UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE PERIOD ENDED MARCH 31, 2002
COMMISSION FILE #0-11321
UNIVERSAL AMERICAN FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
NEW YORK 11-2580136
(State of Incorporation) (I.R.S. Employer I.E. No.)
Six International Drive, Suite 190, Rye Brook, NY 10573
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (914) 934-5200
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 and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
The number of shares outstanding of the Registrant's Common Stock as of
May 4, 2002 was 52,983,203.
UNIVERSAL AMERICAN FINANCIAL CORP.
FORM 10-Q
CONTENTS
Page No.
--------
PART I - FINANCIAL INFORMATION
Consolidated Balance Sheets as of March 31, 2002 and December 31, 2001 3
Consolidated Statements of Operations for the three months ended March 31, 2002 4
and March 31, 2001
Consolidated Statements of Cash Flows for the three months ended March 31, 2002 5
and March 31, 2001
Notes to Consolidated Financial Statements 6-12
Management's Discussion and Analysis of Financial Condition and Results of Operations 13-25
PART II - OTHER INFORMATION
Signature 25
2
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
MARCH 31, 2002 DECEMBER 31, 2001
-------------- -----------------
(Unaudited)
ASSETS
Investments:
Fixed maturities available for sale, at fair value
(amortized cost: 2002, $801,947; 2001, $786,844) $ 799,558 $ 799,218
Equity securities, at fair value (cost: 2002, $4,962; 2001, $4,339) 4,794 4,199
Policy loans 24,011 24,043
Other invested assets 3,630 3,773
----------- -----------
Total investments 831,993 831,233
Cash and cash equivalents 30,559 47,990
Accrued investment income 12,245 12,663
Deferred policy acquisition costs 73,176 66,025
Amounts due from reinsurers 221,862 212,532
Due and unpaid premiums 3,468 3,385
Deferred income tax asset 60,544 59,952
Present value of future profits and goodwill 11,499 11,921
Other assets 29,809 24,515
----------- -----------
Total assets 1,275,155 1,270,216
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Policyholder account balances 239,289 236,742
Reserves for future policy benefits 597,407 591,453
Policy and contract claims - life 7,358 6,282
Policy and contract claims - health 84,035 79,596
Loan payable 58,850 61,475
Amounts due to reinsurers 5,236 6,680
Other liabilities 52,613 57,218
----------- -----------
Total liabilities 1,044,788 1,039,446
----------- -----------
STOCKHOLDERS' EQUITY
Common stock (Authorized: 80 million shares, issued and outstanding:
2002, 53.0 million shares; 2001, 52.8 million shares) 530 528
Additional paid-in capital 156,605 155,746
Accumulated other comprehensive income (3,201) 5,603
Retained earnings 76,777 69,279
Less: Treasury Stock (2002, 0.1 million shares; 2001,
0.1 million shares) (344) (386)
----------- -----------
Total stockholders' equity 230,367 230,770
----------- -----------
Total liabilities and stockholders' equity $ 1,275,155 $ 1,270,216
=========== ===========
See notes to unaudited consolidated financial statements.
3
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, PER SHARE AMOUNTS IN DOLLARS)
THREE MONTHS ENDED MARCH 31,
----------------------------
2002 2001
----------- ----------
(unaudited)
Revenues:
Gross premiums and policyholder fees earned $ 147,436 $ 126,213
Reinsurance premiums assumed 938 822
Reinsurance premiums ceded (83,462) (69,442)
--------- ---------
Net premiums and policyholder fees earned 64,912 57,593
Net investment income 14,327 14,457
Net realized gains on investments 143 2,090
Fee and other income 2,784 2,531
--------- ---------
Total revenues 82,166 76,671
--------- ---------
Benefits, claims and expenses:
Increase in future policy benefits 2,570 3,763
Claims and other benefits 42,646 39,038
Interest credited to policyholders 2,607 2,512
Net increase in deferred acquisition costs (5,932) (4,328)
Amortization of present value of future profits and goodwill 422 724
Commissions 28,557 24,268
Commission and expense allowances on reinsurance ceded (24,737) (21,402)
Interest expense 806 1,618
Other operating costs and expenses 23,602 19,557
--------- ---------
Total benefits, claims and other expenses 70,541 65,750
--------- ---------
Income before taxes 11,625 10,921
Federal income tax expense 4,127 3,885
--------- ---------
Net income $ 7,498 $ 7,036
========= =========
Earnings per common share:
Basic $ 0.14 $ 0.15
========= =========
Diluted $ 0.14 $ 0.15
========= =========
See notes to unaudited consolidated financial statements
4
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
THREE MONTHS ENDED MARCH 31,
----------------------------
2002 2001
--------- ----------
(unaudited)
Cash flows from operating activities:
Net income $ 7,498 $ 7,036
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes 3,565 2,800
Change in reserves for future policy benefits 5,954 12,899
Change in policy and contract claims 5,515 4,565
Change in deferred policy acquisition costs (5,932) (4,328)
Amortization of present value of future profits and goodwill 422 724
Change in policy loans 32 417
Change in accrued investment income 417 649
Change in reinsurance balances (10,543) (11,203)
Realized gains on investments (143) (2,090)
Change in restructuring liability -- (2,421)
Change in income taxes payable (2,401) (1,124)
Other, net (6,575) (5,492)
--------- ---------
Net cash (used) provided by operating activities (2,191) 2,432
--------- ---------
Cash flows from investing activities:
Proceeds from sale or redemption of fixed maturities available for sale 138,228 110,063
Cost of fixed maturities purchased available for sale (152,361) (109,735)
Change in amounts held in trust by reinsurer (939) (610)
Proceeds from sale of equity securities 2,658 5
Cost of equity securities purchased (3,277) (11)
Change in mortgage loans 91 (578)
Change is due from / to broker 132 (6,800)
Change in other invested assets 52 684
Cost of equipment purchased (530) --
--------- ---------
Net cash used by investing activities (15,946) (6,982)
--------- ---------
Cash flows from financing activities:
Net proceeds from issuance of common stock 620 89
Cost of treasury stock purchases (544) (453)
Change in policyholder account balances 2,547 (1,312)
Change in reinsurance balances on policyholder account balances 708 38
Principal repayment on loan payable (2,625) (1,850)
--------- ---------
Net cash provided (used) by financing activities 706 (3,488)
--------- ---------
Net decrease in cash and cash equivalents (17,431) (8,038)
Cash and cash equivalents at beginning of period 47,990 40,250
--------- ---------
Cash and cash equivalents at end of period $ 30,559 $ 32,212
========= =========
Supplemental cash flow information:
Cash paid during the period for interest $ 273 $ 703
========= =========
Cash paid during the period for income taxes $ 2,963 $ 1,810
========= =========
See notes to unaudited consolidated financial statements
5
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The interim financial information herein is unaudited, but in the
opinion of management, includes all adjustments (consisting of normal, recurring
adjustments) necessary to present fairly the financial position and results of
operations for such periods. The results of operations for the three months
ended March 31, 2002 and 2001 are not necessarily indicative of the results to
be expected for the full year. The consolidated financial statements should be
read in conjunction with the Form 10-K for the year ended December 31, 2001.
Certain reclassifications have been made to prior year's financial statements to
conform with current period classifications.
The consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States ("GAAP") and
consolidate the accounts of Universal American Financial Corp. ("Universal
American" or the "Parent Company") and its subsidiaries (collectively the
"Company"), American Progressive Life & Health Insurance Company of New York
("American Progressive"), American Pioneer Life Insurance Company ("American
Pioneer"), American Exchange Life Insurance Company ("American Exchange"),
Pennsylvania Life Insurance Company ("Pennsylvania Life"), Peninsular Life
Insurance Company ("Peninsular"), Union Bankers Insurance Company ("Union
Bankers"), Constitution Life Insurance Company ("Constitution"), Marquette
National Life Insurance Company ("Marquette"), PennCorp Life Insurance Company,
a Canadian company ("PennCorp Life (Canada)"), and CHCS Services, Inc.
The Company offers life and accident and health insurance designed for
the senior market and self-employed market in all fifty states, the District of
Columbia and all the provinces of Canada. It also provides administrative
services to other insurers by servicing their senior market products. The
Company's principal insurance products are Medicare supplement, fixed benefit
accident and sickness disability insurance, long term care, home health care,
senior life insurance and annuities. The Company distributes these products
through an independent general agency system and a career agency system. The
career agents focus only on sales for Pennsylvania Life and PennCorp Life
(Canada) while the independent general agents sell for American Pioneer,
American Progressive and Constitution.
2. COMPREHENSIVE INCOME
The components of comprehensive income, net of related tax, for the
three months ended March 31, 2002 and 2001 are as follows:
THREE MONTHS ENDED MARCH 31,
-----------------------------
2002 2001
------- --------
(In thousands)
Net income $ 7,498 $ 7,036
Other comprehensive income (8,804) 2,017
------- -------
Comprehensive income $(1,306) $ 9,053
======= =======
6
The components of other comprehensive income and the related tax
effects for each component for the three months ended March 31, 2002 and 2001
are as follows:
THREE MONTHS ENDED MARCH 31, 2002 THREE MONTHS ENDED MARCH 31, 2001
------------------------------------------ ------------------------------------------
Before Tax Net of Before Tax Net of
Tax Expense Tax Tax Expense Tax
Amount (Benefit) Amount Amount (Benefit) Amount
-------- --------- -------- -------- --------- --------
(In thousands)
Net unrealized (loss) gain
arising during the year (net
of deferred acquisition costs) $(13,729) $ (4,805) $ (8,924) $ 8,682 $ 3,039 $ 5,643
Less:
Reclassification adjustment
for gains included in net
income (143) (50) (93) (2,090) (732) (1,358)
-------- -------- -------- -------- -------- --------
Net unrealized (losses) gains (13,586) (4,755) (8,831) 6,592 2,307 4,285
Currency translation
adjustments 52 25 27 (3,111) (843) (2,268)
-------- -------- -------- -------- -------- --------
Other comprehensive (loss)
income $(13,534) $ (4,730) $ (8,804) $ 3,481 $ 1,464 $ 2,017
======== ======== ======== ======== ======== ========
3. EARNINGS PER SHARE
The reconciliation of the numerators and the denominators of the basic
and diluted EPS for the three months ended March 31, 2002 and 2001 is as
follows:
THREE MONTHS ENDED MARCH 31, 2002
---------------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- -----------------
(In thousands, per share amounts in dollars)
Weighted average common stock outstanding 52,892
Less: Weighted average treasury shares (122)
--------
Basic EPS:
Net income applicable to common shareholders $ 7,498 52,770 $0.14
======== =====
Effect of Dilutive Securities
Incentive stock options 3,895
Director stock options 190
Agents and others stock options 1,047
Treasury stock assumed from proceeds of options (3,797)
--------
Diluted EPS:
Net income applicable to common
shareholders plus assumed conversions $ 7,498 54,105 $0.14
======== ======== =====
7
THREE MONTHS ENDED MARCH 31, 2001
---------------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- -----------------
(In thousands, per share amounts in dollars)
Weighted average common stock outstanding 46,845
Less: weighted average treasury shares (97)
--------
Basic EPS:
Net income applicable to common shareholders $ 7,036 46,748 $0.15
======== =====
Effect of Dilutive Securities
Incentive stock options 1,502
Director stock options 88
Agents and others stock options 796
Treasury stock assumed from proceeds of options (2,020)
--------
Diluted EPS:
Net income applicable to common
shareholders plus assumed conversions $ 7,036 47,114 $0.15
======== ======== =====
4. INVESTMENTS
As of March 31, 2002 and December 31, 2001, fixed maturity securities
are classified as investments available for sale and are carried at fair value,
with the unrealized gain or loss, net of tax and other adjustments (deferred
policy acquisition costs), included in accumulated other comprehensive income.
MARCH 31, 2002
---------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Classification Cost Gains Losses Value
- -------------- --------- ---------- ---------- ---------
(In thousands)
US Treasury securities
and obligations of US government $ 37,749 $ 849 $ (203) $ 38,395
Corporate debt securities 153,108 631 (3,361) 150,378
Foreign debt securities (1) 391,471 5,577 (7,319) 389,729
Mortgage- and asset-backed securities 219,619 3,836 (2,399) 221,056
--------- --------- --------- ---------
$ 801,947 $ 10,893 $ (13,282) $ 799,558
========= ========= ========= =========
DECEMBER 31, 2001
---------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Classification Cost Gains Losses Value
- -------------- --------- ---------- ---------- ----------
(In thousands)
US Treasury securities
and obligations of US government $ 35,719 $ 1,262 $ (11) $ 36,970
Corporate debt securities 357,431 8,990 (1,805) 364,616
Foreign debt securities (1) 157,077 2,225 (1,640) 157,662
Mortgage- and asset-backed securities 236,617 5,700 (2,347) 239,970
--------- --------- --------- ---------
$ 786,844 $ 18,177 $ (5,803) $ 799,218
========= ========= ========= =========
- ------------
(1) Primarily Canadian denominated bonds supporting our Canadian Insurance
reserves.
8
The amortized cost and fair value of fixed maturities at March 31, 2002
by contractual maturity are shown below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
AMORTIZED FAIR
COST VALUE
--------- --------
(In thousands)
Due in 1 year or less $ 24,669 $ 25,387
Due after 1 year through 5 years 118,111 119,221
Due after 5 years through 10 years 273,207 271,125
Due after 10 years 166,341 162,769
Mortgage- and asset-backed securities 219,619 221,056
-------- --------
$801,947 $799,558
======== ========
During the three months ended March 31, 2002, the Company wrote down
the value of certain fixed maturity securities by $1.6 million (0.2% of
investments). During the three months ended March 31, 2001, the Company wrote
down the value of certain fixed maturity securities by $1.2 million (0.2% of
investments). These write downs represent management's estimate of other than
temporary declines in value and were included in net realized gains on
investments in our consolidated statement of operations.
5. STOCKHOLDERS' EQUITY
Common Stock
The par value of common stock is $.01 per share with 80,000,000 shares
authorized for issuance. Changes in the number of shares of common stock
outstanding, from December 31, 2001 through March 31, 2002, were as follows:
Common stock outstanding at December 31, 2001 52,799,899
Stock options exercised 147,579
Stock purchases pursuant to Agents' Stock Purchase Plan 19,450
----------
Common stock outstanding at March 31, 2002 52,966,928
==========
Treasury Stock
During 2001, the Board of Directors approved a plan to repurchase up to
0.5 million shares of Company stock in the open market. In March 2002, the Board
of Directors approved an amendment of the plan to increase the amount of shares
available for repurchase from 0.5 million to 1.0 million shares. The purpose of
the plan is to fund employee stock bonuses. During the three months ended March
31, 2002, the Company acquired 82,965 shares on the open market for a cost of
$0.5 million at a weighted average market price of $6.56 per share. The Company
distributed 103,216 shares in the form of officer and employee bonuses at a
weighted average market price of $6.45 per share, at the date of distribution.
6. STATUTORY CAPITAL AND SURPLUS REQUIREMENTS
American Progressive, American Pioneer, American Exchange,
Constitution, Marquette, Peninsular, PennCorp Life (Canada), Pennsylvania Life
and Union Bankers (collectively, the "Insurance Subsidiaries") are required to
maintain minimum amounts of capital and surplus as determined by statutory
accounting. Each of the Insurance Subsidiaries' statutory capital and surplus
exceeds its respective minimum requirement. However, substantially more than
such minimum amounts are needed to meet statutory and administrative
requirements of adequate capital and surplus to support the current level of the
Insurance Subsidiaries' operations. At March 31, 2002 the statutory capital and
surplus, including asset valuation reserve, of the U.S. insurance subsidiaries
totaled $99.9 million.
9
Beginning in 1993, the National Association of Insurance Commissioners
("NAIC") imposed regulatory risk-based capital ("RBC") requirements on life
insurance enterprises. At March 31, 2002 all of the Insurance Subsidiaries
maintained ratios of total adjusted capital to RBC in excess of the Authorized
Control Level.
PennCorp Life (Canada) reports to Canadian regulatory authorities based
upon Canadian statutory accounting principles that vary in some respects from
U.S. statutory accounting principles. Canadian net assets based upon Canadian
statutory accounting principles were $36.3 million as of March 31, 2002.
PennCorp Life (Canada) maintained a Minimum Continuing Capital and Surplus
Requirement Ratio ("MCCSR") in excess of the minimum requirement at March 31,
2002.
7. EFFECTS OF ACCOUNTING PRONOUNCEMENTS
In June, 2001, The Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets", effective for fiscal years beginning after December 15,
2001. Under the new rules, goodwill, and intangible assets deemed to have
indefinite lives, will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statement. Other intangible assets will
continue to be amortized over their useful lives.
The Company applied the new rules on accounting for goodwill and other
intangible assets beginning in the first quarter of 2002. Application of the
non-amortization provisions of the Statement resulted in an increase in net
income of $0.1 million (less than $0.01 per diluted share) for the three months
ended March 31, 2002. The Company performed the first of the required impairment
tests of goodwill and indefinite lived intangible assets as of January 1, 2002
and has determined that, based on these tests, goodwill and indefinite lived
intangibles were not impaired.
8. BUSINESS SEGMENT INFORMATION
The Company offers life and health insurance designed for the senior market and
the self-employed market in all 50 states, the District of Columbia and all of
the provinces of Canada. The Company also provides administrative services to
other issuers by servicing their senior market products. Our principal insurance
products are Medicare supplemental health insurance, fixed benefit accident and
sickness disability insurance, long term care insurance, senior life insurance,
annuities and other individual life insurance. Our principal business segments
are: Career Agency, Senior Market Brokerage and Administrative Services. The
Company also reports the corporate activities of our holding company in a
separate segment. During 2002 we modified the way we report segment information
by combining our previously defined Senior Market Brokerage and Special Markets
segments into one segment, Senior Market Brokerage. Our decision to combine the
two segments was based on the significant reduction in the insurance in force in
the Special Markets segment as a result of our exit from the major medical line
of business. Reclassifications have been made to conform prior year amounts to
the current year presentation. A description of these segments follows:
CAREER AGENCY - The Career Agency segment is comprised of the
operations of Pennsylvania Life and PennCorp Life (Canada), both of
which we acquired in 1999. PennCorp Life (Canada) operates exclusively
in Canada, while Pennsylvania Life operates in the United States. The
Career Agency segment includes the operations of a career agency field
force, which distributes fixed benefit accident and sickness disability
insurance, life insurance and supplemental senior health insurance in
the United States and Canada. The career agents are under exclusive
contract with either Pennsylvania Life or PennCorp Life (Canada).
SENIOR MARKET BROKERAGE - This segment includes the operations of
general agency and insurance brokerage distribution systems that focus
on the sale of insurance products to the senior market, including
Medicare Supplement/Select, long term care, senior life insurance and
annuities. In 2002, we combined our Special Markets segment with our
Senior Market Brokerage segment.
10
ADMINISTRATIVE SERVICES - The Company acts as a third party
administrator and service provider for both affiliated and unaffiliated
insurance companies, primarily with respect to various senior market
products and a growing portion of non-insurance products. The services
that we perform include policy underwriting, telephone verification,
policyholder services, claims adjudication, clinical case management,
care assessment and referral to health care facilities.
CORPORATE - This segment reflects the corporate activities of our
holding company, including the payment of interest on our debt and our
public company administrative expenses.
Intersegment revenues and expenses are reported on a gross basis in
each of the operating segments but eliminated in the consolidated
results. These eliminations affect the amounts reported on the
individual financial statement line items, but do not change operating
income before taxes. The significant items eliminated include
intersegment revenue and expense relating to services performed by the
administrative services segment for the Career Agency and Senior Market
Brokerage segments and interest on notes issued by the Corporate
segment to the other operating segments.
Financial results by segment for the three months ended March 31, 2002
and 2001 is as follows:
March 31, 2002 March 31, 2001
----------------------------- ----------------------------
Income (Loss) Income (Loss)
Before Before
Revenue Income Taxes Revenue Income Taxes
--------- -------------- -------- -------------
(In thousands)
Career agency $ 39,764 $ 7,207 $ 40,535 $ 7,366
Senior market brokerage 39,676 4,155 31,890 2,401
Administrative services 9,696 1,876 8,046 1,510
-------- -------- -------- --------
Subtotal 89,136 13,238 80,471 11,277
Corporate 219 (1,756) 27 (2,446)
Intersegment revenues (7,332) -- (5,917) --
-------- -------- -------- --------
Segment total 82,023 11,482 74,581 8,831
Adjustments to segment total:
Net realized gains 143 143 2,090 2,090
-------- -------- -------- --------
$ 82,166 $ 11,625 $ 76,671 $ 10,921
======== ======== ======== ========
Identifiable assets by segment as of March 31, 2002 and December 31,
2001 are as follows:
March 31, 2002 December 31, 2001
-------------- -----------------
(In thousands)
Career agency $ 609,799 $ 605,758
Senior market brokerage 656,037 663,069
Administrative services 32,701 30,930
----------- -----------
Subtotal 1,298,537 1,299,757
Corporate 316,356 313,709
Intersegment assets (1) (339,738) (343,250)
----------- -----------
$ 1,275,155 $ 1,270,216
=========== ===========
(1) Intersegment assets include the elimination of the parent
holding company's investment in its subsidiaries as well as
the elimination of other intercompany balances.
11
9. FOREIGN OPERATIONS
A portion of the Company's career agency segment is conducted in Canada
through Penn Corp Life (Canada). The assets and liabilities of the Canadian
business are located in Canada where the insurance risks are written. Revenues,
excluding capital gains, of the career agency segment by geographic area for the
three months ended March 31, 2002 and 2001, are as follows:
March 31, 2002 March 31, 2001
-------------- --------------
(In thousands)
Revenues
United States $26,022 $26,098
Canada 13,742 14,437
------- -------
Total $39,764 $40,535
======= =======
12
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
We caution readers regarding certain forward-looking statements
contained in the following discussion and elsewhere in this report and in any
other oral or written statements, either made by, or on behalf of the Company,
whether or not in future filings with the Securities and Exchange Commission
("SEC"). Forward-looking statements are statements not based on historical
information. They relate to future operations, strategies, financial results or
other developments. In particular, statements using verbs such as "expect,"
"anticipate," "believe" or similar words generally involve forward-looking
statements. Forward-looking statements include statements that represent our
products, investment spreads or yields, or the earnings or profitability of our
activities.
Forward-looking statements are based upon estimates and assumptions
that are subject to significant business, economic and competitive
uncertainties, many of which are beyond our control and are subject to change.
These uncertainties can affect actual results and could cause actual results to
differ materially from those expressed in any forward-looking statements made by
us, or on our behalf. Whether or not actual results differ materially from
forward-looking statements may depend on numerous foreseeable and unforeseeable
events or developments, some of which may be national in scope, such as general
economic conditions and interest rates. Some of these events may be related to
the insurance industry generally, such as pricing competition, regulatory
developments and industry consolidation. Others may relate to us specifically,
such as credit, volatility and other risks associated with our investment
portfolio, and other factors. We disclaim any obligation to update
forward-looking information.
INTRODUCTION
The following analysis of our consolidated results of operations and
financial condition should be read in conjunction with the consolidated
financial statements and related consolidated footnotes included elsewhere.
We own nine insurance companies (collectively, the "Insurance
Subsidiaries"): American Progressive Life & Health Insurance Company of New York
("American Progressive"), American Pioneer Life Insurance Company ("American
Pioneer"), American Exchange Life Insurance Company ("American Exchange"),
Constitution Life Insurance Company ("Constitution"), Marquette National Life
Insurance Company ("Marquette"), Peninsular Life Insurance Company
("Peninsular"), Pennsylvania Life Insurance Company ("Pennsylvania Life"),
PennCorp Life Insurance Company of Canada ("PennCorp Life (Canada)") and Union
Bankers Insurance Company ("Union Bankers"). In addition to the Insurance
Subsidiaries, we own a third party administrator, CHCS Services, Inc. that
processes our senior market policies, as well as business for unaffiliated
insurance companies.
OVERVIEW
We offer life and health insurance designed for the senior market and the
self-employed market in all 50 states, the District of Columbia and all of the
provinces of Canada. We also provide administrative services to other insurers
by servicing their senior market products. Our principal insurance products are
Medicare Supplement/Select health insurance, fixed benefit accident and sickness
disability insurance, long term care insurance, senior life insurance, annuities
and other individual life insurance. Our principal business segments are: Career
Agency, Senior Market Brokerage and Administrative Services. We also report the
corporate activities of our holding company in a separate segment. During 2002
we modified the way we report segment information by combining our previously
defined Senior Market Brokerage and Special Markets segments into one segment,
Senior Market Brokerage. Our decision to combine the two segments was based on
the significant reduction in the insurance in force in the Special Markets
segment as a result of our exit from the Major Medical line of business.
Reclassifications have been made to conform prior year amounts to the current
year presentation. A description of these segments follows:
13
CAREER AGENCY - The Career Agency segment is comprised of the
operations of Pennsylvania Life and PennCorp Life (Canada). PennCorp
Life (Canada) operates exclusively in Canada, while Pennsylvania Life
operates in the United States. The Career Agency segment includes the
operations of a career agency field force, which distributes fixed
benefit accident and sickness disability insurance, life insurance and
supplemental senior health insurance in the United States and Canada.
The career agents are under exclusive contract with either Pennsylvania
Life or PennCorp Life (Canada).
SENIOR MARKET BROKERAGE - This segment includes the operations of
general agency and insurance brokerage distribution systems that focus
on the sale of insurance products to the senior market, including
Medicare Supplement/Select, long term care, senior life insurance and
annuities. In 2002, we combined our Special Markets segment with our
Senior Market Brokerage segment.
ADMINISTRATIVE SERVICES - We act as a third party administrator and
service provider for both affiliated and unaffiliated insurance
companies, primarily with respect to various senior market products and
a growing portion of non-insurance products. The services that we
perform include policy underwriting, telephone verification,
policyholder services, claims adjudication, clinical case management,
care assessment and referral to health care facilities.
CORPORATE - This segment reflects the corporate activities of our
holding company, including the payment of interest on our debt and our
public company administrative expenses.
Intersegment revenues and expenses are reported on a gross basis in
each of the operating segments. These eliminations affect the amounts
reported on the individual financial statement line items, but do not
change operating income before taxes. The significant items eliminated
include intersegment revenue and expense relating to services performed
by the Administrative Services segment for the Career Agency and Senior
Market Brokerage segments and interest on notes issued by the Corporate
segment to the other operating segments.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States ("GAAP"). The
preparation of our financial statements in conformity with GAAP requires us to
make estimates and assumptions that affect the amounts of assets and liabilities
and disclosures of assets and liabilities reported by us at the date of the
financial statements and the revenues and expenses reported during the reporting
period. As additional information becomes available or actual amounts become
determinable, the recorded estimates may be revised and reflected in operating
results. Actual results could differ from those estimates. Accounts that, in our
judgment, are most critical to the preparation of our financial statements
include policy liabilities and accruals, deferred policy acquisition costs,
valuation of certain investments and deferred taxes. There have been no changes
in our critical accounting policies during the current quarter.
14
RESULTS OF OPERATIONS - CONSOLIDATED OVERVIEW
The following table presents operating income by segment along with a
reconciliation to net income:
For the quarters ended March 31,
--------------------------------
2002 2001
----------- ------------
(In thousands, per share amounts
in dollars)
Career agency $ 7,207 $ 7,366
Senior market brokerage 4,155 2,401
Administrative services 1,876 1,510
-------- --------
Segment operating income 13,238 11,277
Corporate (1,756) (2,446)
-------- --------
Operating income before realized gains and federal income taxes (1) 11,482 8,831
Federal income taxes on operating items (4,077) (3,154)
-------- --------
Net operating Income (1) 7,405 5,677
Realized gains (losses) net of tax 93 1,359
-------- --------
Net Income $ 7,498 $ 7,036
======== ========
Per share data (diluted):
Net operating income (1) $ 0.14 $ 0.12
Realized gains (losses) net of tax -- 0.03
-------- --------
Net Income $ 0.14 $ 0.15
======== ========
- -----------------
(1) We evaluate the results of operations of our segments based on
operating income by segment. Operating income excludes realized gains.
This differs from generally accepted accounting principles, which
includes the effect of realized gains in the determination of net
income. The schedule above reconciles our operating income to net
income in accordance with generally accepted accounting principles.
Quarters Ended March 31, 2002 and 2001
Consolidated net income after federal income taxes increased by $0.5
million to $7.5 million ($0.14 per share diluted) in the first quarter of 2002,
compared to $7.0 million ($0.15 per share diluted) in 2001. Operating income
before realized gains and federal income taxes increased by $2.7 million to
$11.5 million in 2002 compared to $8.8 million in 2001.
Operating income from the Career Agency segment was relatively flat
compared to the first quarter of 2001.
Operating results for the Senior Market Brokerage segment improved by
73% or $1.8 million, compared to the first quarter of 2001. This improvement is
the result of continued internally generated growth of business in the segment,
primarily in the Medicare supplement/select and long term care lines.
Operating income for the Administrative Services segment improved by
$0.4 million or 24%, compared to the first quarter of 2001. This improvement is
primarily a result of the increase in Medicare premiums being serviced by our
administrative services company and the reduction in the amortization of the
present value of future profits.
15
The operating loss from the Corporate segment decreased by $0.7
million, or 28%, compared to the first quarter of 2001, primarily due to a
decrease in the interest cost relating to our outstanding debt.
The effective tax rate on operating income for the first quarter of
2002 was 35.5% compared to 35.7% in 2001.
SEGMENT RESULTS - CAREER AGENCY
For the quarters ended March 31,
--------------------------------
2002 2001
----------- ----------
(In thousands)
Net premiums and policyholder fees:
Life and annuity $ 3,745 $ 3,657
Accident and health 27,795 28,695
-------- --------
Net premiums 31,540 32,352
Net investment income 8,144 8,050
Other income 80 133
-------- --------
Total revenue 39,764 40,535
-------- --------
Policyholder benefits 20,183 21,395
Interest credited to policyholders 636 388
Change in deferred acquisition costs (3,227) (3,125)
Amortization of present value of future profits and goodwill -- 7
Commissions and general expenses, net of allowances 14,965 14,504
-------- --------
Total benefits, claims and other deductions 32,557 33,169
-------- --------
Segment operating income $ 7,207 $ 7,366
======== ========
Quarters ended March 31, 2002 and 2001
Operating income from the Career Agency segment was relatively flat,
decreasing by $0.2 million or 2%, compared to the first quarter of 2001.
REVENUES. Net premiums for the quarter fell by approximately 3% for the
segment compared to the first quarter of 2001. In the US, the decrease is due to
a change in the mix of business, which includes a greater amount of long term
care which is reinsured at 50%. Revenues from our Canadian operations were flat
compared to the first quarter of 2001. Canadian premiums accounted for
approximately 38% of the net premiums of this segment for the first quarter of
2002 and 37% of the net premiums for the first quarter of 2001.
Net investment income increased by approximately $0.1 million, or 1%,
compared to the first quarter of 2001. The increase is due to an increase in the
segment's invested assets due to primarily to earnings of the segment, offset by
a decrease in overall investment yields.
BENEFITS, CLAIMS AND OTHER DEDUCTIONS. Policyholder benefits, including
the change in reserves, decreased by approximately 6% compared to the first
quarter of 2001. The decrease was due primarily to a reduction in the overall
loss ratios for the segment from 66% in the first quarter of 2001 to 64% in the
first quarter of 2002.
Interest credited increased by $0.3 million, due to the increase in
annuity balances, offset by a decrease in the credited rate.
The increase in deferred acquisition costs was approximately $0.2
million more in the first quarter of 2002, compared to the increase in the first
quarter of 2001.
Commissions and other operating expenses, net of allowances, increased
by approximately $0.5 million, or 3%, in the first quarter of 2002 compared to
2001.
16
SEGMENT RESULTS - SENIOR MARKET BROKERAGE
For the quarters ended March 31,
--------------------------------
2002 2001
-------- -------
(In thousands)
Net premiums and policyholder fees:
Life and annuity $ 4,602 $ 4,368
Accident and health 28,770 20,873
-------- --------
Net premiums 33,372 25,241
Net investment income 6,127 6,576
Other income 177 73
-------- --------
Total revenue 39,676 31,890
-------- --------
Policyholder benefits 25,034 21,406
Interest credited to policyholders 1,971 2,123
Change in deferred acquisition costs (2,705) (1,203)
Amortization of present value of future profits and goodwill 43 150
Commissions and general expenses, net of allowances 11,178 7,013
-------- --------
Total benefits, claims and other deductions 35,521 29,489
-------- --------
Segment operating income $ 4,155 $ 2,401
======== ========
The table below details the gross premiums and policyholder fees before
reinsurance for the major product lines in the Senior Market Brokerage segment
and the corresponding average amount of premium retained. We reinsure a
substantial portion of all of our Senior Market Brokerage products to
unaffiliated third party reinsurers under various quota share agreements.
Medicare Supplement/Select written premium is reinsured under quota share
reinsurance agreements ranging between 50% and 75% based upon the geographic
distribution. We have also acquired various blocks of Medicare Supplement
premium, which we reinsure under quota share reinsurance agreements ranging from
50% to 100%. Under our reinsurance agreements, we reinsure the claims incurred
and commissions on a pro rata basis and receive additional expense allowances
for policy issue, administration and premium taxes.
For the quarters ended March 31,
--------------------------------- -----------------------------
2002 2001
--------------------------------- -----------------------------
(In thousands)
Gross Net Gross Net
Premiums Retained Premiums Retained
-------- -------- -------- --------
Medicare Supplement acquired $ 39,440 7% $ 38,518 6%
Medicare Supplement/Select Written 59,027 34% 35,014 30%
Other senior supplemental health 6,087 60% 5,886 61%
Other health 4,549 39% 8,368 53%
Senior life insurance 2,277 67% 1,936 68%
Other life 4,026 74% 3,986 77%
-------- --------
Total gross premiums $115,406 29% $ 93,708 27%
======== ========
Quarters ended March 31, 2002 and 2001
Operating results for the Senior Market Brokerage segment improved by
73% or $1.8 million, compared to the first quarter of 2001. This improvement is
the result of continued internally generated growth of business in the segment,
primarily in the Medicare Supplement/Select and long term care lines combined
with improvement in overall loss ratios for the segment.
17
REVENUES. Gross premium written for the Senior Market portfolio
products have increased $21.7 million, or 23% over the first quarter of 2001, as
a result of continued strong sales of our Senior Market products. New production
of our Senior Market products amounted to $35.8 million in the current quarter
compared to $33.9 million in the same period of the prior year. The increase in
gross premium written relates primarily to the increase in Medicare Supplement
business written by the insurance subsidiaries of $24.0 million or 69%, compared
to the first quarter of 2001. Medicare Supplement written premium grew as a
result of the increase in number of general agents under contract, the expansion
of sales into more states in the northeast and the dis-enrollment of
policyholders from various Health Maintenance Organizations ("HMO's"). In
addition, premiums increased due to normal rate increases implemented by the
Company, offset by expected lapses. This increase is offset, in part, by a
decrease of $3.8 million in other health premiums, primarily major medical, as a
result of our decision to exit this line of business.
Net premiums for the first quarter of 2002 increased by approximately
$8.1 million, or 32%, compared to 2001. The net premiums did not increase in
line with the gross premiums due to the change in the mix of annualized premium
in force. The amount of premium retained increased from 27% in 2001 to 29% in
2002 due to the increase in Medicare Supplement/Select premiums written, which
we retain 30% on average.
Net investment income decreased by $0.5 million compared to the first
quarter of 2001. This is due to decrease in investment yields.
BENEFITS, CLAIMS AND OTHER DEDUCTIONS. Policyholder benefits, including
the change in reserves, increased by approximately $3.6 million, or 17%,
compared to the first quarter of 2001 due to primarily to higher annualized
premium in force. This increase relates primarily to the increase in the
Medicare supplement business in this segment.
Interest credited to policyholders decreased by approximately $0.2
million compared to the first quarter of 2001, primarily as a result of a
decrease in the credited rate in 2002.
The increase in deferred acquisition costs was approximately $1.5
million more in the first quarter of 2002, compared to the increase in the first
quarter of 2001. The increase in deferred acquisition costs relates to the
increase in premiums issued during 2002 compared to 2001.
Commissions and other operating expenses increased by approximately
$4.2 million or 59% in the first quarter of 2002 compared to 2001. The following
table details the components of commission and other operating expenses:
For the quarters ended March 31,
--------------------------------
2002 2001
---------- -------------
(In thousands)
Commissions $ 20,225 $ 15,964
Other operating costs 15,052 11,979
Reinsurance allowances (24,099) (20,931)
-------- --------
Commissions and general expenses, net of allowances $ 11,178 $ 7,012
======== ========
The ratio of commissions to gross premiums increased to 17.5% during
the first quarter of 2002, from 17.0% in 2001 as a result of the increase in new
business written. Other operating costs as a percentage of gross premiums
increased slightly to 13.0% during the first quarter of 2002 from 12.8% in 2001.
Commission and expense allowances received from reinsurers as a percentage of
the premiums ceded decreased to 29.4% during the first quarter of 2002 compared
to 30.6% in 2001.
18
SEGMENT RESULTS - ADMINISTRATIVE SERVICES
For the quarters ended March 31,
--------------------------------
2002 2001
------ ------
(In thousands)
Service fee and other income $9,567 $7,980
Net investment income 129 66
------ ------
Total revenue 9,696 8,046
------ ------
Amortization of present value of future profits and goodwill 379 567
General expenses 7,441 5,969
------ ------
Total expenses 7,820 6,536
------ ------
Segment operating income 1,876 1,510
Depreciation, amortization and interest 689 754
------ ------
Earnings before interest, taxes, depreciation and amortization (1) $2,565 $2,264
====== ======
- -----------------
(1) For our Administrative Services segment, we evaluate results based on
earnings before interest, taxes, depreciation and amortization, which
is not in accordance with generally accepted accounting principles.
Quarters ended March 31, 2002 and 2001
Operating income for the Administrative Services segment improved by
$0.4 million or 24% over the first quarter of 2001, primarily as the result of
the increase in Medicare Supplement premiums being serviced by our
administrative services company and the reduction in the amortization of the
present value of future profits ("PVFP"). Earnings before interest, taxes,
depreciation and amortization ("EBITDA") for this segment increased $0.3 million
or 13% to $2.6 million, compared to the first quarter of 2001.
The table below details service fee revenue earned by our
Administrative Services segment for the three months ended March 31, 2002 and
2001:
For the quarters ended March 31,
--------------------------------
2002 2001
------ ------
(In thousands)
Affiliated Fee Revenue
Medicare supplement $4,133 $2,961
Long term care 521 381
Nurse Navigator(TM) 375 6
Other health insurance 22 176
Life insurance 95 104
------ ------
Total Affiliated Fee Revenue 5,146 3,628
------ ------
Unaffiliated Fee Revenue
Medicare supplement 2,342 2,401
Long term care 1,613 1,539
Other health insurance 128 139
Non-insurance assistance 338 273
------ ------
Total Unaffiliated Fee Revenue 4,421 4,352
------ ------
Total Administrative Service Fee Revenue $9,567 $7,980
====== ======
Administrative Services fee revenue increased by $1.6 million, or 20%,
as compared to the first quarter of 2001. Fees earned on affiliated Medicare
Supplement policies increased $1.2 million compared to the first quarter of
2001. In 2002, approximately 46% of the $9.6 million of fees earned were from
non-affiliated companies compared to 55% of the $8.0 million in 2001.
19
General expenses for the segment increased by $1.5 million, or 25%, due
primarily to the increase in business, as discussed above.
The amortization of PVFP and goodwill relates primarily to the
acquisition of American Insurance Administration Group, Inc. ("AIAG").
Approximately $7.7 million of PVFP was established when AIAG was acquired in
January, 2000. It is being amortized in proportion to the expected profits from
the contracts in force on the date of acquisition. A large portion of the
contracts had a remaining term of three years at the date of acquisition;
accordingly, the amortization is heavily weighted to those periods. During the
first quarter of 2002, approximately $0.4 million was amortized compared to $0.6
million in 2001. As of March 31, 2002, $2.4 million or 31%, of the original
amount remains unamortized.
SEGMENT RESULTS - CORPORATE
For the quarters ended March 31,
--------------------------------
2002 2001
------ ------
(In thousands)
Interest cost on outstanding debt $ 806 $1,618
Amortization of capitalized loan origination fees 132 132
Stock-based compensation expense 160 250
Other parent company expenses, net 658 446
------ ------
Segment operating loss $1,756 $2,446
====== ======
Quarters ended March 31, 2002 and 2001
The net loss from the Corporate segment decreased by approximately 28%,
or $0.7 million compared to the first quarter of 2001, due primarily to a
reduction in interest cost. The decrease in the interest cost is due to a
combination of a reduction in the weighted average interest rate and lower
average outstanding balance as a result of principal repayments, compared to
2001. (See "Liquidity and Capital Resources" for additional information
regarding our credit facility). This is offset by an increase in parent company
expenses as a result of the growth of the company.
Eliminations
The results by segment discussed above do not reflect the elimination
of intersegment revenues. However, the consolidated results include the
elimination of the revenues and expenses associated with services performed by
the Administrative Services segment for affiliates of $7.1 million and $5.7
million, respectively for 2002 and 2001 and the elimination of interest income
and expense of $0.1 million and $0.2 million, respectively for 2002 and 2001 on
bonds issued by the Corporate segment to an affiliate.
LIQUIDITY AND CAPITAL RESOURCES
We use capital primarily to maintain or increase the surplus of our
insurance company subsidiaries and to support our parent company as an insurance
holding company. In addition, we require capital to fund our anticipated growth
through acquisitions of other companies or blocks of insurance or administration
business.
We require cash at our parent company to meet our obligations under our
credit facility and our outstanding debentures held by our subsidiary, American
Progressive. We also require cash to pay the operating expenses necessary to
function as an insurance holding company (applicable insurance department
regulations require us to bear our own expenses), and to meet the costs involved
in being a public company.
20
We believe that our current cash position, the availability of the
revolving credit facility, the expected cash flows of our administrative service
company and the surplus note interest payments from American Exchange can
support our parent company obligations for the foreseeable future. However,
there can be no assurance as to our actual future cash flows or to the continued
availability of dividends from our insurance company subsidiaries.
Contractual Obligations and Commercial Commitments
Our $80 million credit facility consists of a $70 million term loan and
a $10 million revolving loan facility. The loans call for interest at LIBOR for
one, two, three or six months plus 350 basis points (5.42% beginning April 30,
2002). Principal repayments are due on a quarterly basis over a seven-year
period that commenced on July 31, 2000. The final maturity date of the facility
is July 31, 2006. We pay a commitment fee of 50 basis points on the unutilized
portion of the revolving facility. The term loan is secured by a first priority
security interest in 100% of the outstanding common stock of American Exchange,
American Progressive, and WorldNet Services and 65% of the outstanding under
common stock of UAFC (Canada) Inc. (the parent of PennCorp Life (Canada)) and a
subordinate interest in 100% of the outstanding common stock of American
Pioneer. As of March 31, 2002, $55.9 million was outstanding under the term loan
and $3.0 million was outstanding under the revolving loan facility. We incurred
the revolving indebtedness in connection with our acquisition of CHCS in August
2000. During the quarter ended March 31, 2002, we paid $0.3 million in interest
and repaid $2.6 million in principal on the term loan. Additionally, during
April 2002, we made a regularly scheduled repayment that further reduced the
term loan to $53.2 million. During the quarter ended March 31, 2001, we paid
$0.6 million in interest and repaid $1.9 million in principal on the term loan.
The following table shows the schedule of remaining principal payments, as of
May 1, 2002, on the Company's outstanding term loan, with the final payment in
July 2006:
Principal
Repayment
-------------
(In thousands)
2002 $ 5,450
2003 11,525
2004 12,400
2005 13,275
2006 10,575
---------
Total $ 53,225
=========
We are obligated under certain lease arrangements for our executive and
administrative offices in New York, Florida, Texas, and Ontario, Canada. Annual
minimum rental commitments, subject to escalation clauses under non-cancelable
operating leases are as follows:
(In thousands)
--------------
2002 $ 1,737
2003 1,516
2004 1,435
2005 947
2006 and thereafter 5,686
--------
Totals $ 11,321
========
Other than the lease obligations noted above, we do not have any
contractual or other commitments involving off-balance sheet arrangements.
21
Administrative Service Company
Liquidity for our administrative service company is measured by its
ability to pay operating expenses. The primary source of liquidity is fees
collected from clients. We believe that the sources of cash for our
administrative service company exceed scheduled uses of cash and results in
amounts available to dividend to our parent holding company. We measure the
ability of the administrative service company to pay dividends based on its
earnings before interest, taxes, depreciation and amortization ("EBITDA"). For
the year ended December 31, 2001, EBITDA for our administrative services segment
was $9.7 million.
Insurance Subsidiary - Surplus Note
Cash generated by our insurance company subsidiaries will be made
available to our holding company, principally through periodic payments of
principal and interest on surplus notes. As of March 31, 2002, the principal
amount of surplus notes owed to our holding company from our American Exchange
subsidiary totaled $70 million. The notes pay interest to our parent holding
company at LIBOR plus 375 basis points. We anticipate that the surplus notes
will be primarily serviced by dividends from Pennsylvania Life, a wholly owned
subsidiary of American Exchange, and by tax-sharing payments among the insurance
companies that are wholly owned by American Exchange and file a consolidated
Federal income tax return. American Exchange made no interest or principal
payments on the surplus notes to our parent holding company during the three
months ended March 31, 2002.
Insurance Subsidiaries
Our insurance subsidiaries are required to maintain minimum amounts of
capital and surplus as determined by statutory accounting practices. As of March
31, 2002, each insurance company subsidiary's statutory capital and surplus
exceeded its respective minimum requirement. However, substantially more than
these minimum amounts are needed to meet statutory and administrative
requirements of adequate capital and surplus to support the current level of our
insurance subsidiaries' operations. As of March 31, 2002 the statutory capital
and surplus, including asset valuation reserves, of our U.S. domiciled insurance
subsidiaries totaled $99.9 million.
The National Association of Insurance Commissioners has developed, and
state insurance regulators have adopted, risk-based capital requirements on life
insurance enterprises. As of March 31, 2002 all of our insurance company
subsidiaries maintained ratios of total adjusted capital to risk-based capital
in excess of the minimum trigger point for regulatory action.
PennCorp Life (Canada) is subject to Canadian capital requirements and
reports results to Canadian regulatory authorities based upon Canadian statutory
accounting principles that vary in some respects from U.S. statutory accounting
principles. Canadian net assets based upon Canadian statutory accounting
principles were $36.3 million as of March 31, 2002. PennCorp Life (Canada)
maintained a minimum continuing capital and surplus requirement ratio in excess
of the minimum requirement as of March 31, 2002.
Dividend payments by our insurance companies to our parent holding
company or to intermediate subsidiaries are limited by, or subject to the
approval of the insurance regulatory authorities of each insurance company's
state of domicile. Such dividend requirements and approval processes vary
significantly from state to state. The maximum amount of dividends which can be
paid to American Exchange from Pennsylvania Life (to assist in the service of
the surplus note held by American Exchange) without the prior approval of the
Pennsylvania Department of Insurance is restricted to the greater of 10% of the
Pennsylvania Life's surplus as regards policyholders as of the preceding
December 31 or the net gain from operations during the preceding year, but such
dividends can be paid only out of unassigned surplus. Thus, future earnings of
Pennsylvania Life would be available for dividends without prior approval,
subject to the restrictions noted above. Based upon the current dividend
regulations of the respective states, Pennsylvania Life would be able to pay
ordinary dividends of up to $8.4 million and Constitution Life would be able to
pay ordinary dividends of approximately $1.7 million to American Exchange (their
direct parent) without the prior approval from their respective insurance
departments in 2002. Additionally, in 2002, Peninsular Life would be able to pay
ordinary dividends of up to $0.7 million to
22
American Pioneer without approval from the Florida Department. We do not expect
that our remaining subsidiaries will be able to pay ordinary dividends in 2002.
Liquidity for our insurance company subsidiaries is measured by their
ability to pay scheduled contractual benefits, pay operating expenses, and fund
investment commitments. Sources of liquidity include scheduled and unscheduled
principal and interest payments on investments, premium payments and deposits
and the sale of liquid investments. We believe that these sources of cash for
our insurance company subsidiaries exceed scheduled uses of cash.
Liquidity is also affected by unscheduled benefit payments including
death benefits, benefits under accident and health insurance policies and
interest-sensitive policy surrenders and withdrawals. The amount of surrenders
and withdrawals is affected by a variety of factors such as credited interest
rates for similar products, general economic conditions and events in the
industry that affect policyholders' confidence. Although the contractual terms
of substantially all of our in force life insurance policies and annuities give
the holders the right to surrender the policies and annuities, we impose
penalties for early surrenders. As of March 31, 2002 we held reserves that
exceeded the underlying cash surrender values of our inforce life insurance and
annuities by $17.9 million. Our insurance company subsidiaries, in our view,
have not experienced any material changes in surrender and withdrawal activity
in recent years.
Changes in interest rates may affect the incidence of policy surrenders
and withdrawals. In addition to the potential impact on liquidity, unanticipated
surrenders and withdrawals in a changed interest rate environment could
adversely affect earnings if we were required to sell investments at reduced
values in order to meet liquidity demands. We manage our asset and liability
portfolios in order to minimize the adverse earnings impact of changing market
rates. We seek to invest in assets that have duration and interest rate
characteristics similar to the liabilities that they support.
The net yields on our cash and invested assets decreased slightly from
6.76% in 2001 to 6.56% in 2002. A significant portion of these securities are
held to support the liabilities for policyholder account balances, which
liabilities are subject to periodic adjustments to their credited interest
rates. The credited interest rates of the interest-sensitive policyholder
account balances are determined by us based upon factors such as portfolio rates
of return and prevailing market rates and typically follow the pattern of yields
on the assets supporting these liabilities.
As of March 31, 2002, our insurance company subsidiaries held cash and
cash equivalents totaling $28.7 million, as well as fixed maturity securities
that could readily be converted to cash with carrying values (and fair values)
of $805.2 million. The fair values of these holdings totaled more than $833.9
million as of March 31, 2002.
INVESTMENTS
Our investment policy is to balance the portfolio duration to achieve
investment returns consistent with the preservation of capital and maintenance
of liquidity adequate to meet payment of policy benefits and claims. We invest
in assets permitted under the insurance laws of the various states in which we
operate. However, we do not invest in partnerships, special purpose entities,
real estate, commodity contracts, or other derivative securities. Such laws
generally prescribe the nature, quality of and limitations on various types of
investments that may be made. We currently engage the services of two investment
advisors under the direction of the management of our insurance company
subsidiaries and in accordance with guidelines adopted by the Investment
Committees of their respective boards of directors. Conning Asset Management
Company manages our fixed maturity portfolio in the United States and Elliot &
Page, Limited manages our Canadian fixed maturity portfolio. Our policy is not
to invest in derivative programs or other hybrid securities, except for GNMA's,
FNMA's and investment grade corporate collateralized mortgage obligations. We
invest primarily in fixed maturity securities of the U.S. Government and its
agencies and in corporate fixed maturity securities with investment grade
ratings of "Baa3" (Moody's Investor Service), "BBB-" (Standard & Poor's
Corporation) or higher. As of March 31, 2002, 99.2% of our fixed maturity
investments had investment grade ratings from Moody's Investors Service or
Standard & Poor's Corporation. However, we do own some investments that are
rated "BB+" or below by Standard & Poor's (together 0.8% of total fixed
maturities as of March 31, 2002). There were no non-income producing fixed
maturities as of March 31, 2002. We wrote down the value of certain fixed
23
maturity securities by $1.6 million during the three months ended March 31,
2002, and by $1.2 million during the three months ended March 31, 2001. In each
case, these write-downs represent our estimate of other than temporary declines
in value and were included in net realized gains (losses) on investments in our
consolidated statements of operations.
EFFECTS OF ACCOUNTING PRONOUNCEMENTS
In June, 2001, The Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets", effective for fiscal years beginning after December 15,
2001. Under the new rules, goodwill, and intangible assets deemed to have
indefinite lives, will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statement. Other intangible assets will
continue to be amortized over their useful lives.
The Company applied the new rules on accounting for goodwill and other
intangible assets beginning in the first quarter of 2002. Application of the
non-amortization provisions of the Statement resulted in an increase in net
income of $0.1 million (less than $0.01 per diluted share) for the three months
ended March 31, 2002. The Company performed the first of the required impairment
tests of goodwill and indefinite lived intangible assets as of January 1, 2002
and has determined that, based on these tests, goodwill and indefinite lived
intangibles were not impaired.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In general, market risk relates to changes in the value of financial
instruments that arise from adverse movements in interest rates, equity prices
and foreign exchange rates. We are exposed principally to changes in interest
rates that affect the market prices of our fixed income securities.
Interest Rate Sensitivity
Our profitability could be affected if we were required to liquidate
fixed income securities during periods of rising and/or volatile interest rates.
However, we attempt to mitigate our exposure to adverse interest rate movements
through a combination of active portfolio management and by staggering the
maturities of our fixed income investments to assure sufficient liquidity to
meet our obligations and to address reinvestment risk considerations. Our
insurance liabilities generally arise over relatively long periods of time,
which typically permits ample time to prepare for their settlement. To date, we
have not used various financial risk management tools on our investment
securities, such as interest rate swaps, forwards, futures and options to modify
our exposure to changes in interest rates. However, we may consider using them
in the future.
Certain classes of mortgage-backed securities are subject to
significant prepayment risk due to the fact that in periods of declining
interest rates, individuals may refinance higher rate mortgages to take
advantage of the lower rates then available. We monitor and adjust investment
portfolio mix to mitigate this risk.
We regularly conduct various analyses to gauge the financial impact of
changes in interest rate on our financial condition. The ranges selected in
these analyses reflect our assessment as being reasonably possible over the
succeeding twelve-month period. The magnitude of changes modeled in the
accompanying analyses should not be construed as a prediction of future economic
events, but rather, be treated as a simple illustration of the potential impact
of such events on our financial results.
The sensitivity analysis of interest rate risk assumes an instantaneous
shift in a parallel fashion across the yield curve, with scenarios of interest
rates increasing and decreasing 100 and 200 basis points from their levels as of
March 31, 2002, and with all other variables held constant. A 100 basis point
increase in market interest rates would result in a pre-tax decrease in the
market value of our fixed income investments of $51.9 million and a 200 basis
point increase would result in a $97.8 million decrease. Similarly, a 100 basis
point decrease in market interest rates would result in a pre-tax increase in
the market value of our fixed income investments of $49.5 million and a 200
basis point decrease would result in a $104.5 million increase.
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Currency Exchange Rate Sensitivity
Portions of our operations are transacted using the Canadian dollar as
the functional currency. As of and for the three months ended March 31, 2002,
approximately 11% of our assets, 18% of our revenues and 30% of our operating
income before taxes were derived from our Canadian operations. As of and for the
three months ended March 31, 2001, approximately 13% of our assets, 19% of our
revenues and 25% of our operating income before taxes were derived from our
Canadian operations. Accordingly, our earnings and shareholders' equity are
affected by fluctuations in the value of the U.S. dollar as compared to the
Canadian dollar. Although this risk is somewhat mitigated by the fact that both
the assets and liabilities for our foreign operations are denominated in
Canadian dollars, we are still subject to translation losses.
We periodically conduct various analyses to gauge the financial impact
of changes in the foreign currency exchange rate on our financial condition. The
ranges selected in these analyses reflect our assessment of what is reasonably
possible over the succeeding twelve-month period.
A 10% strengthening of the U.S. dollar relative to the Canadian dollar
would result in a decrease in our operating income before taxes for the three
months ended March 31, 2002 of approximately $0.3 million and a decrease in
shareholders' equity as of March 31, 2002 of approximately $2.0 million. Our
sensitivity analysis of the effects of changes in currency exchange rates does
not factor in any potential change in sales levels, local prices or any other
variable.
The magnitude of changes reflected in the above analysis regarding
interest rates and foreign currency exchange rates should, in no manner, be
construed as a prediction of future economic events, but rather as a simple
illustration of the potential impact of such events on our financial results.
PART II - OTHER INFORMATION
NONE
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SIGNATURE
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.
UNIVERSAL AMERICAN FINANCIAL CORP.
By: /S/ Robert A. Waegelein
------------------------
Robert A. Waegelein
Executive Vice President
Chief Financial Officer
Date: May 15, 2002
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