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, 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 November 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 NINE MONTHS ENDED SEPTEMBER 30, 2002 INDEX Page No. Part I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - September 30, 2002 and December 31, 2001................................................. 3 Condensed Consolidated Statements of Operations - three and nine months ended September 30, 2002 and 2001.................................. 4 Condensed Consolidated Statements of Cash Flows - nine months ended September 30, 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............................................ 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk........................................................................ 22 Item 4. Controls and Procedures.................................................................... 22 Part II - OTHER INFORMATION Item 1. Legal Proceedings.......................................................................... 23 Item 2. Changes in Securities and Use of Proceeds.................................................. 23 Item 3. Defaults Upon Senior Securities............................................................ 23 Item 4. Submission of Matters to a Vote of Security Holders........................................ 23 Item 5. Other Information.......................................................................... 23 Item 6. Exhibits and Reports on Form 8-K........................................................... 23 Signatures................................................................................................... 24 Certifications............................................................................................... 25 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CII FINANCIAL, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data) (Unaudited) ASSETS September 30, December 31, 2002 2001 Invested Assets: Debt Securities, Available-for-Sale, at Fair Value.................. $269,560 $212,294 Debt Securities, Held-to-Maturity, at Amortized Cost................ 5,738 13,809 Preferred Stocks, at Fair Value..................................... 7,095 5,884 Mortgage Loans on Non-Affiliated Real Estate, at Cost............... 3,276 11,398 ------- ------- Total Invested Assets........................................... 285,669 243,385 ------- ------- Cash and Cash Equivalents............................................... 27,290 8,641 Reinsurance Recoverable................................................ 183,982 218,079 Premiums Receivable (Net of Allowances of $1,198 and $1,404)........... 9,484 10,669 Note Receivable Affiliate (Note 8)..................................... 7,500 7,500 Deferred Income Taxes.................................................. 17,676 16,305 Property and Equipment, Net............................................ 3,923 4,955 Other Assets........................................................... 13,571 11,939 ------- ------- TOTAL ASSETS............................................................ $549,095 $521,473 ======= ======= LIABILITIES AND STOCKHOLDER'S EQUITY Reserve for Loss and Loss Adjustment Expenses.......................... $398,776 $385,705 Unearned Premiums...................................................... 17,086 14,327 Debentures (Note 3).................................................... 17,765 19,187 Notes Payable Affiliate (Note 8)....................................... 17,000 17,000 Accounts Payable and Other Accrued Expenses............................ 27,498 19,818 ------- ------- TOTAL LIABILITIES...................................................... 478,125 456,037 ------- ------- 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 Gain (Loss)......................... 1,138 (4,436) Retained Earnings................................................... 1,778 1,818 ------- ------- Total Stockholder's Equity........................................ 70,970 65,436 ------- ------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY.............................. $549,095 $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 Nine Months Ended September 30, September 30, 2002 2001 2002 2001 Revenues: Direct Written Premiums............................ $46,128 $ 47,573 $132,441 $143,042 Changes in Direct Unearned Premiums................ (338) 464 (2,447) (2,532) ------ ------- ------ ------- Direct Earned Premiums............................. 45,790 48,037 129,994 140,510 Add: Premiums Assumed............................ 1,167 91 1,328 91 Less: Premiums Ceded.............................. (26) 1,210 (972) 12,309 ------ ------- ------- ------- Net Earned Premiums................................ 46,983 46,918 132,294 128,292 Net Investment Income.............................. 3,643 3,653 11,063 11,664 Net Realized Investment (Losses) Gains............. (184) (97) (281) 235 ------ ------- ------- ------- Total Revenues................................. 50,442 50,474 143,076 140,191 ------ ------- ------- ------- Costs and Expenses: Direct Loss and Loss Adjustment Expenses........... 47,310 58,718 137,651 172,592 Reinsurance Recoveries............................. (7,285) (20,658) (28,853) (68,241) ------ ------- ------- ------- Net Loss and Loss Adjustment Expenses.............. 40,025 38,060 108,798 104,351 Policy Acquisition Costs........................... 7,649 7,722 21,851 20,063 General, Administrative and Other.................. 3,740 3,735 12,045 11,614 Interest Expense................................... 413 412 1,225 1,897 ------ ------- ------- ------- Total Costs and Expenses....................... 51,827 49,929 143,919 137,925 ------ ------- ------- ------- (Loss) Income Before Federal Income Tax Expense......... (1,385) 545 (843) 2,266 Federal Income Tax (Benefit) Expense.................... (1,126) 204 (803) 761 ------ ------- ------- ------- (LOSS) INCOME BEFORE EXTRAORDINARY GAIN.................................... (259) 341 (40) 1,505 Extraordinary (loss) gain from debt extinguishment (net of income tax of $(34), $214).................... (64) 399 ------ ------- ------- ------- Net (Loss) Income....................................... $ (259) $ 277 $ (40) $ 1,904 ====== ======= ======= ======= 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, 2002 2001 Cash Flows from Operating Activities: Net (Loss) Income............................................................... $ (40) $ 1,904 Adjustments to Reconcile Net (Loss) Income to Net Cash Provided by Operating Activities: Extraordinary Gain............................................................ (613) Depreciation.................................................................. 1,256 892 Change in Assets and Liabilities: Reinsurance Recoverable....................................................... 34,097 (8,598) Reserve for Loss and Loss Adjustment Expenses................................. 13,071 36,055 Ceded Reinsurance Premium Payable............................................. 903 (11,059) Change in Other Assets and Liabilities........................................ 5,605 216 ------- ------- Net Cash Provided by Operating Activities................................. 54,892 18,797 ------- ------- Cash Flows from Investing Activities: Capital Expenditures, Net..................................................... (224) (504) Note Receivable Affiliate..................................................... (1,057) Changes in Investments ....................................................... (34,597) (7,500) ------- ------- Net Cash Used for Investing Activities.................................... (34,821) (9,061) ------- ------- Cash Flows from Financing Activities: Payments on Debentures........................................................ (1,422) (27,162) Note Payable Affiliate........................................................ 17,000 ------- ------- Net Cash Used for Financing Activities.................................... (1,422) (10,162) ------- ------- Net Increase (Decrease) in Cash and Cash Equivalents.............................. 18,649 (426) Cash and Cash Equivalents at Beginning of Period.................................. 8,641 28,666 ------- ------- Cash and Cash Equivalents at End of Period........................................ $ 27,290 $ 28,240 ======= ======= Nine Months Ended September 30, 2002 2001 Supplemental Condensed Consolidated Disclosures of Cash Flows Information: Cash Paid During the Period for Interest.......................................... $1,225 $ 2,890 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 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 material adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial results for the interim periods presented. The results of operations for the periods presented are not necessarily indicative of the results that will be achieved for the entire year. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates and assumptions could change in the future as more information becomes available, which could impact the amounts reported and disclosed herein. Actual results may materially differ from estimates. Certain amounts in the Condensed Consolidated Financial Statements for the three and nine months ended September 30, 2001 have been reclassified to conform with the current year presentation. 2. Comprehensive Income The following table presents comprehensive income for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2002 2001 2002 2001 (In thousands) Net (Loss) Income.......................... $ (259) $ 277 $ (40) $1,904 Change in Accumulated Other Comprehensive Income, Net............ 4,140 3,895 5,574 2,667 ----- ----- ----- ----- Comprehensive Income....................... $3,881 $4,172 $5,534 $4,571 ===== ===== ===== ===== 3. Debentures In December 2000, CII Financial commenced an offer to exchange its outstanding 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 obligations on the remaining $5.0 million of Subordinated Debentures at maturity. The exchange offer 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 originally resulted in an extraordinary gain of $712,000 and a corresponding tax provision of $249,000. As the final costs of the transaction were received, the extraordinary gain was adjusted to $557,000 with 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, 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 as described in Note 8 of these financial statements. The 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums currently at 105% 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 and related products. 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 April 2002, the FASB issued Statement of Financial Accounting Standard No. 145, "Rescission 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 not yet completed its evaluation of the impact of SFAS No. 145 on its financial position and results of operations. In June 2002, the FASB issued Statement of Financial Accounting Standard No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A fundamental conclusion reached by the FASB in this statement is that an entity's commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early adoption encouraged. The Company has not yet completed its evaluation of the impact from SFAS No. 146 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, 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 certain 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 later years. 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 has been 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, which has since been adjusted to $1.3 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, which has since been adjusted to $2.7 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 $350,000 in 2001 and 2002, and are included in general and administrative expense. It is likely that guarantee fund assessments related to insolvent workers' compensation insurance companies will continue for the next several years. As a condition to writing workers' compensation insurance in certain states other than California, we are required to participate in that state's assumed reinsurance pools. The percent of our participation is based on the amount of direct premiums we write in that state. The assumed reinsurance pools are essentially insurers of last resort and insure those policyholders who are otherwise unable to obtain workers' compensation insurance. California, our largest premium state, does not have an assumed reinsurance pool. For the nine months ended September 30, 2002, we recorded a net underwriting loss of $890,000 as our share of the pools' results. As we grow our premium writings in the non-California states, our exposure to the assumed reinsurance pools may increase and we may incur additional losses from our mandatory participation. 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, 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 September 30, 2002, SHL had total equity, on a statutory accounting basis, of approximately $17.8 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 demand notes are subordinated to the 9 1/2% senior debentures and the guaranty of Sierra's credit facility. 9. Investments Investments consist principally of U.S. Government and its agencies' securities and municipal bonds, as well as corporate and mortgage-backed securities. At September 30, 2002, over 85% of our portfolio is invested in U.S. Government and its agencies' securities and municipal bonds. Realized gains and losses are calculated using the specific identification method and are included in net income. Unrealized holding gains and losses on available-for-sale securities are included as a separate component of stockholder's equity until realized. Investments that the Company has the intention and ability to hold to maturity are stated at amortized cost and categorized as held-to-maturity. The remaining investments have been categorized as available-for-sale and are stated at their fair value. Fair value is estimated primarily from published market values as of the balance sheet date. The Company does not have any other than temporary investment impairments. 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 our audited Consolidated Financial Statements and accompanying notes for the year ended December 31, 2001, and "Management Discussion and Analysis of Financial Condition and Results of Operations" included in our 2001 annual report on Form 10-K filed with the Securities and Exchange Commission on April 1, 2002, and in conjunction with our unaudited Condensed Consolidated Financial Statements and accompanying notes for the three and nine-month periods ended September 30, 2002 and 2001 included in this Form 10-Q. 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 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," "continue," "could," "estimate," "expect," "intend," "may," "plan," "project," "will" 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. Readers are cautioned not to place undue reliance on these forward-looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Critical Accounting Policies and Estimates In preparing our consolidated financial statements, we are required to make judgments, assumptions and estimates which affect certain of our revenues and expenses, their related balance sheet accounts and our disclosure of our contingent assets and liabilities. Our most significant accounting estimates are the reserve for losses and loss adjustment expense, or LAE, and reinsurance recoverables. Due to the inherent uncertainty in projecting these estimates, it is not only possible but probable that there will be differences between the projections and the actual results. Any subsequent change in an estimate for a prior period would be reflected in the current period's operating results. For a description of our other critical accounting policies and estimates, see 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. We review the adequacy of our reserves for losses and LAE with our independent actuary. We receive a full actuarial review report at the end of each year and less detailed analyses throughout the year. We consider external forces such as changes in the rate of inflation, the regulatory environment, state laws, changes in legal decisions that affect the administration or amount of payment on claims, medical costs and other factors that could cause actual losses and LAE to change. The actuarial projections include a range of estimates reflecting the uncertainty of projections over long periods of time and are based on the anticipated ultimate cost of losses. We evaluate the reserves in the aggregate and make adjustments where appropriate. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reinsurance recoverable primarily represents the estimated amount of unpaid workers' compensation loss and LAE reserves that would be recovered from our reinsurers and, to a lesser extent, amounts billed to the reinsurers for their portion of paid losses and LAE. Reinsurance recoverable for ceded paid claims is recorded in accordance with the terms of the agreements and reinsurance recoverable for unpaid losses and LAE is estimated in a manner consistent with the claim liability associated with the reinsurance policy. Any significant changes in the underlying claim liability could directly affect the amount of reinsurance recoverable. Reinsurance recoverable, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reinsurance contracts do not relieve us from our obligations to insured workers or policyholders. If our reinsurers were to fail to honor their obligations because of insolvency or disputed contract provisions, we could incur significant losses and it could have a material adverse effect on our business. Prior to entering into reinsurance agreements, we evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. RESULTS OF OPERATIONS, THREE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2001. Revenues are comprised of net earned premiums, net investment income and net realized investment losses. Total revenue was $50.4 million in 2002, compared to $50.5 million in 2001. The decrease was due to a decrease in direct earned premiums offset by a reduction in premiums ceded to reinsurers and an increase in premiums assumed. Reflected in the 2002 direct written premiums is a 30.4% decrease in production and a 37.5% composite increase in premium rates. Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums and premiums assumed from our mandatory reinsurance pools, less premiums ceded to reinsurers. Our direct written premiums decreased by 3.0% due primarily to a decline in our California business. Offsetting this was a reduction in the amount of premium ceded to reinsurers, which decreased by $1.1 million due to the expiration of our low level reinsurance agreement on June 30, 2000 and a new reinsurance agreement with lower ceded premiums. The following table reflects a comparison of direct written premiums, by state: Three months ended September 30, 2002 % of total 2001 % of total (dollars in millions) California......................... $32.2 69.9% $34.7 72.8% Nevada............................. 5.1 11.0 4.5 9.5 Colorado........................... 4.2 9.1 4.5 9.5 Texas.............................. 2.5 5.3 2.3 4.8 Other States....................... 2.1 4.7 1.6 3.4 ---- ----- ---- ----- Total........................... $46.1 100.0% $47.6 100.0% ==== ===== ==== ===== As shown in the preceding table, in California, our largest premium state, we had a 7.2% decrease in direct written premiums. However, we obtained an average premium rate increase on California renewing policies of approximately 48.2% for the quarter ended September 30, 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. While total inforce premiums have increased by 2.0% to $169.0 million compared to last year, there was a downward trend in inforce premiums until June, 2002. This has resulted in a decrease in direct written premiums, primarily in California, which we believe is due largely to business lost as a result of premium rate increases we have been attempting to achieve. The number of inforce policies at September 30, 2002, has dropped by 17.4% compared to last year. Inforce premium has increased slightly at October 31, 2002, to $171.5 million due to rate increases and new business. Net investment income was $3.6 million in 2002 and $3.7 million in 2001. This is a result of a decrease in the average investment yield offset by an increase in the average invested balance. We had net realized investment losses of $184,000 in the third quarter of 2002, compared to net realized investment losses of $97,000 in the third quarter of 2001. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. Net Loss and LAE increased by approximately $2.0 million due to the following: o We recorded approximately $100,000 in additional loss and LAE related to the increase in net earned premiums in 2002, compared to 2001. o In 2002, we recorded $5.5 million of net adverse loss development on prior accident years compared to $1.5 million in 2001. Of the $5.5 million recorded, $1.3 million is related to our mandatory participation in assumed reinsurance pools. The net adverse loss 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 in the past few periods and this trend may continue. o In 2001, we recorded an accident year loss and LAE ratio of 77.9%. We have decreased the comparative 2002 accident year loss and LAE ratio to 73.5%, resulting in a decrease to our net loss and LAE totaling $2.1 million. The decrease in the loss ratio is primarily due to significant premium rate increases offset by the termination of our low level reinsurance agreement and increasing claims frequency. 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. During the quarter, we increased our ceded reserves by $7.5 million and received payments from our reinsurers totaling $23.6 million. Our net reinsurance recoverable decreased by $16.1 million in the third quarter of 2002, compared to a $2.0 million decrease in the third quarter of 2001. In February 2002, California enacted AB 749. This new legislation is designed to increase benefits paid to injured workers starting January 1, 2003. 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. Increased loss costs, such as benefit increases, are normally built into the rate making process so that premiums are increased to cover the increase in costs. On October 18, 2002, the California Insurance Commission approved an increase of 10.5% in pure premium rates for new and renewal policies effective in 2003. In addition, the Commission approved a 4.9% increase in pure premium rates for the unexpired terms of policies in force at January 1, 2003. Although we intend to increase our premiums, there is no assurance that our increase will be sufficient enough to cover the ultimate cost increases. The loss and LAE reserves recorded as of September 30, 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. Since 1999, we have experienced adverse loss development on prior accident years. Loss reserves are evaluated periodically and due to the inherent uncertainty in projecting loss reserves, it is possible that we may continue to experience adverse development in the foreseeable future. Our reserve for losses and LAE requires us to make significant estimates. See the discussion of our reserves for losses and LAE under critical accounting policies and estimates for a further explanation. 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 and for the first nine months of 2002 was approximately 38% and 35%, respectively. 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 have executed our 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 ultimate cost increases. Reinsurance contracts do not relieve us from our obligations to claimants or policyholders. At September 30, 2002, we had over $183 million in reinsurance recoverable. Prior to entering into reinsurance agreements we evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. At September 30, 2002, all of our reinsurers were rated A+ or better by Fitch Ratings and the A.M. Best Company. Should these reinsurers be unable to perform their obligations to reimburse us for ceded losses, we would experience significant losses and it could have a material adverse effect on our business. As a percentage of net earned premiums, the loss and LAE ratio for the three month period ended September 30, 2002, was 85.2% compared to 81.1% for the three month period ended September 30, 2001. The increase is primarily due to net adverse loss development on prior accident years and the termination of the low level reinsurance agreement offset partially by significant premium increases. 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 decrease in policy acquisition costs of $73,000 in 2002 is primarily attributable to reductions in marketing costs and premium taxes. General, Administrative and Other Expenses include other underwriting expenses of $4.4 million in 2002, compared to $3.4 million in 2001 and policyholders' dividend expense of $310,000 in 2001, compared to a credit of $475,000 in 2002. The increase in other underwriting expenses was due to several factors including an increase in bad debt expense, other licenses and fees and legal expense. Policyholders' dividends, which primarily are payable on Nevada participating policies, represent .6% of 2001 net earned premiums compared to a credit of 1.0% in 2002. The decrease in policyholders' dividends is due to a reduction in the number of dividend plans offered and a decrease to our policyholders' dividend accrual as some policyholders did not qualify for expected dividends. 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 25.2% compared to 23.8% in 2001. The increase was primarily due to higher net commissions from an adjustment of our estimate of historical ceded premiums related to the low level agreement, commissions assumed from participation in mandatory reinsurance pools and an increase in legal and bad debt expenses. Interest Expense was approximately $400,000 for both periods. The interest expense reported in 2002 and 2001 is related to a note payable to Sierra Health Services, Inc. As a result of the exchange of the Subordinated Debentures and the repayment of the remaining $5.0 million of Subordinated Debentures at maturity, 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. 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 109.4% compared to 105.5% for 2001. The increase was primarily due to an increase in the net adverse development on prior accident years. Excluding adverse loss development, the combined ratio would have been 97.7% for 2002 and 102.4% for 2001. Provision for Income Taxes was recorded as benefit of $1.1 million for the quarter compared to an expense of $204,000 in 2001, with an effective tax rate of 81.3% compared to 37.4% for 2001. The effective tax rate is different than the statutory rate due to the valuation allowance required on the current year losses of CII Financial and the tax preferred investment income of the insurance subsidiaries. The significant change in the rate results from the ratio of tax preferred items in relation to loss/income before federal income tax expense. RESULTS OF OPERATIONS, NINE MONTHS ENDED SEPTEMBER 30, 2002, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2001. Revenues are comprised of net earned premiums, net investment income and net realized investment (losses) gains. Total revenue increased by 2.1% 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 26.7% decrease in production and a 26.3% 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 and premiums assumed from our mandatory reinsurance pools, less premiums ceded to reinsurers. Our direct written premiums decreased by 7.4% due primarily to a decline in our California business. Offsetting this was a reduction in the amount of premium ceded to reinsurers, which decreased by $13.2 million due to the expiration of our low level reinsurance agreement on June 30, 2000, and a new reinsurance agreement with lower ceded premiums. In addition, we recorded an adjustment of our estimate of historical ceded premiums related to the low level agreement which further reduced our ceded reinsurance premiums by $2.0 million. The following table reflects a comparison of direct written premiums, by state: Nine months ended September 30, 2002 % of total 2001 % of total (dollars in millions) California......................... $91.1 68.8% $104.0 72.7% Nevada............................. 16.2 12.2 13.5 9.4 Colorado........................... 12.1 9.1 13.4 9.4 Texas.............................. 7.0 5.3 7.2 5.0 Other States....................... 6.0 4.6 4.9 3.5 ----- ----- ----- ----- Total........................... $132.4 100.0% $143.0 100.0% ===== ===== ===== ----- As shown in the preceding table, in California, our largest premium state, we had a 12.4% decrease in direct written premiums. However, we obtained an average premium rate increase on California renewing policies of approximately 35% for the nine months ended September 30, 2002. The $601,000 or 5.2% decrease in net investment income is due to lower investment yields offset by an increase in the average invested asset balance. We had net realized investment losses of $281,000 in 2002 compared to net realized investment gains of $235,000 in 2001. We try to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments. Net Loss and LAE increased by approximately $4.4 million due to the following: o We recorded approximately $3.0 million in additional loss and LAE related to the increase in net earned premiums in 2002, compared to 2001. o In 2002, we recorded $10.8 million of net adverse loss development on prior accident years compared to $7.3 million in 2001. Of the $10.8 million recorded, $1.3 million is related to our mandatory participation in assumed reinsurance pools. The net adverse loss 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 in the past few periods and this trend may continue. o In 2001, we recorded an accident year loss and LAE ratio of 75.7%. We have decreased the comparative 2002 accident year loss and LAE ratio to 74.1%, resulting in a decrease to our net loss and LAE totaling $2.1 million. The decrease in the loss ratio is primarily due to significant premium rate increases offset by the termination of our low level reinsurance agreement and increasing claims frequency. 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. During the nine months ended September 30, 2002, we increased our ceded reserves by $28.2 million and received payments from our reinsurers totaling $62.3 million. Our net reinsurance recoverable decreased by $34.1 million for the nine months ended September 30, 2002, compared to a $8.6 million decrease for the nine months ended September 30, 2001. Since 1999, we have experienced adverse loss development on prior accident years. Loss reserves are evaluated periodically and due to the inherent uncertainty in projecting loss reserves, it is possible that we may continue to experience adverse development in the foreseeable future. Our reserve for losses and LAE requires us to make significant estimates. See the discussion of our reserves for losses and LAE under critical accounting policies and estimates for a further explanation. As a percentage of net earned premiums, the loss and LAE ratio was 82.2% for 2002, compared to 81.3% for 2001. The increase is primarily due to net adverse loss development on prior accident years and the termination of the low level reinsurance agreement offset partially by significant premium increases. 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 $1.8 million in 2002 is primarily attributable to the run off of the low level reinsurance treaty, whereby we are receiving less ceded commissions from our reinsurer, an increase in net commissions due to an adjustment of our estimate of historical ceded premiums related to the low level agreement and commissions assumed from our participation in mandatory reinsurance pools. General, Administrative and Other Expenses include other underwriting expenses of $11.9 million in 2002 compared to $10.2 million in 2001 and policyholders' dividends of approximately $180,000 in 2002 compared to $1.4 million in 2001. The increase in other underwriting expenses was due to several factors including an increase to bad debt and legal expense. Policyholders' dividends, which primarily are payable on Nevada participating policies, represent .1% of 2002 net earned premiums compared to 1.1% in 2001. The decrease in policyholders' dividends is due to a reduction in the number of dividend plans offered and a decrease to our policyholders' dividend accrual as some policyholders did not qualify for expected dividends. 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 25.6% compared to 23.6% in 2001. The increase was primarily due to higher commissions from an adjustment of our estimate of historical ceded premiums related to the low level agreement, an increase in bad debt and legal expenses and commissions assumed from our participation in mandatory reinsurance pools. Interest Expense decreased by $672,000 or 35.4% during the period due to the completion of the exchange offer for the CII Financial, Inc. 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 reported in 2002 is 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 107.9% compared to 106.0% for 2001. The increase was primarily due to an increase in the net adverse development on prior accident years. Excluding adverse loss development, the combined ratio would have been 99.7% for 2002 and 100.3% for 2001. Provision for Income Taxes was recorded as a benefit of $803,000 compared to an expense of $761,000 in 2001 with an effective tax rate of 95.3% compared to 33.5% for 2001. The effective tax rate is different than the statutory rate due to the valuation allowance required on the current year losses of CII Financial and the tax preferred investment income of the insurance subsidiaries. The significant change in the rate results from the ratio of tax preferred items in relation to loss/income before federal income tax expense. LIQUIDITY AND CAPITAL RESOURCES Debentures In December 2000, CII Financial commenced an offer to exchange its outstanding 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 obligations on the remaining $5.0 million of Subordinated Debentures at maturity. The exchange offer 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 originally resulted in an extraordinary gain of $712,000 and a corresponding tax provision of $249,000. As the final costs of the transaction were received, the extraordinary gain was adjusted to $557,000 with 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, 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 the Notes to Condensed Consolidated Financial Statements. The 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums currently at 105% 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 The following schedule represents our obligations and commitments for long-term debt and operating leases at September 30, 2002. We do not have any capital leases outstanding. The amounts below represent the entire payment, principal and interest, on our outstanding obligations. Long-Term Operating Debt (1) Leases Total (In thousands) Payments due on demand (2)............................. $17,000 $17,000 Payments due within 12 months.......................... 1,421 $2,036 3,457 Payments due in 13 to 36 months........................ 16,344 447 16,791 Payments due in 37 to 60 months........................ 35 35 Payments due in more than 60 months.................... ------ ----- ------ Total............................................. $34,765 $2,518 $37,283 ====== ===== ====== (1) We are a guarantor under Sierra's revolving credit facility which had an outstanding balance of $50.0 million at September 30, 2002. This amount is excluded from the table. (2) We have issued two demand notes in an aggregate amount of $17.0 million to Sierra Health Services, Inc. See Note 8 of the Notes to the Condensed Consolidated Financial Statements. 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 notes payable to affiliates, the payment of the 9 1/2% senior debentures at maturity, and the notes payable to affiliates when demanded. 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 $27.3 million in cash and cash equivalents held at September 30, 2002, $26.7 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 stockholder's 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 they believe 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. In the second quarter of 2002, California Indemnity paid a dividend of $750,000. In California, workers' compensation insurers are required to place qualified securities on deposit with the state to cover potential workers' compensation claims. The amount of the deposit is calculated annually and is largely based on the amount of workers' compensation insurance premiums earned during the preceding three years. A credit for ceded reinsurance to companies authorized as reinsurers by the California Department of Insurance can reduce the amount of deposit that a workers' compensation insurer must place. However, any reduction in the deposit for ceded reinsurance must then be made up by the reinsurer so that 100% of the deposit requirements are met. Failure of the reinsurer to make the required deposit can result in a disallowance of the ceded reinsurance credit by the ceding insurance company. The ceding insurance company will then either have to place the required deposit or show the ceded reinsurance as unauthorized reinsurance, which in turn reduces its total statutory surplus. Our workers' compensation insurance companies were notified by the California Department of Insurance in August of 2002, that some of our reinsurers had failed to make the required deposit. We have notified our reinsurers of this and they are in the process of making the required deposit. If the reinsurers were to fail to make the required deposit, this could have a material adverse effect on our workers' compensation insurance subsidiaries' ability to write business. Cash Flows We had positive cash flows from operating activities of $54.9 million in 2002, compared to $18.8 million in 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 $34.1 million. In addition, the growth in net earned premiums and net adverse loss development on prior accident years has resulted in an increase in loss and LAE reserves for both 2002 and 2001. Our net cash used in investing activities was $34.8 million in 2002, compared to net cash used in investing activities of $9.1 million in 2001. As a result of the cash provided by operations, we had more funds available to invest in 2002. We used $1.4 million in cash for financing activities in 2002, compared to $10.2 million in 2001. Cash used in 2002 included scheduled interest payments on the outstanding debentures. Since the exchange offer was recorded as a debt restructuring, all future payments of interest on the debentures are reflected as reductions of principal. See Note 3 of the Notes to Condensed Consolidated Financial Statements. Cash used in 2001 included $21.5 million for the exchange offer and $5.7 million for subsequent debenture reductions. In addition, we obtained loans from Sierra of $17.0 million in 2001. Recently Issued Accounting Standards In April 2002, the FASB issued Statement of Financial Accounting Standard No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", or 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 us beginning January 1, 2003, but we may adopt the provisions of SFAS No. 145 prior to this date. We have not yet completed our evaluation of the impact of SFAS No. 145 on our financial position and results of operations. In June 2002, the FASB issued Statement of Financial Accounting Standard No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", or SFAS No. 146. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A fundamental conclusion reached by the FASB in this statement is that an entity's commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early adoption encouraged. We have not yet completed our evaluation of the impact from SFAS No. 146 on our financial position and results of operations. CII FINANCIAL, INC. AND SUBSIDIARIES ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As of September 30, 2002, we had unrealized holding gains on available for sale investments of $1.1 million, compared to unrealized holding losses of $4.4 million at December 31, 2001. This fluctuation is due primarily to a decrease in the yield on Government obligations and a decrease in mortgage rates. 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 in advance or their scheduled maturities. ITEM 4. CONTROLS AND PROCEDURES Based on the evaluation by the Chief Executive Officer and Chief Financial Officer of the Company as of a date within 90 days of the filing date of this quarterly report, those officers believe that the Company's disclosure controls and procedures are reasonably effective to ensure that the information required to be included in this report has been recorded, processed, summarized and reported on a timely basis. There have not been any significant changes in the Company's internal controls or in other factors that could significantly affect these controls and there have been no corrective actions taken with regard to significant deficiencies and material weaknesses subsequent to the date of such officers' evaluation. 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 claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. These actions are in various stages of litigation and some may ultimately be brought to trial. In the opinion of management, based on information presently available, 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 (99.1) Certification pursuant to 18 U.S.C. as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Principal Executive Officer dated November 14, 2002. (99.2) Certification pursuant to 18 U.S.C. as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Principal Financial Officer dated November 14, 2002. (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, 2002 /s/ John F. Okita ------------------------ John F. Okita Chief Financial Officer (Principal Financial and Accounting Officer) CERTIFICATION I, Kathleen M. Marlon, Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of CII Financial, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including my corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ Kathleen M. Marlon ----------------------- Kathleen M. Marlon Chief Executive Officer CERTIFICATION I, John F. Okita, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of CII Financial, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including my corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ John F. Okita ----------------------- John F. Okita Chief Financial Officer
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10-Q Filing
Cii Financial Inactive 10-Q2002 Q3 Quarterly report
Filed: 14 Nov 02, 12:00am