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 March 31, 2002 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________________ to ______________________ Commission File Number 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 May 14, 2002, there were 100 shares of common stock outstanding, all of which are held by Sierra Health Services, Inc.CII FINANCIAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE THREE MONTHS ENDED MARCH 31, 2002 INDEX Page No. Part I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - March 31, 2002 and December 31, 2001..................................................... 3 Condensed Consolidated Statements of Operations - three months ended March 31, 2002 and 2001............................................... 4 Condensed Consolidated Statements of Cash Flows - three months ended March 31, 2002 and 2001............................................... 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........................................................................ 16 Part II - OTHER INFORMATION Item 1. Legal Proceedings.......................................................................... 17 Item 2. Changes in Securities and Use of Proceeds.................................................. 17 Item 3. Defaults Upon Senior Securities............................................................ 17 Item 4. Submission of Matters to a Vote of Security Holders........................................ 17 Item 5. Other Information.......................................................................... 17 Item 6. Exhibits and Reports on Form 8-K........................................................... 17 Signatures................................................................................................... 18 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data) ASSETS (Unaudited) March 31, December 31, 2002 2001 Invested Assets: Debt Securities, Available-for-sale, at Fair Value.................. $228,267 $212,294 Debt Securities, Held-to-Maturity, at Amortized Cost................ 11,898 13,809 Preferred Stocks, at Fair Value..................................... 7,505 5,884 Mortgage Loans on Non-Affiliated Real Estate........................ 10,961 11,398 ------- ------- Total Invested Assets........................................... 258,631 243,385 ------- ------- Cash and Cash Equivalents............................................... 9,077 8,641 Reinsurance Recoverable................................................. 201,130 218,079 Premiums Receivable (Net of Allowances of $1,459 and $1,404)............ 10,197 10,669 Note Receivable Affiliate (Note 8)...................................... 7,500 7,500 Deferred Income Taxes................................................... 20,274 16,305 Property and Equipment, Net............................................. 4,546 4,955 Other Assets............................................................ 15,339 11,939 ------- ------- TOTAL ASSETS............................................................ $526,694 $521,473 ======= ======= LIABILITIES AND STOCKHOLDER'S EQUITY Reserve for Loss and Loss Adjustment Expenses........................... $388,966 $385,705 Unearned Premiums....................................................... 16,827 14,327 Debentures (Note 3)..................................................... 18,476 19,187 Notes Payable Affiliate (Note 8)........................................ 17,000 17,000 Accounts Payable and Other Accrued Expenses............................. 22,352 19,818 ------- ------- TOTAL LIABILITIES....................................................... 463,621 456,037 ------- ------- 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.................................... (7,038) (4,436) Retained Earnings....................................................... 2,057 1,818 ------- ------- Total Stockholder's Equity........................................ 63,073 65,436 ------- ------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY................................. $526,694 $521,473 ======= ======= See accompanying notes to condensed consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands) (Unaudited) Three Months Ended March 31, 2002 2001 Revenues: Direct Written Premiums............................................................ $ 44,506 $ 50,229 Changes in Direct Unearned Premiums................................................ (2,501) (3,006) ------- ------- Direct Earned Premiums............................................................. 42,005 47,223 Add: Premiums Assumed............................................................ 54 Less: Premiums Ceded.............................................................. 480 8,333 ------- ------- Net Earned Premiums................................................................ 41,579 38,890 Net Investment Income.............................................................. 3,580 4,110 Net Realized Investment Gains...................................................... 72 385 ------- ------- Total Revenues................................................................. 45,231 43,385 ------- ------- Costs and Expenses: Direct Loss and Loss Adjustment Expenses........................................... 44,528 49,307 Reinsurance Recoveries............................................................. (10,872) (16,938) ------- ------- Net Loss and Loss Adjustment Expenses.............................................. 33,656 32,369 Policy Acquisition Costs........................................................... 7,190 6,261 General, Administrative and Other.................................................. 3,483 3,732 Interest Expense................................................................... 404 882 ------- ------- Total Costs and Expenses....................................................... 44,733 43,244 ------- ------- Income Before Federal Income Tax Expense................................................ 498 141 Federal Income Tax Expense.............................................................. 259 225 ------- ------- Net Income (Loss)....................................................................... $ 239 $ (84) ======= ======= See accompanying notes to condensed consolidated financial statements. CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) Three Months Ended March 31, 2002 2001 Cash Flows From Operating Activities: Net Income (Loss)............................................................... $ 239 $ (84) Adjustments to Reconcile Net Income (Loss) to Net Cash Provided by Operating Activities: Depreciation.................................................................. 355 312 Change in Assets and Liabilities: Reinsurance Recoverable....................................................... 16,949 1,001 Reserve for Loss and Loss Adjustment Expense.................................. 3,261 5,354 Change in Other Assets and Liabilities........................................ (201) (5,154) ------- ------- Net Cash Provided by Operating Activities........................ 20,603 1,429 ------- ------- Cash Flows From Investing Activities: Capital Expenditures, Net..................................................... 54 136 Changes in Investments ....................................................... (19,510) (24,164) ------- ------- Net Cash Used for Investing Activities............................................ (19,456) (24,028) ------- ------- Cash Flows From Financing Activities: Payments on Debentures........................................................ (711) - ------- ------- Net Cash Used for Financing Activities............................................ (711) - ------- ------- Net Increase (Decrease) in Cash and Cash Equivalents.............................. 436 (22,599) Cash and Cash Equivalents at Beginning of Period.................................. 8,641 28,666 ------- ------- Cash and Cash Equivalents at End of Period........................................ $ 9,077 $ 6,067 ======= ======= Three Months Ended March 31, 2002 2001 Supplemental Condensed Consolidated Disclosures of Cash Flows Information: Cash Paid During the Period for Interest.......................................... $ 404 $ - 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 company. 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, 2001 and 2000. 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 March 31, 2002 2001 (In thousands) Net Income (Loss).............................. $ 239 $(84) Change in Accumulated Other Comprehensive Income, Net.................. (2,602) 920 ------ --- Comprehensive (Loss) Income.................... $(2,363) $836 ====== === 3. Debentures 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 transaction was treated as a restructuring of debt; therefore a gain on restructuring was recognized for the difference and the carrying amount of the remaining Subordinated Debentures and the 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 $557,000 and a corresponding tax provision of $195,000. The 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 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 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 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest. Since the time of the exchange, Sierra has purchased $1.0 million in outstanding 9 1/2% senior debentures. The debentures are eliminated upon Sierra's consolidation. 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 No. 142"), which is effective January 1, 2002. SFAS No. 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 No. 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 did not have any impact from the adoption of SFAS No. 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 No. 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 did not have any impact from the adoption of SFAS No. 144 on its financial position and results of operations. In April 2002, the FASB issued Statement of Financial Accounting Standard No. 145, "Recission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS No. 145"). SFAS No. 145 requires that gains and losses from extinguishment of debt be classified as extraordinary items only if they meet the criteria in Accounting Principles Board Opinion No. 30 ("Opinion No. 30"). Applying the provisions of Opinion No. 30 will distinguish transactions that are part of an entity's recurring operations from those that are unusual and infrequent that meet the criteria for classification as an extraordinary item. SFAS No. 145 is effective for the Company beginning January 1, 2003, but the Company may adopt the provisions of SFAS No. 145 prior to this date. The Company has net yet evaluated the impact of SFAS No. 145 on its financial position and results of operations. 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. Starting in 2000, the California Insurance Guarantee Association, or CIGA, issued assessments as a result of the insolvency of the insurers owned by Superior National Insurance Group and other insolvent workers' compensation insurance companies. The assessments are initially made on direct written premiums reported in the prior year and are subsequently adjusted to the actual direct premiums written in the following year. For example, CIGA issued an assessment in 2000 using the 1999 direct premiums written as the initial assessment. We began recouping the assessment on policies effective January 1, 2001. Our initial assessment will be adjusted to our actual premiums written in 2001. Any difference between the actual and initial premiums written would be either refunded to the member insurer, in the case of lower actual premiums, or an additional assessment imposed, in the case of higher actual premiums. In addition, any excess assessments that we recoup would have to be paid to CIGA. The CIGA assessments are recorded as an asset, which is reduced as we recoup the assessments. On an on-going basis, we evaluate the asset for impairment. In 2000, CIGA assessed us 1% of the 1999 direct premiums written for $1.2 million. In 2001, CIGA assessed us 2% of the 2000 direct premiums written for $3.1 million. In January 2002, CIGA assessed an additional 2% of the 2000 direct written premiums for $3.1 million. These assessments are being recouped starting with policies effective January 1, 2001 through December 31, 2003. There were no assessments by non-California states in 2000 and total assessments by all other states were less than $236,000 in 2001. It is likely that guarantee fund assessments related to insolvent workers' compensation insurance companies will continue for the next several years. 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. At March 31, 2002, SHL had total equity, on a statutory accounting basis, of approximately $13.7 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 on demand. CII Financial continues to provide a guaranty of Sierra's revolving credit facility. The notes are subordinated to the 9 1/2% senior debentures and the guaranty of Sierra's credit facility. 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. The information contained below is subject to risk factors. We urge you to review carefully the section "Risk Factors" in our 2001 Form 10-K filed on April 1, 2002 for a more complete discussion of the risks associated with an investment in our securities. See "Note on Forward-Looking Statements and Risk Factors" under Item 1 of our 2001 Form 10-K. 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, both as amended. All statements other than statements of historical fact are forward-looking statements for purposes of federal and state securities laws. The cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, as amended, and identify important factors that could cause our actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to us. These forward-looking statements are identified by their use of terms and phrases such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "project," "will," "continue," and other similar terms and phrases, including references to assumptions. Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Critical Accounting Policies and Estimates A description of our critical accounting policies and estimates can be found in Item 7 of our 2001 Form 10-K and for a more extensive discussion of our accounting policies, see Note 2, Summary of Significant Accounting Policies, in the Notes to the Consolidated Financial Statements in our 2001 Form 10-K filed on April 1, 2002. RESULTS OF OPERATIONS, THREE MONTHS ENDED MARCH 31, 2002, COMPARED TO THREE MONTHS ENDED MARCH 31, 2001. Revenues are comprised of net earned premiums, net investment income and net realized investment gains. Total revenue increased by 4.3% due primarily to a reduction in premiums ceded to reinsurers offset by a reduction in direct earned premiums and a decrease in investment income. Reflected in the 2002 direct written premiums is a 33% decrease in production and a 25% 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 11.4% due primarily to a decline in our California business. Offsetting this was a reduction in the amount of premium ceded to reinsurers, which resulted in an increase in earned premium of $7.9 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. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table reflects a comparison of direct written premiums, by state: Three months ended March 31, 2002 % of total 2001 % of total (dollars in millions) California......................... $30.4 68.3% $36.0 71.7% Nevada............................. 6.1 13.7 5.4 10.7 Colorado........................... 3.9 8.8 4.6 9.2 Texas.............................. 2.3 5.2 2.5 5.0 Other States....................... 1.8 4.0 1.7 3.4 ---- ----- ---- ----- Total........................... $44.5 100.0% $50.2 100.0% ==== ===== ==== ===== As shown in the preceding table, our largest premium state, California, had a 15.6% decrease in direct written premiums. However, we obtained an average premium rate increase on California renewing policies of approximately 32% for the quarter ended March 31, 2002. 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 6.1% to $163.5 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 March 31, 2002 has also dropped by 21.8% compared to last year. The $530,000 or 12.9% decrease in net investment income is due to lower investment yields offset by an increase in the average invested asset balance. Net realized gains decreased $313,000 or 81.3%. 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 $1.3 million due to the following: o We recorded approximately $2.1 million in additional loss and LAE related to the increase in net earned premiums in 2002 compared to 2001. o In 2002, we recorded $2.0 million of net adverse loss development for prior accident years compared to $1.6 million in 2001. The net adverse development 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. Approximately $400,000 of the net adverse loss development recorded in 2002 is due to the effects of Assembly Bill 749, or AB 749, as described below. o In 2001, we recorded an accident year loss and LAE ratio of 79.1%. We have reduced the comparative 2002 accident year loss and LAE ratio to 76.0%, 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 resulted in an increase in the reinsurance recoverable balance which is then reduced by amounts collected from reinsurers. Net reinsurance recoverable decreased by $16.9 million from December 31, 2001 to March 31, 2002 compared to a decrease of $1.0 million from December 31, 2000 to March 31, 2001. In February 2002, California enacted AB 749. This new legislation is designed to increase benefits paid to injured workers starting January 1, 2003. The Workers' Compensation Insurance Rating Bureau of California, or WCIRB, has preliminarily estimated that the new legislation will increase the loss costs for accident year 2003 by approximately 7%. Increased loss costs, such as benefit increases, are normally built into the rating-making process so that premiums are increased to cover the increase in costs. Although we intend to increase our premiums, there is no assurance that our increase will be sufficient enough to cover the estimated cost increases or that the WCIRB's estimate is accurate. AB 749 is effective for claims occurring on and after January 1, 2003. However, due to other statutes, certain temporary total disability claims with dates of injury prior to 2003 will automatically increase to the new benefit levels effective January 1, 2003. The loss and LAE reserves recorded as of March 31, 2002 reflect our best estimate of the ultimate loss costs for reported and unreported claims occurring in the current accident year as well as those occurring in accident years 2001 and prior. Workers' compensation claim payments are made over several years from the date of the claim. Until the final payments for reported claims are made, reserves are invested to generate investment income. Under our low level reinsurance agreement, we reinsured 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 was $17,000. This agreement covered all policies in force at July 1, 1998 and continued until June 30, 2000, when we exercised an option to extend coverage to all policies in force as of June 30, 2000. The termination of the low level agreement has resulted in our keeping more retained losses and LAE. However, our California premium rates have been increasing, which we believe has helped mitigate the loss of this favorable reinsurance protection. The premium rate increases on policies renewed in California during 2001 was approximately 38%. 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 terminated on June 30, 2001 and only covered claims with dates of injury occurring by that date. We already had an existing excess of loss reinsurance agreement that covers 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract, with no exclusion for terrorist acts, that expires on December 31, 2002. We intend to execute an option to extend the coverage for all policies in force as of December 31, 2002 until they expire. In the wake of the events of September 11, 2001 and the ensuing hardening of the reinsurance market, we expect our future reinsurance costs to significantly increase and our coverage limits to decrease. We cannot currently estimate what the impact to our operating results will be when we obtain replacement coverage in January 2003. Although we intend to increase our premiums to cover any increases in our reinsurance costs there is no assurance that our increase will be sufficient enough to cover the estimated cost increases. Reinsurance contracts do not relieve us from our obligations to claimants or policyholders. At March 31, 2002, we had over $201 million in reinsurance recoverable. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. At March 31, 2002, all of our reinsurers were rated A+ or better by Fitch Ratings and the A.M. Best Company. Should these companies be unable to perform their obligations to reimburse us for ceded losses, we would experience significant losses. As a percentage of net earned premiums, the loss and LAE ratio for the three month period ended March 31, 2002, was 80.9% compared to 83.2% for the threee month period ended March 31, 2001. The decrease is primarily due to significant premium increases offset by termination of the low level reinsurance agreement. 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 $929,000 in 2002 is primarily attributable to the increase in earned premiums and the run off of the low level reinsurance treaty, whereby we are ceding less commission to our reinsurers. General, Administrative and Other Expenses include other underwriting expenses of $2.9 million in 2002 compared to $3.1 million in 2001 and policyholders' dividends of $583,000 in 2002 compared to $638,000 in 2001. Policyholders' dividends, which primarily are payable on Nevada participating policies, represent 1.4% of 2002 net earned premiums compared to 1.6% in 2001. The underwriting expense ratio, which includes policy acquisition costs and other underwriting expenses as a percentage of net earned premiums, was slightly higher in 2002 at 24.3% compared to 24.1% in 2001. The increase was primarily due to lower ceded commissions due to the run off of the low level reinsurance agreement. Interest Expense decreased by $478,000 or 54.2% during the period due to the completion of the exchange offer for the CII Financial, Inc. 7 1/2% Convertible Subordinated Debentures, or Subordinated Debentures, that closed on May 7, 2001. As a result of the exchange of the Subordinated Debentures, all future interest payments on the 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 2002 is all related to a note payable to Sierra Health Services, Inc. See Note 8 of the Notes to Condensed Consolidated Financial Statements. 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 106.6% compared to 108.9% for 2001. The decrease was primarily due to significant composite rate increases. Excluding adverse loss development, the combined ratio would have been 101.7% for 2002 and 104.8% for 2001. Provision for Income Taxes was recorded at $259,000 for the quarter compared to $225,000 in 2001 with an effective tax rate of 52.0% compared to 159.6% for 2001. The change in the effective tax rate is due to a combination of tax preferred investments and changes in the valuation allowance. The effective tax rate is greater than the statutory rate due to the effects of the phase in of additional unearned premiums as a result of a change in tax law in 2001. LIQUIDITY AND CAPITAL RESOURCES Debentures 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 transaction was treated as a restructuring of debt; therefore a gain on restructuring was recognized for the difference and the carrying amount of the remaining Subordinated Debentures and the 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 $557,000 and a corresponding tax provision of $195,000. The 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 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 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 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest. Since the time of the exchange, Sierra has purchased $1.0 million in outstanding 9 1/2% senior debentures. The debentures are eliminated upon Sierra's consolidation. Obligations and Commitments A schedule of obligations and commitments as of December 31, 2001 can be found in Item 7 under Liquidity and Capital Resources in our 2001 Form 10-K filed on April 1, 2002. 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 9 1/2% senior debentures and the payment of the 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 lifetime 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 $9.1 million in cash and cash equivalents held at March 31, 2002, $9.0 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, 2001, California Indemnity, which is our only direct insurance subsidiary, had unassigned funds of $2.1 million from which it could pay a dividend without prior approval. Cash Flows We had positive cash flows from operating activities of $20.6 million for the quarter ended March 31, 2002 compared to $1.4 million in the first quarter of 2001. Our cash flow for 2002 was primarily due to the run-off of the low level reinsurance agreement, which provided net reinsurance recoveries of $16.9 million. In addition, the growth in net earned premiums has resulted in an increase in loss and LAE reserves for both 2002 and 2001. Our net cash used in investing activities was $19.5 million in the first quarter of 2002 compared to cash used in investing activities of $24.0 million for the first quarter of 2001. As a result of the cash provided by operations, we had more funds available to invest in 2002. In the first quarter of 2002, we used $711,000 in cash to make a scheduled interest payment on the outstanding debentures. Since the exchange offer all future payments on the debentures are reductions of principal. CII FINANCIAL, INC. AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Unrealized holding losses on available for sale investments have increased by $2.6 million since December 31, 2001 due primarily to an increase in the yield on Government obligations. 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: May 15, 2002 /S/ JOHN F. OKITA ------------------------------ JOHN F. OKITA Chief Financial Officer (Principal Financial and Accounting Officer)
- Company Dashboard
- Filings
-
10-Q Filing
Cii Financial Inactive 10-Q2002 Q1 Quarterly report
Filed: 15 May 02, 12:00am