted basis.
The warrants are part of the consideration for the reinsurance contract
and the original fair value is recognized as reinsurance premiums over
the anticipated life of the contract, which is six years. The warrants
were valued at the issuance date using a Black-Scholes model with the
following assumptions: 6.0 years expected life, volatility of 70.9% and
a risk free rate of 4.74%. The $15,855 value of the warrants was
recorded as a deferred premium as of December 31, 2001. Of the original
$15,855 value, $2,643 of deferred premium was amortized during each of
the years 2004, 2003 and 2002.
As a result of the Company's intention to commute, it considered only
the expense and risk charges anticipated prior to the commutation date
in its most recent DAC recoverability analyses and has not recorded the
potential of future escalating charges in its current DAC recoverability
analysis. In addition, the Company is recognizing the additional
consideration of entering into the agreement, represented by the fair
value of the warrants granted to the reinsurer, over the period of time
to the expected commutation date.
In the event the Company determines that commutation of the reinsurance
agreement on December 31, 2007 is unlikely, but likely at some future
date, it will include additional annual reinsurer expense and risk
charges in its DAC recoverability analysis. As a result, it could impair
the value of its DAC asset and record the impairment in its financial
statements at that time. However, the Company currently believes that it
will have a sufficient amount of statutory capital and surplus to
commute the agreement by December 31, 2007 or that sufficient
alternatives, such as additional capital issuance or new reinsurance
opportunities, will be available to enable it to commute the agreement
by December 31, 2007.
F-31
At December 31, 2004, 2003 and 2002, the Company received letters of
credit of $169,463, $169,463 and $149,339, respectively, which allowed
its subsidiaries to receive statutory reserve credit and statutory
surplus credit for its 2001 quota share reinsurance agreement with
Centre.
2002 CENTRE AGREEMENT
The 2001 Centre Agreement granted the reinsurer an option to participate
in reinsuring new business sales on a quota share basis. In August 2002,
the reinsurer exercised its option to reinsure up to 50% of future
sales, subject to a limitation of the reinsurer's risk. The reinsurer
may continue this level of participation on the first $100 million in
new policy premium issued after January 1, 2002. The final agreement,
which was entered into in December 2002, further provides the reinsurer
the option to reinsure a portion of the next $1 billion in newly issued
long-term care annual insurance premium, subject to maximum quota share
amounts of up to 40% as additional policies are written.
This agreement does not qualify for reinsurance treatment in accordance
with GAAP because the agreement does not result in the reasonable
possibility that the reinsurer may realize a significant loss. This is
due to an aggregate limit of liability that reduces the likelihood of
the reinsurer realizing a significant loss on the agreement. The
agreement meets the requirements to qualify for reinsurance treatment
under statutory accounting rules.
OTHER REINSURANCE AGREEMENTS
PTNA is party to a reinsurance agreement to cede 100% of certain whole
life and deferred annuity policies issued by PTNA to a third party
insurer. These policies are intended for the funeral arrangement or
"pre-need" market. Total reinsurance recoverables related to this
agreement as of December 31, 2004 and 2003 were approximately $2,861 and
$2,923, respectively. Effective January 1, 1996, this agreement was
modified, and as a result, no new business is reinsured under this
facility. Effective December 31, 2002, the Company entered into an
assumption agreement with another insurer that desired to acquire this
business. Upon approval of certain required state insurance departments
and policyholders, the acquiring company will assume all future
liability for the business reinsured.
PTNA is a party to a reinsurance agreement to cede certain home health
care claims beyond 36 months. Reinsurance recoverables related to this
treaty were $11,236 and $10,614 at December 31, 2004 and 2003,
respectively. The reinsurer has notified PTNA that they believe the
Company is in breach of its current agreement as a result of entering
the 2001 Centre Agreement without the prior written approval of the
reinsurer. PTNA has contested this assertion of breach and is continuing
discussions with the reinsurer to reach an equitable resolution,
including, but not limited to, arbitration, the recapture of the excess
home health care coverage and reserves, premium rate increases, or
additional reinsurance business in the future. Further, the Company
believes that the agreement does not allow for unilateral cancellation
in the event of breach. The ultimate resolution of this dispute cannot
be determined at this time.
In addition to the reinsurance agreement to cede certain home health
care claims beyond 36 months, PTNA is also a party to a coinsurance
agreement with the same reinsurer on a previously acquired block of
long-term care business whereby 66% is ceded to a third party. At
December 31, 2004 and 2003 reinsurance recoverables taken related to
this treaty were $5,887 and $5,486, respectively.
In 2001, ANIC ceded substantially all of its disability policies to an
unaffiliated insurer on a quota share basis. The insurer may assume
ownership of the policies as a sale upon various state and policyholder
approvals. At December 31, 2004 and 2003, reinsurance recoverables
related to this treaty were $3,256 and $3,681, respectively.
The Company remains liable in the event that the reinsuring companies
are unable to meet their obligations.
F-32
The Company has assumed and ceded reinsurance on certain life and
accident and health contracts under various agreements. The tables below
highlight the amounts shown in the accompanying consolidated statements
of income and comprehensive income, which are net of reinsurance
activity:
Ceded to Assumed
Gross Other from Other Net
Amount Companies Companies Amount
----------- ------------ ------------- -----------
December 31, 2004
--------------------------------
Ordinary life insurance
In-force $ 39,865 $ 7,133 $ - $ 32,732
Premiums:
Accident and health 317,674 4,325 4,621 317,970
Life 2,000 86 1 1,915
Benefits to policyholders:
Accident and health 181,003 3,279 1,446 179,170
Life 2,309 272 - 2,037
Inc in policy reserves:
Accident and health 48,615 (1,117) 1,619 51,351
Life 75 (65) - 140
Commissions 39,139 631 607 39,115
December 31, 2003 (1)
--------------------------------
Ordinary life insurance
In-force $ 44,192 $ 7,656 $ - $ 36,536
Premiums:
Accident and health 319,246 4,424 4,973 319,795
Life 2,249 100 2 2,151
Benefits to policyholders:
Accident and health 199,751 1,261 1,661 200,151
Life 2,172 296 - 1,876
Inc in policy reserves:
Accident and health 42,304 (1,926) 1,175 45,405
Life 212 (178) - 390
Commissions 40,887 744 657 40,800
December 31, 2002 (1)
--------------------------------
Ordinary life insurance
In-force $ 42,767 $ 3,583 $ - $ 39,184
Premiums:
Accident and health 331,356 5,394 5,347 331,309
Life 2,480 147 1 2,334
Benefits to policyholders:
Accident and health 290,965 3,316 1,526 289,175
Life 2,167 163 - 2,004
Inc in policy reserves:
Accident and health 76,364 2,417 8,447 82,394
Life (827) (1,339) - 512
Commissions 46,339 1,183 585 45,741
(1) Restated to reflect impact of previously unreserved policy riders. See Note 2 -
"Restatement"
16. TRANSACTIONS WITH RELATED PARTIES:
Irv Levit Insurance Management Corporation, an insurance agency which is
owned by our former Chairman and Chief Executive Officer, now director
and Founding Chairman, currently produced approximately $21, $13 and $11
F-33
of renewal premiums for some of our subsidiaries for the years ended
December 31, 2004, 2003 and 2002, respectively, for which it received
commissions of approximately $4, $3 and $2, respectively. Irv Levit
Insurance Management Corporation also received commission overrides on
business written for some of our subsidiaries by certain agents,
principally general agents who were its agents prior to January 1979 and
any of their sub-agents hired prior and subsequent to January 1979.
These commission overrides totaled approximately $452, $433 and $510 for
the years ended December 31, 2004, 2003 and 2002, respectively.
A member of the Company's board of directors was a principal in Davidson
Capital Management, which provides investment management services to the
Company. The Company paid this firm a fee of $34, $20 and $99 during the
years ended December 31, 2004, 2003 and 2002, respectively.
A member of the Company's board of directors and the chairman of its
audit committee is a senior executive with Advest, Inc., an investment
banking firm, which has provided investment banking services in the past
and that the Company engaged as a financial advisor in a past offering
of its 6 1/4% Convertible Subordinated Notes due 2008. This firm
received $580 in advisory fees in 2003. There were no advisory fees paid
in 2004 and 2002.
A member of the Company's board of directors has in the past been a
principal and has an ownership interest in U.S. Care, Inc., a marketing
organization to which the Company paid commissions of $170, $165 and
$128 in 2004, 2003 and 2002, respectively. The Company also made a loan
of $100, with interest applied at 9%, to U.S. Care, Inc. in 2001, which
is guaranteed by renewal commissions payable to the Company in future
periods. The outstanding balance on the loan was $78 and $100 at
December 31, 2004 and 2003, respectively.
17. CONCENTRATIONS OF CREDIT RISK:
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and investments. The Company places its cash and cash
equivalents and investments with high quality financial institutions,
and attempts to limit the amount of credit exposure to any one
institution. However, at December 31, 2004, and at other times during
the year, amounts in any one institution exceeded the Federal Deposit
Insurance Corporation limits. The Company is also party to certain
reinsurance transactions whereby the Company remains ultimately liable
for claims exposure under ceded policies in the event the assuming
reinsurer is unable to meet its commitments due to default or
insolvency.
18. FAIR VALUE OF FINANCIAL INSTRUMENTS:
Fair values are based on estimates using present value or other
valuation techniques where quoted market prices are not available. Those
techniques are significantly affected by the assumptions used, including
the discount rate and estimates of future cash flows. The fair value
amounts presented do not purport to represent and should not be
considered representative of the underlying value of the Company.
The methods and assumptions used to estimate the fair values of each
class of the financial instruments described below are as follows:
Investments -- The fair value of fixed maturities and equity securities
are based on quoted market prices. It is not practicable to determine
the fair value of policy loans since such loans are not separately
transferable and are often repaid by reductions to benefits and
surrenders.
Notional experience account - The fair value of the notional experience
account reflects the market value of the underlying benchmark indices,
which are comprised of US treasury strips, agencies and investment grade
corporate bonds.
Cash and cash equivalents -- The statement value approximates fair
value.
F-34
Long-term debt -- The convertible, subordinated debt, as a publicly
traded instrument, has a readily accessible fair market value, and, as
such is reported at that value. This value incorporates the fair value
of the preferred interest on early conversion liability.
December 31, 2004 December 31, 2003
----------------------- -----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------- --------- ---------- ---------
Financial assets:
Investments
Bonds, available for sale $ 59,171 $ 59,171 $ 43,853 $ 43,853
Policy loans 338 338 288 288
Cash and Cash Equivalents 15,296 15,296 12,808 12,808
Notional experience account 901,368 901,368 784,778 784,778
Financial liabilities:
Convertible debt $ 85,167 $ 105,098 $ 88,467 $ 94,705
19. EQUITY ISSUANCE:
In March 2002, the Company completed a private placement of 510 shares
of common stock for net proceeds of $2,352. The common stock was sold to
several current and new institutional investors, at $4.65 per share. The
offering price was a 10 percent discount to the 30-day average price of
our common stock prior to the issuance of the new shares. The proceeds
of the private placement provided additional liquidity to the parent
company to meet its debt service obligations.
In 2004, 2003 and 2002, the Company completed private placements of 100
shares of common stock in each year as compensation to its financial
advisor.
In 2004 and 2003, holders of $29,499 and $8,122, respectively of the
Company's Notes elected to convert their notes into shares of the
Company's common stock. As a result, the Company issued 16,857 and 4,641
shares and issued an additional 1,490 and 543 shares as early payment of
interest otherwise payable through October 15, 2005 during 2004 and
2003, respectively.
20. SUBSEQUENT EVENTS:
Subsequent to December 31, 2004, holders of $8,738 of the Company's
Notes elected to convert their Notes into 4,993 shares of the Company's
common stock and an additional 161 shares were issued as early payment
of interest.
The Company entered a lease agreement effective March 11, 2005 under
which it sold Property and equipment with a value of $4,000 to a third
party and agreed to lease back the same equipment. The term of the lease
is two years and the lease will be accounted for as a capital lease.
21. CONDENSED FINANCIAL STATEMENTS:
The following lists the condensed financial information for the parent
company as of December 31, 2004 and 2003 and for the years ended
December 31, 2004, 2003 and 2002.
F-35
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE INFORMATION)
2003
ASSETS 2004 RESTATED (1)
----------- ------------
Bonds, available for sale at market (amortized cost $2,242) $ 2,247 $ -
Cash and cash equivalents 9,611 370
Investment in subsidiaries* 270,692 230,843
Other assets 10,586 13,848
----------- -----------
Total assets $ 293,136 $ 245,061
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Preferred interest on early conversion $ 1,403 $ 3,018
Long-term debt, less discount of $1,426 and $1,625, respectively 85,167 88,467
Accrued interest payable 1,795 1,201
Accounts payable and other liabilities 7,401 4,703
Due to subsidiaries* - 3,593
----------- -----------
Total liabilities 95,766 100,982
----------- -----------
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding - -
Common stock, par value $.10; 150,000 shares authorized;
44,091 and 25,645 shares issued, respectively 4,409 2,565
Additional paid-in capital 137,288 105,926
Accumulated other comprehensive income (loss) 147 598
Retained earnings 62,231 41,695
----------- -----------
204,075 150,784
Less 915 of common shares held in treasury, at cost (6,705) (6,705)
----------- -----------
Total shareholders' equity 197,370 144,079
----------- -----------
Total liabilities and shareholders' equity $ 293,136 $ 245,061
=========== ===========
(1) Restated to reflect impact of previously unreserved policy riders.
* Eliminated in consolidation.
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto.
F-36
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(amounts in thousands)
2003 2002
2004 RESTATED (1) RESTATED (1)
------------ ------------ ------------
Investment and other income $ 150 $ 180 $ 16
Change in preferred interest on early conversion liability 2,237 (981) -
General and administrative expense (4,890) (6,601) (4,199)
Litigation accrual expense (4,150) - -
Interest expense (9,713) (7,682) (4,711)
------------ ------------ ------------
Loss before equity in undistributed net
earnings of subsidiaries* (16,366) (15,084) (8,894)
Equity in undistributed net earnings
(losses) of subsidiaries* 36,902 1,914 (22,849)
------------ ------------ ------------
Net income (loss) 20,536 (13,170) (31,743)
Retained earnings, beginning of year 41,695 54,865 86,608
------------ ------------ ------------
Retained earnings, end of year $ 62,231 $ 41,695 $ 54,865
============ ============ ============
(1) Restated to reflect impact of previously unreserved policy riders.
*Eliminated in consolidation.
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto.
F-37
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(AMOUNTS IN THOUSANDS)
2003 2002
2004 RESTATED (1) RESTATED (1)
----- ------------ ------------
Bonds, available for sale at market (amortized cost $2,241)
Net income (loss) $ 20,536 $(13,170) $(31,743)
Adjustments to reconcile net income (loss)
to cash used in operations:
Equity in undistributed earnings of subsidiaries (36,902) (1,914) 22,850
Depreciation and amortization 3,614 2,865 2,999
Net amortization (Accrection) of Premium (Discount) on bonds 199 57 -
Change in preferred interest on early conversion liability (2,237) 981 -
Equity issued for interest expense from long-term debt
conversions 2,809 1,069 -
Net realized gains (7) (60) -
Increase (decrease) due to change in:
Due to/from subsidiaries (3,593) (3,385) 350
Other, net 3,464 2,153 439
-------- -------- --------
Net cash used in operations (12,117) (11,404) (5,105)
-------- -------- --------
Cash flows from investing activities:
Sales and maturities of investments (4,177) 9,592 -
Purchase of investments 6,442 (9,589) -
Acquisition of property and equipment (57) - -
-------- -------- --------
Net cash provided by investing activities 2,208 3 -
-------- -------- --------
Cash flows from financing activities:
Contribution to subsidiary (6,850) (12,227) -
Dividend from subsidiary - 475 2,151
Proceeds from shares issued to financial advisor - - 393
Repayment of long-term debt - (8,957) (2,858)
Issuance of long-term debt 26,000 32,421 -
Proceeds from rights offering - - 2,352
-------- -------- --------
Net cash provided by financing activities 19,150 11,712 2,038
-------- -------- --------
Increase (decrease) in cash and cash equivalents 9,241 311 (3,067)
Cash and cash equivalents balances:
Beginning of year 370 59 3,126
-------- -------- --------
End of year $ 9,611 $ 370 $ 59
======== ======== ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $ 5,393 $ 4,299 $ 4,299
======== ======== ========
(1) Restated to reflect impact of previously unreserved policy riders.
The condensed financial information should be read in conjunction with the
Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto.
F-38