UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________ to ____________________ Commission File Number 1-10589 CII FINANCIAL, INC. (Exact name of registrant as specified in its charter) CALIFORNIA 95-4188244 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2716 NORTH TENAYA WAY LAS VEGAS, NV 89128 (Address of principal executive offices) (Zip Code) (702) 242-7040 (Registrant's telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No As of November 13, 2001, there were 100 shares of common stock outstanding. CII FINANCIAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2001 INDEX Page No. Part I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - September 30, 2001 and December 31, 2000................................................. 3 Condensed Consolidated Statements of Operations - three and nine months ended September 30, 2001 and 2000.................................. 4 Condensed Consolidated Statements of Cash Flows - nine months ended September 30, 2001 and 2000............................................ 5 Notes to Condensed Consolidated Financial Statements....................................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................ 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk........................................................................ 18 Part II - OTHER INFORMATION Item 1. Legal Proceedings.......................................................................... 19 Item 2. Changes in Securities and Use of Proceeds.................................................. 19 Item 3. Defaults Upon Senior Securities............................................................ 19 Item 4. Submission of Matters to a Vote of Security Holders........................................ 19 Item 5. Other Information.......................................................................... 19 Item 6. Exhibits and Reports on Form 8-K........................................................... 19 Signatures................................................................................................... 20PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data) September 30 December 31 2001 2000 (Unaudited) ASSETS Invested assets: Debt securities, available-for-sale, at fair value.................. $193,995 $177,671 Debt securities, held-to-maturity, at amortized cost ............... 13,597 21,258 Preferred stocks, at fair value..................................... 2,784 5,130 Mortgage loans on non-affiliated real estate........................ 11,743 12,362 -------- -------- Total invested assets................................................... 222,119 216,421 -------- -------- Cash and cash equivalents............................................... 28,240 28,666 Reinsurance recoverable................................................ 255,803 247,205 Premiums receivable (net of allowances of $1,520 and $1,449)........... 11,097 11,785 Note receivable affiliate (Note 8)..................................... 7,500 Deferred income taxes.................................................. 10,194 16,251 Property and equipment, net............................................ 3,705 4,126 Other assets........................................................... 11,138 9,148 -------- -------- TOTAL ASSETS.............................................................. $549,796 $533,602 ======== ======== LIABILITIES Reserve for loss and loss adjustment expenses.......................... $410,609 $374,554 Unearned premiums...................................................... 16,026 13,493 Ceded reinsurance premiums payable..................................... 14 11,073 Debentures (Note 3).................................................... 19,187 47,059 Notes payable affiliate (Note 8)....................................... 17,000 Accounts payable and other accrued expenses............................ 19,037 24,071 -------- -------- TOTAL LIABILITIES......................................................... 481,873 470,250 -------- -------- COMMITMENTS AND CONTINGENCIES (Note 7) STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; 100 shares issued and outstanding........................... 3,604 3,604 Additional paid-in capital.............................................. 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments ........... (1,868) (4,535) Retained Earnings (accumulated deficit)................................. 1,737 (167) -------- -------- TOTAL STOCKHOLDER'S EQUITY................................................. 67,923 63,352 -------- -------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY................................. $549,796 $533,602 ======== ======== See accompanying notes to condensed consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands) (Unaudited) Three Months Ended Nine Months Ended September 30 September 30 2001 2000 2001 2000 REVENUES Direct written premiums............................... $ 47,573 $ 56,570 $143,042 $ 153,034 Changes in direct unearned premiums................... 464 566 (2,532) (2,906) -------- -------- -------- --------- Direct earned premiums................................ 48,037 57,136 140,510 150,128 Less: premiums ceded................................. 1,119 18,872 12,218 59,177 -------- -------- -------- --------- Net earned premiums................................... 46,918 38,264 128,292 90,951 Net investment income................................. 3,653 3,887 11,664 11,217 Net realized investment (losses) gains................ (97) (71) 235 (460) -------- -------- -------- --------- Total revenues.......................................... 50,474 42,080 140,191 101,708 -------- -------- -------- --------- COSTS AND EXPENSES Direct loss and loss adjustment expenses.............. 58,718 72,196 172,592 207,323 Reinsurance recoveries................................ (20,658) (41,893) (68,241) (123,303) -------- -------- -------- --------- Net loss and loss adjustment expenses................. 38,060 30,303 104,351 84,020 Policy acquisition costs.............................. 8,031 6,083 21,440 14,174 General, administrative and other..................... 3,426 3,560 10,237 14,804 Interest expense...................................... 412 875 1,897 2,717 -------- -------- -------- --------- Total costs and expenses................................ 49,929 40,821 137,925 115,715 -------- -------- -------- --------- INCOME (LOSS) BEFORE FEDERAL INCOME TAX EXPENSE AND EXTRAORDINARY GAIN.................................. 545 1,259 2,266 (14,007) Federal income tax expense (benefit).................... 204 448 761 (4,902) -------- -------- -------- --------- INCOME (LOSS) BEFORE EXTRAORDINARY GAIN................................... 341 811 1,505 (9,105) Extraordinary (loss) gain from debt extinguishment (net of income tax of $(34), $51, $214 and $353)........ (64) 93 399 654 -------- -------- -------- --------- NET INCOME (LOSS)....................................... $ 277 $ 904 $ 1,904 $ (8,451) ======== ======== ======== ========= See accompanying notes to condensed consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) Nine Months Ended September 30 2001 2000 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)............................................................. $ 1,904 $ (8,451) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Extraordinary gain.......................................................... (613) (1,007) Depreciation and amortization............................................... 892 1,197 Provision for asset impairment.............................................. 3,000 Change in assets and liabilities: Reinsurance recoverable..................................................... (8,598) (79,732) Reserve for loss and loss adjustment expense................................ 36,055 97,508 Ceded reinsurance premiums payable.......................................... (11,059) (1,897) Change in other assets and liabilities...................................... 216 (12,871) ------- -------- Net cash provided by (used in) operating activities.................. 18,797 (2,253) ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net..................................................... (504) (820) Changes in investments ....................................................... (1,057) 10,717 Note receivable affiliate..................................................... (7,500) ------- -------- Net cash (used in) provided by investing activities.................. (9,061) 9,897 ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Dividend to Sierra............................................................ (2,637) Payments on debentures........................................................ (27,162) (2,432) Notes payable affiliate....................................................... 17,000 ------- -------- Net cash used in financing activities................................ (10,162) (5,069) ------- -------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS............................ (426) 2,575 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD................................ 28,666 16,833 ------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD...................................... $28,240 $ 19,408 ======= ======== Nine Months Ended September 30 2001 2000 Supplemental Condensed Consolidated Disclosures of Cash Flows Information: Cash paid during the period for interest (net of amount capitalized).............. $ 2,890 $ 3,713 Non-cash Investing and Financing Activities: Debentures exchanged......................................................... 19,692 See accompanying notes to condensed consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation CII Financial, Inc. ("CII Financial", a workers' compensation insurance holding company, together with its subsidiaries, collectively referred to as the "Company") is a wholly owned subsidiary of Sierra Health Services, Inc. ("Sierra"), a managed health care organization. The Company's insurance subsidiaries consist of California Indemnity Insurance Company ("California Indemnity") and its wholly owned subsidiaries, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas. The accompanying unaudited financial statements include the consolidated accounts of the Company. All material intercompany balances and transactions have been eliminated. These statements have been prepared in conformity with accounting principles generally accepted in the United States of America as used in preparing the Company's annual audited consolidated financial statements but do not contain all of the information and disclosures that would be required in a complete set of audited financial statements. They should, therefore, be read in conjunction with the Company's audited consolidated financial statements and related notes thereto as of and for the years ended December 31, 2000 and 1999. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial results for the interim periods presented. 2. Comprehensive Income The following table presents comprehensive income for the periods indicated: Three Months Ended Nine Months Ended September 30 September 30 (In thousands) 2001 2000 2001 2000 Net Income (Loss)........................... $ 277 $ 904 $1,904 $(8,451) Change in Accumulated Other Comprehensive Income, Net................. 3,895 847 2,667 3,549 ------ ------ ------ ------- Comprehensive Income (Loss)................. $4,172 $1,751 $4,571 $(4,902) ====== ====== ====== ======= 3. Debentures In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "Subordinated Debentures") of which $47,059,000 were outstanding at March 31, 2001. Interest on the Subordinated Debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share. During the first nine months of 2000, the Company repurchased $3,439,000 of the Subordinated Debentures in the open market resulting in an extraordinary gain of $1,007,000 and a corresponding tax provision of $353,000. In December 2000, CII Financial commenced an offer to exchange the Subordinated Debentures for cash and/or new debentures. To facilitate the exchange, CII Financial borrowed $17.0 million from Sierra and California Indemnity obtained the necessary approval from the California Department of Insurance to pay a dividend of $5.0 million to CII Financial. On May 7, 2001, CII Financial closed its exchange offer on $42.1 million of its outstanding Subordinated Debentures. CII Financial purchased $27.1 million in principal amount of Subordinated Debentures for $20.0 million in cash and issued $15.0 million in new 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in Subordinated Debentures. In September 2001, California Indemnity received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used the funds to fully pay the remaining $5.0 million in Subordinated Debentures at maturity. The exchange offer contained concessions by the holders of the Subordinated Debentures, including extending the maturity and accepting an interest rate that may have been lower than what CII Financial could have obtained from other lenders. In accordance with accounting principles generally accepted in the United States of America, the exchange of the new 9 1/2% senior debentures for the Subordinated Debentures was treated as a restructuring of debt. Additionally, the Subordinated Debentures are considered to represent one payable, even though there are many debenture holders. Although some of the debenture holders exchanged the Subordinated Debentures for cash, some exchanged them for new 9 1/2% senior debentures and others a combination of the two, this does not change the substance of the transaction for CII Financial; accordingly, the exchange was considered to be a single transaction. In the transaction, total future cash payments (interest and principal) on the remaining Subordinated Debentures and the new 9 1/2% senior debentures are less than the balance of the Subordinated Debentures at the time of the exchange less the cash consideration given in the exchange. Accordingly, a gain on restructuring was recognized for the difference and the carrying amount of the remaining Subordinated Debentures and new 9 1/2% senior debentures is the total future cash payments on the debentures. Costs incurred in connection with the exchange were used to offset the gain on restructuring. All future cash payments related to the debentures are reductions of the carrying amount of the debentures therefore no future interest expense will be recognized for the debentures. The transaction resulted in an extraordinary gain of $613,000 and a corresponding tax provision of $214,000. The new 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The new 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. (See Note 8 of these financial statements) The new 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums starting at 110% and declining to 100% for redemptions after April 1, 2004. In the event of a change in control of CII Financial, the holders of these new 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest. 4. Segment Information For each of the periods presented, the Company operated in a single business segment, workers' compensation insurance. 5. Codification of Statutory Accounting Principles In March 1998, the National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles ("the Codification"). The Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The insurance subsidiaries were required to implement the Codification, with certain applicable state modifications, for the preparation of statutory financial statements effective January 1, 2001. The adoption of the Codification, as modified by the applicable state, increased the Company's insurance subsidiaries' statutory capital and surplus as of January 1, 2001, by approximately $7.0 million, which is primarily due to prescribed statutory accounting principles under the Codification regarding income taxes, earned but unbilled premiums and electronic data processing equipment. 6. Recently Issued Accounting Standards In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142"), which is effective January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles such as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires companies to complete a transitional goodwill impairment test six months from the date of adoption. The Company does not have any goodwill or other significant intangible assets and believes that there will not be any material impact from SFAS 142 on its financial position and results of operations. In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), which is effective January 1, 2002. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as some foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. The Company has not determined the effect of implementing this standard. 7. Commitments and Contingencies The Company's insurance subsidiaries are required to participate in state guaranty associations in all states in which they do business. The guaranty associations assess solvent insurance companies to fund claims of policyholders of insolvent insurance companies. Assessments are typically based on a percentage of direct premiums written on a specific line(s) of insurance in the calendar year previous to the assessment. The associations can assess 1% to 2% of direct premiums written, net of return premium ("net direct written premiums"). In California and certain other states, insurance companies are allowed to recoup the assessments from their policyholders, while other states allow an offset against premium taxes or a combination of both. In California, there were no guaranty association assessments imposed on companies writing solely workers' compensation insurance between 1990 and 1999. In October 2000, the Company received a notice from the California Insurance Guarantee Association of an assessment of $1.2 million of which one-half was paid prior to December 31, 2000 and the remainder was paid in June 2001. This assessment is being recouped by a 1% surcharge on workers' compensation insurance policies with effective dates on and after January 1, 2001. The assessment was based on 1% of net direct written premiums in 1999 and will be subsequently trued-up based on net direct written premiums in 2000. Legislation was enacted in September 2001 in California that raised the assessment to 2% of net direct written premiums for a one-year period. In October 2001, the Company received and paid an assessment of $3.1 million. This assessment will be recouped by a 2% surcharge on workers' compensation insurance policies with effective dates on and after January 1, 2002. The assessment was based on 2% of net direct written premiums in 2000 and will be subsequently trued-up based on net direct written premiums in 2001. Due to the current ability to substantially recoup assessments or reduce premium taxes, the Company does not believe that guaranty association assessments will materially affect its financial condition or results of operations. 8. Note Receivable and Notes Payable to Affiliate In connection with the exchange offer for the Subordinated Debentures (see Note 3 of these financial statements), California Indemnity lent Sierra $7.5 million. The loan bears interest at 8.5%, which is due semi-annually on March 31 and September 30 of each year, commencing September 30, 2001. All outstanding principal and accrued interest is due on September 30, 2004. The loan is secured by the common stock of Sierra Health and Life Insurance Company ("SHL"), a wholly owned subsidiary of Sierra, equal to 120% of the principal amount outstanding. At September 30, 2001, SHL had total equity, on a statutory accounting basis, of approximately $13.9 million. As an additional part of the exchange offer transaction, Sierra lent CII Financial $15.0 million as well as an additional $2.0 million to enable CII Financial to pay the accrued interest on the Subordinated Debentures due on March 15, 2001 and other operating expenses. Each of the loans are demand notes payable and bear interest at 9.5%, which is due semi-annually on March 15 and September 15 of each year, commencing September 15, 2001. The notes are subordinated to the new 9 1/2% senior debentures and CII Financial's guaranty of Sierra's credit facility. CII FINANCIAL, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Condensed Consolidated Financial Statements and related Notes thereto. Any information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and any other sections of this Quarterly Report on Form 10-Q that is not historical fact is forward-looking and is based on management's projections, assumptions and estimates; actual results may vary materially. Forward-looking statements are subject to certain risks and uncertainties that have been discussed in other filings made by the Company and its parent, Sierra Health Services, Inc. Our operating results are primarily the results of our workers' compensation insurance subsidiaries and consist of underwriting profit/loss, net investment income, net realized gains/losses, other income/expense, interest expense and income taxes. RESULTS OF OPERATIONS, THREE MONTHS ENDED SEPTEMBER 30, 2001, COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2000. Revenues are comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 20% due primarily to a reduction in premiums ceded to reinsurers. Reflected in the 2001 direct written premiums is a 31% decrease in production and a 27% composite increase in premium rates for all states. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums decreased by 15.9% due primarily to a decline in our California business. Offsetting this was a reduction in the amount of premium ceded to reinsurers, which increased earned premium by $17.8 million. The decrease in ceded reinsurance premiums was primarily due to the expiration and run-off of our low level reinsurance agreement on June 30, 2000 along with new lower retention reinsurance agreements, all of which reduced the percentage of premiums being ceded. The following table reflects a comparison of direct written premiums, by state: Three months ended September 30 2001 % of total 2000 % of total (dollars in millions) California $34.7 72.8% $42.1 74.4% Nevada 4.5 9.5 4.5 8.0 Colorado 4.5 9.5 5.8 10.2 Texas 2.3 4.8 2.1 3.7 Other States 1.6 3.4 2.1 3.7 ----- ----- ----- ----- Total $47.6 100.0% $56.6 100.0% ===== ===== ===== ===== As shown in the preceding table, our largest premium state, California, had a 17.6% decrease in direct written premiums. However, we obtained an average premium rate increase on California renewing policies of approximately 33% for the quarter ended September 30, 2001. Premiums in force are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies in force at a point in time. Total inforce premiums have decreased by 12.7% to $165.6 million compared to last year. This has resulted in a decrease in direct written premiums, especially in California, which we believe is due largely to business lost as a result of premium rate increases we have been attempting to receive. The number of inforce policies at September 30, 2001 has also dropped by 25.2% compared to last year. The $300,000 or 6.8% decrease in net investment income is due to lower investment yields offset by an increase in the average invested asset balance. CII FINANCIAL, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS We had net realized losses of $100,000 in both the third quarter of 2001 and 2000. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. Net loss and loss adjustment expenses, or LAE, increased by approximately $7.8 million due to the following: o We recorded approximately $7.0 million in additional loss and LAE related to the increase in net earned premiums in 2001 compared to 2000. o In the third quarter of 2001, we recorded $1.5 million of net adverse loss development for prior accident years compared to net positive development of $500,000 in the third quarter of 2000 recorded for prior accident years. The net adverse development recorded in 2001 was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. o In the third quarter of 2000, we recorded an accident year loss and LAE ratio of 80.5%. We have reduced the comparative 2001 accident year loss and LAE ratio to 77.9%, resulting in a decrease to our net loss and LAE totaling $1.2 million. The reduction in the loss ratio is primarily due to the composite premium rate increases obtained on new and renewal business. The net adverse loss development on prior accident years included those years that were covered by our low level reinsurance agreement. This results in an increase in the reinsurance recoverable balance which is then reduced by amounts collectable from reinsurers for paid losses. Net reinsurance recoverable decreased by $2.0 million in the third quarter of 2001 and increased by $14.7 million in the third quarter of 2000. Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000, when we executed an option to extend coverage to all policies in force as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. This agreement covered claims with dates of injury between July 1, 2000 and June 30, 2001. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract that will expire December 31, 2002. The termination of the low level agreement will result in our keeping more retained losses and LAE. However, our California premium rates have been increasing, which we believe will largely mitigate the loss of this favorable reinsurance protection. As a percentage of net earned premiums, the loss and LAE ratio was 81.1% compared to 79.2% for 2000. The increase is primarily due to the prior year development booked in 2001. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $1.9 million in 2001 is primarily attributable to the run off of the low level reinsurance treaty, whereby we are ceding less commission to our reinsurer. General, administrative and other expenses include other underwriting expenses of $3.2 million in the third quarter of 2001 compared to $2.8 million in the third quarter of 2000 and policyholders' dividends of $300,000 in 2001 compared to $800,000 in 2000. Policyholders' dividends, which primarily are payable on Nevada participating policies, represent .6% of 2001 net earned premiums compared to 2.0% in 2000. The underwriting expense ratio, which includes policy acquisition costs and other underwriting expenses as a percentage of net earned premiums, was relatively flat at 23.8% compared to 23.2% in 2000. Interest expense decreased by $500,000 or 52.9% during the period due to the exchange offer for the CII Financial, Inc. 7 1/2% Convertible Subordinated Debentures (the "Subordinated Debentures") that closed on May 7, 2001. As a result of the restructuring of the Subordinated Debentures, all future interest payments after the closing on both the remaining Subordinated Debentures and the new 9 1/2% senior debentures are reductions of the carrying amount of the debentures and no further interest expense is recorded. See Note 3 of the Notes to Condensed Consolidated Financial Statements. The interest expense recorded in the third quarter of 2001 is all related to a note payable to Sierra Health Services, Inc. See Note 8 of the Notes to Condensed Consolidated Financial Statements. The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 105.5% compared to 104.4% in 2000. The increase was primarily due to a higher loss and LAE ratio of 1.9 percentage points in addition to an increase in the underwriting expense ratio of .6 percentage points, offset by a decrease in the policyholders' dividend ratio of 1.4 percentage points. The increase in the loss and LAE ratio was primarily due to an increase of $2.0 million in the amount of adverse prior year loss development recorded in 2001 compared to 2000, offset by a decrease in the 2001 accident year loss ratio due to continued price strengthening. Provision for income taxes was recorded at $200,000 for the quarter compared to $400,000 in 2000 with an effective tax rate of 37.4% compared to 35.6% for 2000. The change in the effective tax rate is due to a combination of tax preferred investments and changes in the valuation allowance. RESULTS OF OPERATIONS, NINE MONTHS ENDED SEPTEMBER 30, 2001, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2000. Revenues are comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 38% due primarily to a reduction in premiums ceded to reinsurers. Reflected in the 2001 direct written premiums is a 29% decrease in production and a 32% composite increase in premium rates for all states. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums decreased by 6.5% due primarily to a decline in our California business offset by growth in Nevada, Texas and Colorado. The reduction in the amount of premium ceded to reinsurers increased earned premium by $47.0 million. The decrease in ceded reinsurance premiums was primarily due to the expiration and run-off of our low level reinsurance agreement on June 30, 2000 along with new lower retention reinsurance agreements, all of which reduced the percentage of premiums being ceded. The following table reflects a comparison of direct written premiums, by state: Nine months ended September 30 2001 % of total 2000 % of total (dollars in millions) California $104.0 72.7% $117.6 76.9% Nevada 13.5 9.4 11.3 7.4 Colorado 13.4 9.4 12.4 8.1 Texas 7.2 5.0 5.6 3.7 Other States 4.9 3.5 6.1 3.9 ------ ----- ------ ----- Total $143.0 100.0% $153.0 100.0% ====== ===== ====== ===== As shown in the preceding table, our largest premium state, California, had an 11.6% decrease in direct written premiums. We obtained an average premium rate increase on California renewing policies of approximately 40% for the nine months ended September 30, 2001 and 23% for policies that renewed in the first nine months of 2000. However, the production of new and renewal business is decreasing because of the higher premium rates we are attempting to achieve. The $1.1 million or 10.6% increase in net investment income is due to an increase in the average invested asset balance offset by lower investment yields. We had net realized gains of $200,000 compared to net realized losses of $500,000 in 2000. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. Net loss and loss adjustment expenses, or LAE, increased by approximately $20.3 million due to the following: o We recorded approximately $26.2 million in additional loss and LAE related to the increase in net earned premiums in 2001 compared to 2000. o In 2001, we recorded $7.3 million of net adverse loss development for prior accident years, primarily 1996 to 1998, compared to net adverse loss development of $20.2 million recorded in 2000, primarily for accident years 1996 to 1999. The net adverse development recorded was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. o We established a higher loss and LAE ratio for the 2001 accident year, which has resulted in an increase of approximately $7.0 million. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE. The net adverse loss development on prior accident years included those years that were covered by our low level reinsurance agreement. This results in an increase in the reinsurance recoverable balance which is then reduced by amounts collectable from reinsurers. Net reinsurance recoverable increased by $8.6 million in 2001 and $73.7 million in 2000. Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000, when we executed an option to extend coverage to all policies in force as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. This agreement covered claims with dates of injury between July 1, 2000 and June 30, 2001. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract that will expire December 31, 2002. The termination of the low level agreement will result in our keeping more retained losses and LAE. However, our California premium rates have been increasing, which we believe will largely mitigate the loss of this favorable reinsurance protection. As a percentage of net earned premiums, the loss and LAE ratio was 81.3% compared to 92.4% for 2000. The decrease is primarily due to the prior year development booked in 2000, offset by the expiration of the low level reinsurance agreement for policies effective after June 30, 2000. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $7.3 million in 2001 is primarily attributable to the run off of the low level reinsurance treaty, whereby we are ceding less commission to our reinsurer. General, administrative and other expenses include other underwriting expenses of $8.8 million compared to $10.1 million in 2000 and policyholders' dividends of $1.4 million compared to $1.7 million in 2000. In addition, we recorded an asset impairment charge of $3.0 million in 2000 for the write-off of capitalized costs on an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations. Policyholders' dividends, which primarily are payable on Nevada participating policies, represent 1.1% of 2001 net earned premiums compared to 1.8% of 2000 net earned premiums. The decrease of $1.6 million in general, administrative and other expenses in 2001 is primarily due to expense reduction initiatives, which reduced personnel and related expenses. The underwriting expense ratio, which includes policy acquisition costs and other underwriting expenses as a percentage of net earned premiums, was 23.6% compared to 26.7% in 2000. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, a reduction in personnel expenses and lower agents' commissions and allowances. Interest expense decreased by $.8 million or 30.2% during the period due to the exchange offer for the Subordinated Debentures that closed on May 7, 2001. As a result of the restructuring of the Subordinated Debentures, all future interest payments made after the closing of the offer on both the remaining Subordinated Debentures and the new 9 1/2% senior debentures are reductions of the carrying amount of the debentures and no further interest expense will be recorded. See Note 3 of the Notes to Condensed Consolidated Financial Statements. The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 106.0% compared to 120.9% for the first nine months of 2000. The decrease was primarily due to a lower loss and LAE ratio of 11.1 percentage points as well as a decrease in the underwriting expense ratio of 3.1 percentage points and a decrease in the policyholders' dividend ratio of .7 percentage points. The decrease in the loss and LAE ratio was primarily due to $7.3 million in adverse prior year loss development recorded in 2001 compared to $20.2 million recorded in 2000, offset by an increase in the 2001 accident year loss ratio due to the run off of the low level reinsurance. The reduction in the underwriting expense ratio was primarily due to the asset impairment charge recorded in 2000 and higher retained net earned premiums and expense reduction initiatives taken by the Company. Provision for income taxes was recorded at $800,000 compared to a benefit of $4.9 million in 2000 with an effective tax rate of 33.6% compared to 35.0% for 2000. The change in the effective tax rate is due to a combination of tax preferred investments and changes in the valuation allowance. LIQUIDITY AND CAPITAL RESOURCES Debentures In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "Subordinated Debentures") of which $47,059,000 were outstanding at March 31, 2001. The Subordinated Debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. Interest on the Subordinated Debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share. CII Financial anticipated that it would not have readily available sources of cash to pay the Subordinated Debentures when they were scheduled to mature in September 2001 and initiated a proposed exchange offer in December 2000. CII Financial offered to exchange new debentures and/or cash for the Subordinated Debentures. To facilitate the exchange, CII Financial received loans of $17.0 million from Sierra and California Indemnity Insurance Company, a wholly owned subsidiary of CII Financial, obtained approval from the California Department of Insurance to pay a dividend of $5.0 million to CII Financial. On May 7, 2001, CII Financial closed its exchange offer for $42.1 million of its outstanding Subordinated Debentures. CII Financial purchased $27.1 million in principal amount of Subordinated Debentures for $20.0 million in cash and issued $15.0 million in new 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in Subordinated Debentures. The transaction resulted in an extraordinary gain of $613,000 and a corresponding tax provision of $214,000. See Note 3 of the Notes to Condensed Consolidated Financial Statements for an explanation of the accounting treatment of the transaction. In August 2000, CII Financial became a guarantor of Sierra's revolving credit facility. The revolving credit facility commitment was $121.1 million as of September 30, 2001 and will decrease by $3.0 million on December 31, 2001 and an additional $6.0 million on June 30, 2002. The outstanding balance decreased from $135 million to $94 million during the nine month period. Under the terms of the revolving credit facility, capital contributions to us from Sierra that we use to repay the Subordinated Debentures could have required Sierra to reduce permanently an equal amount of the outstanding balance of its credit facility commitment. In September 2001, California Indemnity Insurance Company, or California Indemnity, received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used these funds to fully pay the remaining $5.0 million in Subordinated Debentures that matured on September 15, 2001. The new 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The new 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. The new 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums starting at 110% and declining to 100% for redemptions after April 1, 2004. In the event of a change in control of CII Financial, the holders of these new 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest. CII Financial expects to service the new 9 1/2% senior debentures from future cash flows, primarily from dividends that will be paid by its insurance subsidiaries from their future earnings. Recent Events We are not aware of any direct losses that may have occurred as a result of the events of September 11, 2001 or the subsequent anthrax incidents. We have reviewed the financial strength ratings of our primary reinsurers with certain rating agencies subsequent to the events of September 11, 2001. The rating agencies have either affirmed or left the ratings unchanged on all of our primary reinsurers. As a result, we do not expect to incur any losses on our reinsurance contracts as a result of the events of September 11, 2001. Other Our insurance subsidiaries require liquidity to pay policy claims and benefits, for operating expenses, income taxes and to purchase fixed assets to maintain and enhance their operations. The source of our insurance subsidiaries' funds come from the premiums they collect, the investment income they earn and receipts from their reinsurers. The liquidity requirements of our non-insurance operations, which are essentially the holding company, CII Financial, are substantially all related to the servicing of interest payments on the new 9 1/2% senior debentures and the payment of the new 9 1/2% senior debentures at maturity. Our insurance subsidiaries are required to maintain sufficient liquid assets to pay claims and other policy obligations. Workers' compensation insurance is referred to as a "long-tail" business because of the length of time that typically occurs between when the premium is collected and when a claim is fully paid and settled due to life-time benefits that could be provided to a claimant. The excess of premiums collected over claims and expenses paid are invested until needed. State regulations dictate the kinds of investments we can have and we try to match the maturity of our investments with expected future cash needs. CII Financial is a holding company and its only significant asset is its investment in California Indemnity. Of the $28.2 million in cash and cash equivalents held at September 30, 2001, $27.5 million is designated for use only by the regulated insurance companies. CII Financial has limited sources of cash and is dependent upon dividends paid by California Indemnity. The payment of stockholders' dividends by California Indemnity is regulated by the California Insurance Code and, at a minimum, requires a 10 business day prior notice to the California Department of Insurance. If a payment of a dividend or distribution whose fair market value, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of ten percent of the insurer's surplus or its net income for the preceding year end, then the insurance commissioner has up to 30 days to disapprove it. The California Department of Insurance will not allow a payment of a dividend or distribution if it will cause an insurer's policyholders' surplus to be unreasonable in relation to the insurer's liabilities and the adequacy of the insurer's financial needs. In making this determination, the California Department of Insurance considers a variety of factors including, but not limited to, the size of the insurer, the amount, type and geographic concentration of insurance it writes, the quality of its assets and reinsurance programs, and operating trends. In addition, California law provides that an insurer may not pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year exceeds the amount shown as unassigned funds (reduced by any unrealized gains included in such amount) on the insurer's statutory statement as of the previous December 31. As of December 31, 2000, California Indemnity, which is our only direct insurance subsidiary, had unassigned funds of $174,000 from which it could pay a dividend without prior approval. As noted above, to make the exchange offer for the outstanding Subordinated Debentures, California Indemnity received approval from the California Department of Insurance and paid a dividend to CII Financial of $5.0 million in early May 2001 and received approval to pay an additional $5.0 million in September 2001. California Indemnity must receive the prior approval of the California Department of Insurance to pay any further dividends in 2001. Cash Flows We had positive cash flows from operating activities of $18.8 million in 2001 compared to negative cash flows of $2.3 million for 2000. Our positive cash flow in 2001 was largely due to the run-off of the low level reinsurance agreement. The growth in premium revenues has resulted in an increase in loss and LAE reserves and in unearned premiums. Our negative cash flow for 2000 was largely due to a net loss of $8.5 million offset by changes in assets and liabilities. Our net cash used in investing activities was $9.1 million compared to cash provided by investing activities of $9.9 million for 2000. The primary use of cash for investing activities in 2001 was a loan to Sierra by California Indemnity of $7.5 million in conjunction with the exchange offer. Due to the negative cash flows from operations during 2000, we sold some of our investments which resulted in positive cash from investments of $10.7 million. We used $10.2 million in cash for financing activities in 2001 compared to $5.1 million in 2000. Cash used in 2001 included $21.5 million for the exchange offer and $5.7 million for subsequent debenture reductions. We obtained loans from Sierra of $17.0 million in 2001. During 2000, we used $2.4 million to repurchase outstanding debentures and paid a dividend of $2.6 million to Sierra. CII FINANCIAL, INC. AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Unrealized holding losses on available for sale investments have decreased by $2.7 million since December 31, 2000 due primarily to an increase in the market value of bonds. We believe that changes in market interest rates, resulting in unrealized holding gains or losses, should not have a material impact on future earnings or cash flows as it is unlikely that we would need or choose to substantially liquidate our investment portfolio. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are subject to various claims and other litigation in the ordinary course of business. Such litigation includes workers' compensation claims by injured workers and by providers for payment for medical services rendered to injured workers. In the opinion of management, the ultimate resolution of these pending legal proceedings should not have a material adverse effect on our financial condition. ITEM 2. CHANGES IN 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 AND REPORTS ON FORM 8-K (a) Exhibits - None (b) Reports on Form 8-K The Company has not filed any Reports of Form 8-K during this reporting period. 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. CII FINANCIAL, INC. (Registrant) Date: November 14, 2001 /S/ JOHN F. OKITA JOHN F. OKITA Chief Financial Officer (Principal Financial and Accounting Officer)
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10-Q Filing
Cii Financial Inactive 10-Q2001 Q3 Quarterly report
Filed: 14 Nov 01, 12:00am