Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006 | Commission file number 0-8483 |
CERES GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware | 34-1017531 | |
(State or other jurisdiction of | (I.R.S. Employer Identification No.) | |
incorporation or organization) |
17800 Royalton Road, Cleveland, Ohio | 44136 | |
(Address of principal executive offices) | (Zip Code) |
(440) 572-2400
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YESþ NOo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act (check one).
Large accelerated filero | Accelerated Filerþ | Non-accelerated filero |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YESo NOþ
The number of shares of common stock, par value $0.001 per share, outstanding as of April 26, 2006 was 33,295,044.
CERES GROUP, INC. and SUBSIDIARIES
Index
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29 | ||||||||
29 | ||||||||
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29 | ||||||||
29 | ||||||||
30 | ||||||||
EX-31.1 CEO Certification Pursuant to Section 302 | ||||||||
EX-31.2 CFO Certification Pursuant to Section 302 | ||||||||
EX-32 Certification Pursuant to 18 U.S.C. Section 1350 |
Table of Contents
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CERES GROUP, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
March 31, | December 31, | |||||||
2006 | 2005 | |||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Investments | ||||||||
Fixed maturities available-for-sale, at fair value | $ | 448,372 | $ | 447,537 | ||||
Equity securities available-for-sale, at fair value | 27,786 | 27,466 | ||||||
Limited partnership | 3,861 | 4,640 | ||||||
Policy and mortgage loans | 11,198 | 9,263 | ||||||
Total investments | 491,217 | 488,906 | ||||||
Cash and cash equivalents (of which $5,679 and $6,070 is restricted, respectively) | 25,267 | 26,764 | ||||||
Accrued investment income | 4,598 | 5,340 | ||||||
Premiums receivable | 3,044 | 4,388 | ||||||
Reinsurance receivable | 127,476 | 131,227 | ||||||
Property and equipment, net | 4,515 | 4,708 | ||||||
Deferred acquisition costs | 77,803 | 73,955 | ||||||
Value of business acquired | 10,752 | 11,126 | ||||||
Goodwill | 10,657 | 10,657 | ||||||
Licenses | 3,440 | 3,440 | ||||||
Other assets | 10,992 | 10,492 | ||||||
Total assets | $ | 769,761 | $ | 771,003 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Policy liabilities and benefits accrued | ||||||||
Future policy benefits, losses and claims | ||||||||
Life | $ | 17,012 | $ | 16,402 | ||||
Deposit and investment contracts | 237,937 | 237,928 | ||||||
Accident and health | 113,250 | 112,242 | ||||||
Total future policy benefits, losses and claims | 368,199 | 366,572 | ||||||
Unearned premiums | 37,006 | 35,707 | ||||||
Other policy claims and benefits payable | 101,583 | 105,744 | ||||||
Total policy liabilities and benefits accrued | 506,788 | 508,023 | ||||||
Deferred reinsurance gain | 5,147 | 5,451 | ||||||
Other policyholders’ funds | 15,856 | 14,970 | ||||||
Debt | 6,250 | 7,313 | ||||||
Deferred federal income taxes payable | 2,393 | 3,524 | ||||||
Other liabilities | 28,177 | 28,349 | ||||||
Total liabilities | 564,611 | 567,630 | ||||||
Stockholders’ equity | ||||||||
Non-voting preferred stock, $0.001 par value, 1,900,000 shares authorized, none issued | ¾ | ¾ | ||||||
Convertible voting preferred stock, $0.001 par value, at stated value, 100,000 shares authorized, none issued | ¾ | ¾ | ||||||
Common stock, $0.001 par value, 50,000,000 shares authorized, 34,966,698 and 34,929,181 shares issued, respectively; 33,262,995 and 33,225,478 shares outstanding, respectively | 35 | 35 | ||||||
Additional paid-in capital | 134,897 | 134,735 | ||||||
Retained earnings | 84,084 | 78,542 | ||||||
Accumulated other comprehensive (loss) income | (3,847 | ) | 80 | |||||
Treasury stock, at cost, 1,703,703 shares at March 31, 2006 and December 31, 2005 | (10,019 | ) | (10,019 | ) | ||||
Total stockholders’ equity | 205,150 | 203,373 | ||||||
Total liabilities and stockholders’ equity | $ | 769,761 | $ | 771,003 | ||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CERES GROUP, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
(dollars in thousands, except share and per share amounts)
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
REVENUES | ||||||||
Premiums, net | ||||||||
Medical | $ | 55,827 | $ | 56,566 | ||||
Senior and other | 55,367 | 50,070 | ||||||
Total premiums, net | 111,194 | 106,636 | ||||||
Net investment income | 6,974 | 6,083 | ||||||
Net realized gains (losses) | 109 | (840 | ) | |||||
Fee and other income | 4,627 | 4,588 | ||||||
122,904 | 116,467 | |||||||
BENEFITS, LOSSES AND EXPENSES | ||||||||
Benefits, claims, losses and settlement expenses | ||||||||
Medical | 40,058 | 38,920 | ||||||
Senior and other | 41,419 | 38,486 | ||||||
Total benefits, claims, losses and settlement expenses | 81,477 | 77,406 | ||||||
Selling, general and administrative expenses | 35,323 | 32,512 | ||||||
Net (deferral) amortization and change in acquisition costs and value of business acquired | (2,593 | ) | 441 | |||||
Interest expense and financing costs | 159 | 175 | ||||||
114,366 | 110,534 | |||||||
Income before federal income taxes | 8,538 | 5,933 | ||||||
Federal income tax expense | 2,996 | 1,084 | ||||||
Net income | $ | 5,542 | $ | 4,849 | ||||
Net income per share | ||||||||
Basic | $ | 0.17 | $ | 0.14 | ||||
Diluted | 0.17 | 0.14 | ||||||
Weighted average shares outstanding | ||||||||
Basic | 33,239,294 | 34,536,410 | ||||||
Diluted | 33,374,520 | 34,670,549 |
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CERES GROUP, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For the Three Months Ended March 31, 2006
Unaudited
(dollars in thousands, except share amounts)
Common Stock | ||||
Balance at March 31, 2006 | $ | 35 | ||
Additional Paid-in Capital | ||||
Balance at beginning of year | $ | 134,735 | ||
Issuance of stock: | ||||
Employee/agent benefit plans | 162 | |||
Balance at March 31, 2006 | $ | 134,897 | ||
Retained Earnings | ||||
Balance at beginning of year | $ | 78,542 | ||
Net income | 5,542 | |||
Balance at March 31, 2006 | $ | 84,084 | ||
Accumulated Other Comprehensive Income (Loss) | ||||
Balance at beginning of year | $ | 80 | ||
Unrealized loss on securities, net of tax benefit of $2,115 | (3,927 | ) | ||
Balance at March 31, 2006 | $ | (3,847 | ) | |
Treasury Stock | ||||
Balance at beginning of year | $ | (10,019 | ) | |
Treasury stock purchased, at cost | ¾ | |||
Balance at March 31, 2006 | $ | (10,019 | ) | |
Total Stockholders’ Equity | $ | 205,150 | ||
Number of Shares of Common Stock | ||||
Balance at beginning of year | 34,929,181 | |||
Issuance of stock: | ||||
Employee/agent benefit plans | 37,517 | |||
Balance at March 31, 2006 | 34,966,698 | |||
Number of Shares of Treasury Stock | ||||
Balance at beginning of year | 1,703,703 | |||
Treasury stock purchased | ¾ | |||
Balance at March 31, 2006 | 1,703,703 | |||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CERES GROUP, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Unaudited
(dollars in thousands)
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
Net income | $ | 5,542 | $ | 4,849 | ||||
Other comprehensive income (loss): | ||||||||
Unrealized holding losses on securities | (6,931 | ) | (7,393 | ) | ||||
Reclassification adjustments for realized losses (gains) included in net income | 8 | (233 | ) | |||||
Unrealized gain adjustment to deferred acquisition costs and value of business acquired | 881 | 1,113 | ||||||
Total other comprehensive loss before federal income tax benefit | (6,042 | ) | (6,513 | ) | ||||
Income tax benefit related to items of other comprehensive loss | (2,115 | ) | (2,279 | ) | ||||
Other comprehensive loss, net of tax | (3,927 | ) | (4,234 | ) | ||||
Total comprehensive income | $ | 1,615 | $ | 615 | ||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CERES GROUP, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
(dollars in thousands)
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
Operating activities | ||||||||
Net income | $ | 5,542 | $ | 4,849 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 577 | 774 | ||||||
Stock-based compensation expense | 174 | ¾ | ||||||
Net realized (gains) losses | (109 | ) | 840 | |||||
Net change in fixed maturities trading | ¾ | 336 | ||||||
Net change in equity securities trading | ¾ | (1,177 | ) | |||||
Equity in limited partnership earnings | (128 | ) | (92 | ) | ||||
Deferred federal income taxes | 982 | 1,084 | ||||||
Changes in assets and liabilities: | ||||||||
Accrued investment income | 742 | 920 | ||||||
Reinsurance and premiums receivable | 5,095 | (1,158 | ) | |||||
Deferred acquisition costs | (3,329 | ) | (172 | ) | ||||
Value of business acquired | 736 | 613 | ||||||
Federal income taxes payable/recoverable | 173 | (2 | ) | |||||
Other assets | (654 | ) | 1,289 | |||||
Future policy benefits, claims and funds payable | (3,255 | ) | 1,099 | |||||
Unearned premium | 1,299 | 2,011 | ||||||
Deferred reinsurance gain | (304 | ) | (469 | ) | ||||
Other liabilities | (67 | ) | (2,495 | ) | ||||
Net cash provided by operating activities | 7,474 | 8,250 | ||||||
Investing activities | ||||||||
Net purchases of furniture and equipment | (58 | ) | (187 | ) | ||||
Purchase of fixed maturities available-for-sale | (25,181 | ) | (14,360 | ) | ||||
Return of capital from/(investment in) limited partnership | 816 | (82 | ) | |||||
Cash distributions from limited partnership | 91 | 93 | ||||||
(Increase)/decrease in policy and mortgage loans, net | (1,935 | ) | 20 | |||||
Proceeds from sales of fixed maturities available-for-sale | 5,594 | 9,972 | ||||||
Proceeds from calls and maturities of fixed maturities available-for-sale | 11,158 | 11,468 | ||||||
Net cash (used in) provided by investing activities | (9,515 | ) | 6,924 | |||||
Financing activities | ||||||||
Increase in annuity account balances | 7,982 | 5,528 | ||||||
Decrease in annuity account balances | (6,375 | ) | (4,191 | ) | ||||
Principal payments on debt | (1,063 | ) | (625 | ) | ||||
Proceeds from issuance of common stock related to employee benefit plans | ¾ | 93 | ||||||
Net cash provided by financing activities | 544 | 805 | ||||||
Net (decrease) increase in cash | (1,497 | ) | 15,979 | |||||
Cash and cash equivalents at beginning of year | 26,764 | 22,635 | ||||||
Cash and cash equivalents at end of period | $ | 25,267 | $ | 38,614 | ||||
Supplemental disclosures of cash flow information | ||||||||
Cash paid during the period for interest | $ | 147 | $ | 163 | ||||
Cash paid during the period for federal income taxes | 1,839 | ¾ |
The accompanying notes are an integral part of these condensed consolidated financial statements.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
March 31, 2006
Unaudited
A. Summary of Business and Significant Accounting Policies
Summary of Business
The accompanying unaudited condensed consolidated financial statements of Ceres Group, Inc. and subsidiaries, included herein, have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.
The condensed consolidated financial statements for March 31, 2006 include the continuing operations of Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, and United Benefit Life Insurance Company.
The condensed consolidated balance sheet presented at December 31, 2005 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.
Unless the context indicates otherwise, “we,” “our” and “us” refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis.
Significant Accounting Policies
For further information, refer to “Critical Accounting Policies” and “Other Accounting Policies and Insurance Business Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005.
Use of Estimates
The preparation of the condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. At March 31, 2006 and December 31, 2005, restricted cash was $5.7 million and $6.1 million, respectively. Restricted cash primarily represents cash held
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
related to fully insured employer shared risk plans, which is restricted from any other use. We are entitled to the investment income from these funds. A corresponding liability is included in the accompanying condensed consolidated balance sheets.
Investments
Our insurance subsidiaries had certificates of deposit and fixed maturity securities on deposit with various state insurance departments to satisfy regulatory requirements.
Property and Equipment
Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 35 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally three to seven years.
New Accounting Pronouncements
On January 1, 2006 we adopted Statement of Financial Accounting Standards No. 123R, (Revised 2004),Share-Based Payment(SFAS 123R), which amends SFAS 123 and supersedes APB 25. SFAS 123R requires that all share-based payment transactions, including grants of employee stock options, be recognized in the Consolidated Statement of Operations based on their fair values. In addition, SFAS 123R amends SFAS No. 95,Statement of Cash Flows,to require that excess tax benefits be reported as a financing cash flow rather than as a reduction to taxes paid, which is included within operating cash flows. Upon adoption, pro forma disclosures are no longer an alternative. We adopted SFAS 123R using the modified prospective transition method. Under this method, fair value accounting and recognition provisions of SFAS 123R are applied to share-based awards granted or modified subsequent to the date of adoption and prior periods are not restated. In addition, for awards granted prior to the effective date, the unvested portion of the awards shall be recognized in periods subsequent to the adoption based on the grant date fair value determined for recognition or pro forma disclosure purposes under SFAS 123. For the three months ended March 31, 2006, we recognized additional pre-tax stock-based compensation expense of approximately $0.1 million related to the adoption of SFAS 123R.
Prior to the adoption of SFAS 123R in January 2006, we accounted for our stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees(APB Opinion No. 25). Accordingly, no compensation expense was recognized for our stock option plans in our Consolidated Statements of Operations.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
The following table illustrates the effect on net income and net income per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation for the three months ended March 31, 2005.
Three Months | ||||
Ended | ||||
March 31, 2005 | ||||
(dollars in | ||||
thousands, except | ||||
per share amounts) | ||||
Net income, as reported | $ | 4,849 | ||
Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax | (18) | |||
Pro forma net income | $ | 4,831 | ||
Net income per share | ||||
Basic-as reported | $ | 0.14 | ||
Basic-pro forma | 0.14 | |||
Diluted-as reported | $ | 0.14 | ||
Diluted-pro forma | 0.14 |
See Note H. Stock Plans for further information on our stock-based compensation plans.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation.
B. Debt
March 31, | December 31, | |||||||
2006 | 2005 | |||||||
(dollars in thousands) | ||||||||
Bank credit facility | $ | 6,250 | $ | 7,313 |
At March 31, 2006, our credit facility consisted of a $1.6 million term loan A and a $4.6 million term loan B with National City Bank. The term loan A has remaining quarterly principal payments of $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The term loan B has remaining quarterly principal payments of $375,000 through December 2006, $562,500 through December 2007, and a payment of $1,250,000 on March 1, 2008.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.0%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 3.75%, respectively. At March 31, 2006, the interest rate on our term loan A balance of $1.6 million was 8.06% per annum and on our $4.6 million term loan B was 8.56% per annum.
Our obligations under the credit agreement are guaranteed by four of our non-regulated subsidiaries and are secured by pledges of the capital stock of Central Reserve, Continental General and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At March 31, 2006, we were in compliance with these covenants.
C. Reinsurance
Consistent with the general practice of the insurance industry, we reinsure portions of the coverage provided by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure on major risks and limits our potential losses on reinsured business. Reinsurance involves one or more insurance companies participating in the liabilities or risks of another insurance company in exchange for a portion of the premiums. Although the effect of reinsurance is to lessen our risks, it may lower net income. We have entered into a variety of reinsurance arrangements under which we cede business to other insurance companies to mitigate risk. A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America, a health and life reinsurance company. We also have assumed risk on a “quota share” basis from other insurance companies.
Under quota share reinsurance, the reinsurer assumes or cedes an agreed percentage of certain risks insured by the ceding insurer and shares premium revenue and losses proportionately. When we cede business to others, reinsurance does not discharge us from our primary liability to our insureds. The reinsurance company that provides the reinsurance coverage agrees to become the ultimate source of payment for the portion of the liability it is reinsuring and indemnifies us for that portion. However, we remain liable to our insureds with respect to ceded reinsurance if any reinsurer fails to meet its obligations to us. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products, which are amortized over the expected profit stream of the in force business.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
In December 2005, Continental General entered into a quota share reinsurance agreement with Coventry Health Care and its affiliates. Under the terms of the treaty, Continental General agreed to assume 25% of the risk of all Medicare Part D policies with Coventry sold by our agents effective January 1, 2006 and after.
The following table summarizes the net impact of our reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, commissions, and other operating expenses:
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
(dollars in thousands) | ||||||||
Premiums, net | ||||||||
Direct | $ | 125,741 | $ | 124,758 | ||||
Assumed | 1,086 | 241 | ||||||
Ceded | (15,633 | ) | (18,363 | ) | ||||
Total premiums, net | $ | 111,194 | $ | 106,636 | ||||
Benefits, claims, losses and settlement expenses, net | ||||||||
Benefits, claims, losses and settlement expenses | $ | 93,999 | $ | 94,394 | ||||
Reinsurance recoveries | (12,522 | ) | (16,988 | ) | ||||
Total benefits, claims, losses and settlement expenses, net | $ | 81,477 | $ | 77,406 | ||||
Selling, general and administrative expenses | ||||||||
Commissions | $ | 19,016 | $ | 17,401 | ||||
Other operating expenses | 19,374 | 18,861 | ||||||
Reinsurance allowances | (3,067 | ) | (3,750 | ) | ||||
Total selling, general and administrative expenses | $ | 35,323 | $ | 32,512 | ||||
D. Net Income Per Share
Basic and diluted net income per common share is calculated in accordance with SFAS No. 128,Earnings per Share. Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period including the effect of the assumed exercise of dilutive stock options and warrants under the treasury stock method. Basic and diluted weighted average shares of common stock are as follows:
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
Weighted average shares: | ||||||||
Basic | 33,239,294 | 34,536,410 | ||||||
Incremental shares from assumed exercise of stock options and warrants | 135,226 | 134,139 | ||||||
Diluted | 33,374,520 | 34,670,549 | ||||||
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
E. Contingencies and Commitments
The nature of our business subjects us to a variety of legal actions (including class actions) and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration, our relationship with the associations that market our products, and alleged violations of state and federal statutes.
We are involved in various legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
F. Federal Income Taxes
We account for federal income taxes using the liability method in accordance with SFAS No. 109,Accounting for Income Taxes.Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. 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. Deferred tax assets are reviewed for recoverability and a valuation allowance is established, if necessary.
At March 31, 2006 and December 31, 2005, we had a federal income tax receivable, which is included in other assets on our Condensed Consolidated Balance Sheets, of $0.9 million and $1.0 million, respectively.
Prior to 1984, the Life Insurance Company Income Tax Act of 1959, as amended by the Deficit Reduction Act of 1984 (DRA), permitted the deferral from taxation of a portion of statutory income under certain circumstances. In these situations, the deferred income was accumulated in the Policyholders Surplus Account (PSA). On January 1, 1984 the balance of the PSA account was fixed and only subject to taxation in the event amounts in the PSA account were distributed to shareholders, or if the balance of the account exceeded certain limitations prescribed by the IRS. On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004. Included among the various provisions of the Act was a two-year suspension of the taxation on distributions of amounts from a company’s PSA and reordering rules for current distributions. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend to Ceres Group. Accordingly, we made a $2.9 million tax free distribution from the PSA account and reduced the corresponding tax contingency reserve of $1.0 million in the first quarter of 2005.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
G. Operating Segments
We apply SFAS No. 131,Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: Medical, Senior and Other, and Corporate and Other. Products included in the Medical segment include catastrophic and comprehensive medical plans. Significant products in the Senior and Other segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The Corporate and Other segment encompasses all other activities, including investment income, interest expense, and corporate expenses of the parent company.
The following table presents the revenues, expenses, and profit (loss) before federal income taxes, for the three months ended March 31, 2006 and 2005 attributable to our industry segments. Investment income is allocated by segment based on the level of policy liabilities and benefits accrued and allocated capital. We assume that the longer duration, higher yielding investments support the life, annuity and long-term care blocks of business. The remaining investments, which tend to be shorter in duration, support the major medical and Medicare supplement blocks of business. We do not separately allocate assets or income tax expenses (benefits) by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
(dollars in thousands) | ||||||||
Medical | ||||||||
Revenues | ||||||||
Net premiums | $ | 55,827 | $ | 56,566 | ||||
Net investment income | 878 | 971 | ||||||
Net realized gains (losses) | 3 | (81 | ) | |||||
Fee and other income | 4,075 | 3,961 | ||||||
60,783 | 61,417 | |||||||
Expenses | ||||||||
Benefits and claims | 40,058 | 38,920 | ||||||
Other operating expenses | 17,500 | 19,415 | ||||||
57,558 | 58,335 | |||||||
Segment profit before federal income taxes | $ | 3,225 | $ | 3,082 | ||||
Senior and Other | ||||||||
Revenues | ||||||||
Net premiums | $ | 55,367 | $ | 50,070 | ||||
Net investment income | 6,025 | 5,112 | ||||||
Net realized losses | (9 | ) | (874 | ) | ||||
Fee and other income | 552 | 627 | ||||||
61,935 | 54,935 | |||||||
Expenses | ||||||||
Benefits and claims | 41,419 | 38,486 | ||||||
Other operating expenses | 14,797 | 13,167 | ||||||
56,216 | 51,653 | |||||||
Segment profit before federal income taxes | $ | 5,719 | $ | 3,282 | ||||
Corporate and Other | ||||||||
Revenues | ||||||||
Net investment income | $ | 71 | $ | — | ||||
Net realized gains | 115 | 115 | ||||||
186 | 115 | |||||||
Expenses | ||||||||
Interest expense and financing costs | 159 | 175 | ||||||
Other operating expenses | 433 | 371 | ||||||
592 | 546 | |||||||
Segment loss before federal income taxes | $ | (406 | ) | $ | (431 | ) | ||
Income before federal income taxes | $ | 8,538 | $ | 5,933 | ||||
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
The following table presents net premiums by major product line for the three months ended March 31, 2006 and 2005:
Three Months Ended | ||||||||
March 31, | ||||||||
2006 | 2005 | |||||||
(dollars in thousands) | ||||||||
Medical | ||||||||
Individual | $ | 39,910 | $ | 39,758 | ||||
Group | 15,917 | 16,808 | ||||||
Total medical premiums, net | $ | 55,827 | $ | 56,566 | ||||
Senior and Other | ||||||||
Medicare | $ | 43,085 | $ | 38,409 | ||||
Long-term care | 6,013 | 5,746 | ||||||
Life and annuity | 4,219 | 3,582 | ||||||
Dental | 1,132 | 1,325 | ||||||
Other | 918 | 1,008 | ||||||
Total senior and other premiums, net | $ | 55,367 | $ | 50,070 | ||||
Total premiums, net | $ | 111,194 | $ | 106,636 | ||||
H. Stock Plans
We have a stock plan, the 1998 Key Employee Share Incentive Plan, which provides for the granting of stock options, stock appreciation rights, stock and restricted stock awards to certain employees, non-employee directors, consultants and advisors. This plan permits the granting of up to 3,000,000 shares of our common stock. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. At March 31, 2006, there were options outstanding under this plan to purchase 1,187,603 shares.
In 1999, 372 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees each received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. We terminated this plan in December 2000. At March 31, 2006, there were options outstanding under the plan to purchase 285,000 shares.
In 1998 and 1999, pursuant to various individual employment agreements, we granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years and expire ten years from the date of grant. At March 31, 2006, there were options outstanding pursuant to these grants to purchase 315,000 shares.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
In 1999, pursuant to the 1999 Special Agents’ Stock Option Plan, we granted 78,706 common stock options to certain regional sales directors and managing general agents. Each grant vested immediately and expires ten years from the date of grant. We terminated this plan at the end of 2000. At March 31, 2006, there were options outstanding under the plan to purchase 78,706 shares.
The following table presents our stock option activity for the three months ended March 31, 2006 :
Weighted | ||||||||||||||||
Weighted | Average | |||||||||||||||
Number | Average | Aggregate | Remaining | |||||||||||||
of | Exercise | Intrinsic | Contractual | |||||||||||||
Shares | Price | Value | Term | |||||||||||||
Outstanding at beginning of year | 1,882,973 | $ | 6.24 | |||||||||||||
Granted | — | — | ||||||||||||||
Exercised | — | — | ||||||||||||||
Expired | — | — | ||||||||||||||
Forfeited | (16,664 | ) | 4.60 | |||||||||||||
Outstanding at March 31, 2006 | 1,866,309 | 6.25 | $ | — | 4.8 | |||||||||||
Exercisable at March 31, 2006 | 1,628,809 | 6.35 | $ | — | 4.3 | |||||||||||
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the market price of our stock on March 31, 2006 and the exercise price, times the number of shares) that would have been received by option holders had all option holders exercised their options on March 31, 2006. This amount is subject to change based on the market price of our stock. At March 31, 2006, the market price of our stock was $5.52 which was less than the weighted average exercise price. Therefore, there was no aggregate intrinsic value associated with our stock options at March 31, 2006.
On January 1, 2006, we adopted SFAS 123R using a modified prospective transition method. Under this method, we are required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards at the date of adoption. Prior period amounts are not restated. For the three months ended March 31, 2006, we recognized additional pre-tax stock-based compensation expense of approximately $0.1 million related to the adoption of SFAS 123R.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. For the three months ended March 31, 2006 and 2005, there were no additional stock options granted.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Warrants
On December 23, 2003, we issued a warrant to purchase 25,000 shares of our common stock at an exercise price of $5.27 per share to a current marketing agency of the Company which exchanged its QQLink stock for cash and the warrant. This warrant, which expires in 2008, was outstanding at March 31, 2006.
Stock Purchase Plan
Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on June 27, 2000. Under the plan, employees may purchase shares of our common stock at a 15% discount from fair value. All of our full time employees, including officers, are eligible to participate in the employee stock purchase plan, subject to limited exceptions. Eligible employees participate voluntarily, and may withdraw from an offering at any time before the stock is purchased. Participation terminates automatically upon termination of employment other than for death, disability or retirement. Six-month offerings are made available beginning May 1 and November 1 of each year. The purchase price per share in an offering will not be less than 85% of the lesser of the stock’s fair value at the beginning of the offering period or on the applicable exercise date and may be paid through payroll deductions.
Agent Stock Purchase Plan
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by our Board.
Stock Awards
Pursuant to the 1998 Key Employee Share Incentive Plan, as amended, 55,000 shares of restricted stock awards were granted to executive officers in 2004. The awards vest 25% over four years. In addition, 21,771 and 11,263 shares of our common stock were granted to non-employee directors of our Board during the three months ended March 31, 2006 and 2005, respectively.
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CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
Notes to Condensed Consolidated Financial Statements — Continued
March 31, 2006
Unaudited
The following table reflects the activity for non-vested shares for the three months ended March 31, 2006:
Weighted | ||||||||
Number | Average | |||||||
of | Grant Date | |||||||
Shares | Fair Value | |||||||
Nonvested shares at beginning of year | 41,250 | $ | 6.97 | |||||
Granted | — | — | ||||||
Vested | (13,750 | ) | 6.97 | |||||
Canceled | — | — | ||||||
Nonvested shares at March 31, 2006 | 27,500 | $ | 6.97 | |||||
I. Subsequent Event
On May 1, 2006, we entered into a definitive merger agreement with Great American Financial Resources, Inc. (GAFRI), whereby GAFRI will acquire all of our outstanding shares of common stock through a cash merger. Under the terms of the merger agreement, GAFRI will pay $6.13 in cash for each outstanding share of Ceres common stock, for a total equity price of approximately $205 million on a fully diluted basis. We anticipate that the transaction will be completed in the third quarter of 2006. The transaction is subject to the approval of Ceres’ stockholders and the Ohio and Nebraska Departments of Insurance and other customary conditions, including regulatory approvals.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion should be read in conjunction with our condensed consolidated financial statements, notes and tables included elsewhere in this report, as well as, the more detailedManagement’s Discussion and Analysis of Financial Condition and Results of Operations,or MD&A, contained in our 2005 Annual Report on Form 10-K. MD&A may contain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties, which may cause actual results to differ materially from those expressed in the forward-looking statements. See “Forward-Looking Statements” for further information.
Overview
Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Medical segment includes major medical health insurance for individuals, families, associations and small to mid-size businesses. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. To help control medical costs Ceres also provides medical cost management services to its insureds.
Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells both major medical health insurance to individuals, families, associations and small employer groups and senior products to Americans age 55 and over. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations, and Americans age 55 and over. Provident American Life discontinued new medical sales activities and currently has approximately 200 active major medical certificate holders and 300 life policyholders. In June 2005, Provident American Life began marketing and selling a new portfolio of senior products. United Benefit Life has no active policyholders.
Recent Event
On May 1, 2006, we entered into a definitive merger agreement with Great American Financial Resources, Inc. (GAFRI), whereby GAFRI will acquire all of our outstanding shares of common stock through a cash merger. Under the terms of the merger agreement, GAFRI will pay $6.13 in cash for each outstanding share of Ceres common stock, for a total equity price of approximately $205 million on a fully diluted basis. We anticipate that the transaction will be completed in the third quarter of 2006. The transaction is subject to the approval of Ceres’ stockholders and the Ohio and Nebraska Departments of Insurance and other customary conditions, including regulatory approvals.
Critical Accounting Policies
Refer toCritical Accounting Policiesin our 2005 Annual Report on Form 10-K for information on accounting policies that we consider critical in preparing our consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates were made. However, these estimates could change materially if different information or assumptions were used.
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Results of Operations
We have three reportable segments:
• | Medical – includes catastrophic and comprehensive major medical plans; | ||
• | Senior and Other – includes Medicare supplement, long-term care, dental, life insurance and annuities; and | ||
• | Corporate and Other – includes primarily interest income, interest expense, and corporate expenses of the holding company. |
The financial information for the three months ended March 31, 2006 and 2005 includes the operations of all our subsidiaries for the entire period. See Note G. Operating Segments, to our Condensed Consolidated Financial Statements for further information.
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Quarter Ended March 31, 2006 Compared to Quarter Ended March 31, 2005
Three | Three | |||||||||||||||
Months | Months | Increase | ||||||||||||||
Ended | Ended | (Decrease) from | ||||||||||||||
March 31, | March 31, | Previous Year | ||||||||||||||
2006 | 2005 | Dollars | % | |||||||||||||
(dollars in thousands, except per share amounts) | ||||||||||||||||
Premiums, net | ||||||||||||||||
Medical | $ | 55,827 | $ | 56,566 | $ | (739 | ) | (1.3 | )% | |||||||
Senior and other | 55,367 | 50,070 | 5,297 | 10.6 | ||||||||||||
Total premiums, net | 111,194 | 106,636 | 4,558 | 4.3 | ||||||||||||
Net investment income | 6,974 | 6,083 | 891 | 14.6 | ||||||||||||
Net realized gains (losses) | 109 | (840 | ) | 949 | 113.0 | |||||||||||
Fee and other income | 4,627 | 4,588 | 39 | 0.9 | ||||||||||||
122,904 | 116,467 | 6,437 | 5.5 | |||||||||||||
Benefits, claims, losses and settlement expenses | ||||||||||||||||
Medical | 40,058 | 38,920 | 1,138 | 2.9 | ||||||||||||
Senior and other | 41,419 | 38,486 | 2,933 | 7.6 | ||||||||||||
Total benefits, claims, losses and settlement expenses | 81,477 | 77,406 | 4,071 | 5.3 | ||||||||||||
Selling, general and administrative expenses | 35,323 | 32,512 | 2,811 | 8.6 | ||||||||||||
Net (deferral) amortization and change in acquisition costs and value of business acquired | (2,593 | ) | 441 | (3,034 | ) | (688.0 | ) | |||||||||
Interest expense and financing costs | 159 | 175 | (16 | ) | (9.1 | ) | ||||||||||
114,366 | 110,534 | 3,832 | 3.5 | |||||||||||||
Income before federal income taxes | 8,538 | 5,933 | 2,605 | 43.9 | ||||||||||||
Federal income tax expense | 2,996 | 1,084 | 1,912 | 176.4 | ||||||||||||
Net income | $ | 5,542 | $ | 4,849 | $ | 693 | 14.3 | |||||||||
Net income per share | ||||||||||||||||
Basic | $ | 0.17 | $ | 0.14 | $ | 0.03 | 21.4 | |||||||||
Diluted | 0.17 | 0.14 | 0.03 | 21.4 | ||||||||||||
Medical loss ratio | 71.8 | % | 68.8 | % | — | — | ||||||||||
Senior loss ratio | 74.8 | % | 76.9 | % | — | — | ||||||||||
Overall loss ratio | 73.3 | % | 72.6 | % | — | — | ||||||||||
Selling, general and administrative expense ratio | 31.8 | % | 30.5 | % | — | — |
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Net Premiums (net of reinsurance ceded)
For the quarter ended March 31, 2006, total net premiums increased 4.3% to $111.2 million compared to $106.6 million for the first quarter of 2005.
Medical
Medical premiums for the quarter ended March 31, 2006 were $55.8 million compared to $56.6 million for the quarter ended March 31, 2005, a decrease of 1.3%. The decrease in medical premiums was primarily the result of a 3.8% decrease in major medical certificates in force from 63,582 at March 31, 2005 to 61,171 at March 31, 2006 due to continued high lapsation rates on renewal business partially offset by an increase in new business production and renewal rate increases.
Medical premiums increased 1.3% from the fourth quarter of 2005 due to the significant increase in new business on the recently released Advantage product series. Due to the continued increase in new sales, Medical segment premiums are still expected to increase approximately 5% in 2006.
Senior and Other
Senior and other premiums increased $5.3 million to $55.4 million for the quarter ended March 31, 2006 compared to $50.1 million for the same quarter in 2005. This 10.6% increase in senior and other premiums was primarily the result of rate increases that were implemented in the first quarter of 2006. The increases were partially offset by higher shock lapse rates associated with the first quarter 2006 Medicare supplement rate increases.
Based on current new business production trends and slightly higher-than-expected lapse rates on our Medicare supplement business related to the 2006 rate increases, Senior segment premiums are now expected to increase approximately 11% in 2006.
Other Revenues
Net investment income was $7.0 million for the first quarter of 2006 compared to $6.1 million for the first quarter of 2005, an increase of 14.6%. The increase was attributable to an increase in the overall book yield of our fixed maturities portfolio caused by the increased interest rate environment and higher average invested balances. The book yield of our fixed maturities portfolio at March 31, 2006 was 5.45%, compared to a book yield of 5.31% at March 31, 2005. In addition, we reallocated our investment in convertible bond securities in the second quarter of 2005 to a higher yielding collateralized securities fund.
Net realized gains were $0.1 million for the first quarter of 2006 compared to net realized losses of $0.8 million for the first quarter of 2005. The first quarter of 2005 includes $1.2 million in unrealized losses on our trading portfolios, which were liquidated in the third quarter of 2005.
Fee and other income was $4.6 million for the quarter ended March 31, 2006 which was comparable to the first quarter of 2005.
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Benefits, Claims, Losses and Settlement Expenses
Total benefits, claims, losses and settlement expenses increased to $81.5 million for the quarter ended March 31, 2006 compared to $77.4 million for the first quarter of 2005, an increase of 5.3%.
Medical
Medical benefits, claims, losses and settlement expenses were $40.1 million for the quarter ended March 31, 2006 compared to $38.9 million for the first quarter of 2005, an increase of 2.9%. In addition, the medical loss ratio was 71.8% for the quarter ended March 31, 2006 compared to 68.8% for the same quarter of 2005. The first quarter 2006 loss ratio was primarily impacted by a strengthening of claim reserves and an increase in January in-patient hospital stays. The loss ratio in the Medical segment is expected to be higher in the balance of 2006 as insureds meet their initial co-pays and deductibles. We expect the loss ratio in 2006 to remain consistent with 2005.
Senior and Other
Senior and other benefits, claims, losses and settlement expenses were $41.4 million for the quarter ended March 31, 2006, compared to $38.5 million in the first quarter of 2005. The senior and other loss ratio was 74.8% for the first quarter of 2006 compared to 76.9% for the first quarter of 2005. The improvement in the loss ratio in the first quarter of 2006 was due primarily to favorable long-term care experience, partially offset by an increase in the Medicare supplement loss ratio from 71.9% in the first quarter of 2005 to 74.0% in the first quarter of 2006. The Medicare supplement loss ratio is still expected to be approximately 72% for the full year 2006 compared to 73.8% for 2005.
Other Expenses and Net Income
Selling, general and administrative expenses increased to $35.3 million in the first quarter of 2006 compared to $32.5 million in the first quarter of 2005, an increase of $2.8 million or 8.6%. The $2.8 million increase was primarily attributable to the following:
• | a $1.6 million increase in commissions due to an increase in the overall commissions rate attributable to higher first year premium; | ||
• | a $0.5 million increase in other operating expenses due primarily to an increase in salaries and benefits; and | ||
• | reduced reinsurance allowances of $0.7 million due to expected lapsation of closed blocks of reinsured business. |
As a percentage of premium, selling, general and administrative expenses were 31.8% in the first quarter of 2006 compared to 30.5% in the first quarter of 2005.
The net amortization and change in deferred acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $2.6 million for the first quarter of 2006 compared to net amortization of $0.4 million for the first quarter of 2005.
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In the Senior segment, the DAC asset increased by $2.3 million in the first quarter of 2006 compared to $1.5 million for the same period in 2005 attributable to an increase in Medicare supplement new business production. In the Medical segment, the DAC asset increased $1.1 million in the first quarter of 2006 compared to a decrease of $1.3 million in the first quarter of 2005. The higher level of costs capitalized was attributable to a significant increase in new sales in the Medical segment.
Interest expense and financing costs were $0.2 million for the first quarter of 2006 which was comparable to the first quarter of 2005.
Income before federal income taxes was $8.5 million for the first quarter of 2006, compared to $5.9 million for the same period in 2005.
A federal income tax expense of $3.0 million was recorded for the first quarter of 2006. This compares to a federal income tax expense of $1.1 million for the first quarter of 2005, which included a $1.0 million ($0.03 per share) federal income tax benefit related to the reduction of federal income tax reserves associated with the elimination of our untaxed policyholder surplus account exposure. The effective tax rate was 35.1% of the income before federal income taxes for the first quarter of 2006. The effective tax rate for the first quarter of 2005, including the reduction of federal income tax reserves, was 18.3% of the income before federal income taxes.
Net income was $5.5 million, or $0.17 per share, for the first quarter of 2006, compared to $4.8 million, or $0.14 per share for the first quarter of 2005.
Liquidity and Capital Resources
Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, operating expenses such as rent, salaries, employee benefits, commissions, taxes, and interest on debts. Net cash provided by operating activities for the period ended March 31, 2006 was $7.5 million compared to $8.3 million at March 31, 2005. Cash provided by operating activities decreased compared to the first quarter of 2005 due to $1.8 million in federal income tax payments to the Internal Revenue Service in the first quarter of 2006 and an increase in major medical claim payments. The first quarter of 2005 included the payment of the California litigation settlements.
Assets decreased to $769.8 million at March 31, 2006 from $771.0 million at December 31, 2005. Assets of $491.2 million, or 63.8% of the total assets, were in investments at March 31, 2006. Fixed maturities, our primary investment, were $448.4 million, or 91.3% of total investments, at March 31, 2006 compared to $447.5 million at December 31, 2005. Other investments consist of equity securities, an investment in a limited partnership, and policy loans and mortgage loans.
Approximately 95.5% of our fixed maturities available-for-sale were of investment grade quality at March 31, 2006. In addition to the fixed maturities, we also had $25.3 million in cash and cash equivalents of which $5.7 million was restricted at March 31, 2006.
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The total reinsurance receivable was $127.5 million at March 31, 2006. Of this amount, $124.7 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds substantially all of these reserves.
The total policy liabilities and benefits accrued were 89.8% of the total liabilities at March 31, 2006 compared to 89.5% at December 31, 2005.
Credit Agreement. At March 31, 2006, our credit facility consisted of a $1.6 million term loan A and a $4.6 million term loan B with National City Bank. The term loan A has remaining quarterly principal payments of $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The term loan B has remaining quarterly principal payments of $375,000 through December 2006, $562,500 through December 2007, and a payment of $1,250,000 on March 1, 2008.
Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.0%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 3.75%, respectively. At March 31, 2006, the interest rate on our term loan A balance of $1.6 million was 8.06% per annum and on our $4.6 million term loan B was 8.56% per annum.
Our obligations under the credit agreement are guaranteed by four of our non-regulated subsidiaries and are secured by pledges of the capital stock of Central Reserve, Continental General and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries, and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends, and stock repurchases. At March 31, 2006, we were in compliance with these covenants.
Off-Balance Sheet Arrangements.We do not have transactions or relationships with variable interest entities, and we do not have any off-balance sheet financing other than normal operating leases.
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Contractual Obligations.The following schedule summarizes current and future contractual obligations as of March 31, 2006:
Payments Due by Year | ||||||||||||||||||||
Less than | After 5 | |||||||||||||||||||
Contractual Obligations | Total | 1 year | 1-3 years | 4-5 years | years | |||||||||||||||
(dollars in thousands) | ||||||||||||||||||||
Long-term debt | $ | 6,250 | $ | 3,313 | $ | 2,937 | $ | — | $ | — | ||||||||||
Long-term debt interest (1) | 616 | 437 | 179 | — | — | |||||||||||||||
Operating leases | 22,149 | 2,665 | 4,506 | 3,947 | 11,031 | |||||||||||||||
Unfunded/callable investment commitments (2) | 10,000 | 10,000 | — | — | — | |||||||||||||||
Deposit and investment contracts (3) | 237,937 | 21,329 | 37,003 | 33,289 | 146,316 | |||||||||||||||
Other policy claims and benefits payable (4) | 101,583 | 71,418 | 17,447 | 6,463 | 6,255 | |||||||||||||||
Total contractual obligations | $ | 378,535 | $ | 109,162 | $ | 62,072 | $ | 43,699 | $ | 163,602 | ||||||||||
(1) | The interest associated with our variable-rate term loans is based upon interest rates in effect at March 31, 2006. The contractual amounts to be paid on variable-rate obligations are affected by changes in market interest rates. Future changes in market interest rates could materially affect the contractual amounts to be paid. | |
(2) | Represents estimated timing for fulfilling unfunded and callable capital commitments for an investment in a limited partnership. Outstanding commitments are included in payments due in less than one year since the timing of funding these commitments cannot be reasonably estimated. | |
(3) | Estimated payments required under interest sensitive life and annuity contracts. The actual payments could vary based on changes in assumed crediting rates, persistency, and mortality levels. | |
(4) | Includes claims and benefits payable on our major medical, Medicare supplement, long-term care and other health care products. |
In 2005, we committed to invest $10.0 million in a limited partnership, NYLIM Real Estate Mezzanine Fund II, L.P. The investments by this partnership are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. The capital commitments can be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitment, but may elect to do so. The partnership has not made any capital calls on our $10.0 million commitment. Therefore, at March 31, 2006, we had outstanding unfunded and callable capital commitments totaling $10.0 million related to this limited partnership.
In addition, we committed to invest $5.0 million in the aggregate, in two commercial mortgage loan trusts in 2005. The outstanding unfunded commitment of $2.0 million at December 31, 2005 was funded in the first quarter of 2006.
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees charged primarily on our major medical business.
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Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
If our non-regulated subsidiaries do not generate sufficient fee income or we are unable to take dividends from our insurance subsidiaries to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. In addition, if needed, additional financing may not be available on terms favorable to us or at all.
Financial Information about Industry Segments
We have three segments: Medical, which includes catastrophic and comprehensive major medical plans; Senior and Other, which includes Medicare supplement, long-term care, dental, life insurance and annuities; and Corporate and Other, which includes interest income, interest expense, and corporate expenses of the parent company. See Note G. Operating Segments, to our Condensed Consolidated Financial Statements for further information.
New Accounting Pronouncements
See Note A. Summary of Business and Significant Accounting Policies, to our condensed consolidated financial statements for a discussion of recently issued Accounting Standards.
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Item 3. Quantitative and Qualitative Disclosure about Market Risk
As of March 31, 2006, we had gross unrealized losses on individual available-for-sale investments of $10.5 million compared to $6.3 million at December 31, 2005. There were 42 securities that were in a continuous unrealized loss position for twelve months or longer with unrealized losses totaling $3.3 million at March 31, 2006, compared to 36 securities with unrealized losses totaling $2.0 million at December 31, 2005. None of our investments are delinquent or in payment default and there are no conditions present that indicate a high probability that all amounts will not be collected. Based on our evaluation along with that of our external investment managers, there were no investments in an unrealized loss position that had experienced a decline in market value that was considered by us to be significant and other-than-temporary at March 31, 2006.
Interest rate risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders’ equity is estimated to be $10.2 million after-tax at March 31, 2006. This amount represents approximately 5.0% of our stockholders’ equity at that date.
See also Part II Item 1A. – “Risk Factors.”
Item 4. Controls and Procedures
Evaluation of disclosure controls and procedures.We carried out an evaluation, under the supervision and with the participation of our President and Chief Executive Officer along with our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of March 31, 2006. Based upon that evaluation, our President and Chief Executive Officer along with our Chief Financial Officer concluded that our disclosure controls and procedures are effective and designed to ensure that material information relating to us and our consolidated subsidiaries in the reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Changes in internal control.There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The nature of our business subjects us to a variety of legal actions and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration and alleged violations of state and federal statutes.
In addition, we are involved in various other legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
Item 1A. Risk Factors
The Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2005 as filed with the SEC on March 16, 2006 have not materially changed with the exception of the addition of the first risk factor related to the proposed merger. Some of the risks which may be relevant to us could include:
• | failure to obtain stockholder approval or the failure to satisfy other closing conditions, including regulatory approval, with respect to the proposed merger; | ||
• | failure to accurately predict health care costs when pricing our products and establishing our liabilities for future policy benefits and claim liabilities could have a significant impact on our business and results of operations; | ||
• | we may lose business to competitors offering products similar to ours at lower prices; | ||
• | our profitability depends in large part on our ability to accurately predict and effectively manage rising health care costs, and accurately predict loss ratios, persistency, and the performance of and improvements in our business, as well as implement necessary increases in premium rates; | ||
• | changes in government regulation may affect our profitability, increase our costs of compliance or cause us to discontinue marketing certain products or marketing in certain states; | ||
• | we are subject to a variety of legal actions relating to our business operations, including claims related to the denial of benefits, which may result in financial losses or harm our reputation; | ||
• | changes in the relationship with the associations that make available our health insurance products to their members and/or changes in laws and regulations governing “association group” insurance could have a material adverse effect on our business, financial |
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condition and results of operations; | |||
• | our profitability may be adversely affected if we are unable to maintain our current preferred provider organization (PPO) arrangements and to enter into other appropriate arrangements; | ||
• | our success depends on our ability to develop, market, distribute and administer profitable and competitive products and services in a timely, cost-effective manner; | ||
• | a failure of our information systems to provide timely and accurate information could adversely affect our business and results of operations; | ||
• | failure by our reinsurers to timely and fully meet their obligations under our reinsurance agreements could have an adverse effect on our profitability and financial conditions; | ||
• | our insurance subsidiaries are subject to risk-based or statutory capital requirements and our failure to meet these standards could subject us to regulatory actions; | ||
• | a decline in our financial agency ratings could adversely affect our operations; | ||
• | our investment portfolio involves risks, including risks inherent with ownership of bonds and risks associated with rising interest rates; | ||
• | applicable laws restrict the acquisition of more than 10% of our outstanding voting securities; | ||
• | changing regulations of corporate governance and public disclosure that has increased both our costs and the risk of non-compliance, including Section 404 of the Sarbanes-Oxley Act of 2002; | ||
• | our dependence on senior management and key personnel; | ||
• | our ability to continue to meet the terms of our debt obligations under our credit agreement, as amended, which contains a number of significant financial and other covenants; | ||
• | the adequacy of funds, including fee income, received from our non-regulated subsidiaries, and the restrictions on our insurance subsidiaries’ ability to pay dividends to Ceres, to meet our debt obligations; | ||
• | the performance of others on whom we rely for administrative and operations services; | ||
• | changes in accounting and reporting practices; | ||
• | payments to state assessment funds; | ||
• | changes in tax laws; and | ||
• | our ability to fully collect all agent advances. |
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The risks listed above should not be construed as exhaustive.
Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us.
In particular, forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “continue” or similar words. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially and adversely from those in the forward-looking statements, including those risks outlined above in “Risk Factors.” We undertake no obligation to publicly release the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits
Exhibits:
31.1 | CEO certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
31.2 | CFO certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
32 | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
CERES GROUP, INC. | ||||
Date: May 10, 2006 | By: | /s/ David I. Vickers | ||
David I. Vickers | ||||
Executive Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) |
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