Table of Contents
the acquired
business that are no longer premium paying with substantial reserves and
investment income on reserves. In the three months ended September 30, 2007,
paid claims were up $0.6 million, premiums were down $0.1 million, there was an
increase of $0.5 million in accident and health reserve increases, and there
was a release of redundant life reserves of $1.7 million, when compared to the
three months ended September 30, 2006.
Insurance Commissions
Commission
expenses increased $0.7 million, or 21.9%, to $3.9 million for the three months
ended September 30, 2007, from $3.2 million for the three months ended
September 30, 2006. This increase consists of normal increases related to
increased renewal premiums, in addition to an increase in first year
commissions that were not deferred, a large portion of which relates to the
increased sales of stop loss products.
General Insurance Expenses
General
insurance expenses decreased $0.4 million, or 3.7%, to $10.4 million for the
three months ended September 30, 2007, from $10.8 million for the three months
ended September 30, 2006. The decreased expenses for the three months ended
September 30, 2007 include some unusual items, primarily $1.1 million of costs
associated with our pending merger transaction that is offset by a $1.5 million
reduction in stock based compensation expense created by the voluntary
surrender of stock options held by the Company’s executive officers in
September 2007. The $1.5 million reduction is represented by a credit of $1.2
million in the three months ended September 30, 2007 compared to an expense of
$0.3 million in the three months ended September 30, 2006.
Overhead
expenses that are not directly associated with a particular business segment
are allocated to the various business segments on a pro rata basis based on
different factors, such as headcount, policy count, number of policies issued,
premiums and other relevant factors.
Insurance Taxes, Licenses and Fees
Insurance
taxes, licenses and fees were flat at $1.3 million for the three months ended
September 30, 2007 and 2006, respectively.
Amortization of DAC and VOBA
First
year commissions and general insurance expenses associated with the acquisition
of new business are deferred and amortized over the premium-paying period of
the related policies. The total deferrals of policy acquisition costs were $4.6
million and $5.0 million for the three months ended September 30, 2007 and
2006, respectively. Deferrals can fluctuate on a quarterly basis, but will
generally increase over a period of time in a rising sales environment.
The
amortization of DAC and VOBA increased $0.3 million, or 17.6%, to $2.0 million
for the three months ended September 30, 2007, from $1.7 million for the three
months ended September 30, 2006. The DAC balance at September 30, 2007
increased by $14.6 million over the balance at September 30, 2006, which
accounted for a large part of the increase in amortization expense.
Provision for Income Taxes
Total
income taxes may differ from the amount computed by applying the federal
corporate tax rate of 35% due to tax-advantaged investments and net operating
loss carry forwards available. The effective income tax rates for the three
months ended September 30, 2007 and 2006 were (57.6) % and 35.0%, respectively.
The variation in these rates is due to a valuation allowance of $0.4 million
that was established during the current quarter.
Under SFAS No.
109, management must provide a valuation allowance for any deferred tax amounts
that it believes are uncertain to be realized. The decision by A.M. Best to
change the outlook of our rating from stable to negative, and the resulting
strategic options being considered, has created uncertainty about our ability
and timing to generate taxable income at the holding company. Because of this
uncertainty, the Company deemed it appropriate to establish
36
Table of Contents
a valuation
allowance of $0.4 million which represents the portion of the deferred tax
asset that was generated by net operating losses at the holding company during
the current quarter.
Liquidity and Capital Resources
KMG
America is a holding company and had minimal operations of its own prior to the
completion of its initial public offering and the Kanawha acquisition. KMG
America’s assets consist primarily of the capital stock of Kanawha and its
non-insurance subsidiary. Accordingly, KMG America’s cash flows depend upon the
availability of dividends and other statutorily permissible payments, such as
payments under tax allocation agreements and under management agreements, from
Kanawha. Kanawha’s ability to pay dividends and to make other payments is
limited primarily by applicable laws and regulations of South Carolina, the
state in which Kanawha is domiciled, which subjects insurance operations to
significant regulatory restrictions. These laws and regulations require, among
other things, that Kanawha, KMG America’s insurance subsidiary, maintain
minimum solvency requirements and limit the amount of dividends it can pay to
the holding company. Solvency regulations, capital requirements, types of
insurance offered and rating agency status are some of the factors used in
determining the amount of capital available for dividends. In general, South
Carolina will permit annual dividends from insurance operations equal to the
greater of (1) the most recent calendar year’s statutory net income or (2) 10%
of total capital and surplus of the insurance operations at the end of the
previous calendar year, provided that the dividend payment does not exceed
earned surplus, in which case further limitations apply. While the South Carolina
Insurance Department acknowledges distinctions between ordinary and
extraordinary dividends, their approval is required before any dividend
payments can be made.
If
KMG America is able to successfully execute its business plan and accelerate Kanawha’s
earnings growth in its insurance operations, KMG America expects that the
maximum allowable dividend from Kanawha to the holding company will increase at
an accelerated rate year-over-year. If the ability of Kanawha to pay dividends
or make other payments to KMG America is materially restricted by regulatory
requirements, it could adversely affect KMG America’s ability to pay any
dividends on its common stock and/or service its debt and pay its other
corporate expenses.
The
primary sources of funds for KMG America’s subsidiaries consist of insurance
premiums and other considerations, fees and commissions collected, proceeds
from the sales and maturity of investments and investment income. Cash is
primarily used to pay insurance claims, agent commissions, operating expenses,
product surrenders and withdrawals and taxes. KMG America generally invests its
subsidiaries’ excess funds in order to generate income. The primary use of
dividends and other distributions from subsidiaries to KMG America will be to
pay certain expenses of the holding company. We currently have no intention of
paying dividends to our shareholders and will reinvest cash flows from
operations into our businesses for the foreseeable future.
On
March 22, 2007, KMG America completed the issuance and sale in a private
placement of $35,000,000 in aggregate principal amount of trust preferred
securities (the “Trust Preferred Securities”) issued by the Company’s
newly-formed subsidiary, KMG Capital Statutory Trust I, a Delaware statutory
trust (the “Trust”). The Trust Preferred Securities will mature on March 15,
2037, may be called at par by the Company any time after March 15, 2012, and
require quarterly distributions of interest by the Trust to the holder of the
Trust Preferred Securities. Distributions are payable quarterly at a fixed
interest rate equal to 8.02% per annum through March 15, 2012, and then will be
payable at a floating interest rate equal to the 3-month London Interbank
Offered Rate (“LIBOR”) plus 310 basis points per annum. The Trust
simultaneously issued one of the Trust’s common securities (the “Common
Securities”) to the Company for a purchase price of $1,083,000, which
constitutes all of the issued and outstanding common securities of the Trust.
The
Trust used the proceeds from the sale of the Trust Preferred Securities
together with the proceeds from the sale of the Common Securities to purchase
$36,083,000 in aggregate principal amount of unsecured junior subordinated
deferrable interest debt securities due March 15, 2037, issued by the Company
(the “Junior Subordinated Debt”). The net proceeds to the Company from the sale
of the Junior Subordinated Debt to the Trust will be used by the Company for
general corporate purposes.
The
Junior Subordinated Debt was issued pursuant to an Indenture, dated March 22,
2007 (the “Indenture”), between the Company, as issuer, Wilmington Trust
Company, as trustee, and the administrators named
37
Table of Contents
therein. The
terms of the Junior Subordinated Debt are substantially the same as the terms
of the Trust Preferred Securities. The interest payments on the Junior
Subordinated Debt paid by the Company will be used by the Trust to pay the
quarterly distributions to the holders of the Trust Preferred Securities. The
Indenture permits the Company to redeem the Junior Subordinated Debt (and thus
a like amount of the Trust Preferred Securities) on or after March 15, 2012. If
the Company redeems any amount of the Junior Subordinated Debt, the Trust must
redeem a like amount of the Trust Preferred Securities.
On
December 21, 2006, the Company entered into a credit agreement with Wachovia,
which provides a $15.0 million unsecured revolving credit facility from which
we borrowed $14.0 million to repay the five-year subordinated promissory note
that was issued to fund a portion of the purchase price for the Kanawha
acquisition. The remaining $1.0 million available under the credit facility may
be used to finance the Company’s working capital, liquidity needs and general
working requirements and those of its subsidiaries. Amounts outstanding under
the credit agreement will bear interest at a rate calculated according to, at
the Company’s option, a base rate or the LIBOR rate plus an applicable
percentage. The applicable percentage is based on the A.M. Best financial
strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans
and from 1.25% to 1.35% for LIBOR rate loans. In the case of LIBOR rate loans,
interest on amounts outstanding is payable at the end of the interest period,
which can be one, two, three or six months, as selected by the Company in its
notice of borrowing. Wachovia’s obligation to fund the credit agreement
terminates, and all principal outstanding under the credit agreement is due and
payable, no later than December 31, 2007. As of September 30, 2007, the $14.0
million outstanding under the credit agreement was a LIBOR rate plus applicable
percentage loan with an interest rate of 6.76%. Pursuant to the terms of the
Merger Agreement, the Company agreed that, between September 7, 2007, and the
Effective Time of the Merger, subject to certain exceptions or unless otherwise
agreed to by Humana, it would not repay or retire any indebtedness for borrowed
money except as required by the terms of such indebtedness. The Company also
agreed not to incur or assume any indebtedness for borrowed money not currently
outstanding (except to maintain the A.M. Best capital adequacy ratio of Kanawha
at 130%) or to assume or otherwise become liable or responsible for the
obligations of any person or to create, assume or incur any material lien or
otherwise encumber any capital stock or other equity securities of the Company
or its subsidiaries, except with the prior written consent of Humana.
The
credit agreement requires the Company to comply with certain covenants,
including, among others, maintaining a maximum ratio of consolidated
indebtedness to total capitalization, a minimum available dividend amount for
Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.
The Company must also comply with limitations on certain payments, additional
debt obligations, dispositions of assets and its lines of business. The credit
agreement also restricts the Company from creating or allowing certain liens on
its assets and from making certain investments.
If
the Company is unable to complete the Merger, the Company will need to either
extend the credit agreement with Wachovia or seek other forms of additional
financing. While we expect to be able to extend the credit facility with
Wachovia, there can be no assurance that we will be able to do so or to obtain
financing from any other source on terms acceptable to the Company. If we are
unable to extend the Wachovia credit agreement or obtain financing from other
sources, this could have a material adverse effect on our liquidity, operating
performance and financial condition.
While
our primary focus is organic growth of our existing businesses by expanding our
product and marketing capabilities, we do evaluate opportunities to grow
through strategic alliances and acquisitions of blocks of business and/or
companies that are compatible with our core businesses. If such opportunities
arise we may make significant capital expenditures or acquisitions in 2007 or
subsequent years. However, our primary focus is on significantly expanding
outlays relating to marketing and sales activities over the next several years
including outlays required to continue to build a national sales organization,
which is a key component of our strategy. These outlays will include expenses
such as salaries and cash incentive compensation, employee benefits, occupancy
and information technology expenses of additional sales personnel, advertising
and marketing costs, consulting and recruiting. The execution of our business
plan will require additional outlays associated with the development of a
national insurance company including home office expenses for executive
management and additional financial, actuarial and underwriting personnel,
infrastructure development and back-office expenses, as well as costs
associated with our being a public company.
38
Table of Contents
We
anticipate that these costs will be offset over time by increased sales
production resulting from hiring additional sales personnel and increased
cross-selling, as well as efficiencies resulting from greater scale.
On
September 7, 2007, the Company and Humana entered into the Merger Agreement, by
and among the Company, Humana and Merger Sub, a wholly-owned subsidiary of
Humana. Under the Merger Agreement, Merger Sub will merge with and into the
Company, with the Company continuing after the Merger as the surviving
corporation and a wholly-owned subsidiary of Humana. At the effective time of
the Merger, each outstanding share of Company common stock will be converted
into the right to receive $6.20 in cash, without interest.
The
Merger was unanimously approved by the boards of directors of the Company and
Humana. The Merger is subject to customary closing conditions, including the
approval by the Company’s shareholders and the receipt of governmental and
regulatory approvals, including the approval of the South Carolina Department
of Insurance. On October 5, 2007, the Federal Trade Commission and the
Antitrust Division of the U.S. Department of Justice granted early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of
1976, as amended, in connection with the Merger. The Company has scheduled
November 16, 2007, as the date of the special meeting of shareholders to vote
on the Merger, and the close of business on October 12, 2007, has been set as
the record date for the meeting. Shareholders of record as of the close of
business on the record date will be entitled to vote at the meeting. The
closing of the Merger is expected to occur late in the fourth quarter of 2007,
possibly as early as November 30, 2007. There can be no assurance that the
Merger Agreement and the Merger will be approved by the Company’s shareholders,
and there can be no assurance that the other conditions to the completion of
the proposed merger will be satisfied. If the proposed merger is not completed,
there can be no assurance that a comparable transaction could be achieved.
Analysis
of Change in Financial Condition and Cash Flows
The
nature of the life insurance business is that premiums are collected and
invested and will be used for the payment of claims when they arise, and policy
reserve liabilities are established in anticipation of these future claims. As
a result, the change in financial condition directly corresponds to the cash
flows and they are discussed here in tandem.
We
monitor cash flows at both the consolidated and subsidiary levels. Cash flow
forecasts at the consolidated and subsidiary levels are provided on a monthly
basis, and we use trend and variance analyses to project future cash needs,
making adjustments to the forecasts when needed.
The table
below shows the Company’s net cash flows in the indicated periods:
|
|
|
|
|
|
|
|
|
|
Net cash provided by (used in)
|
|
Nine Months
Ended
September 30, 2007
|
|
Nine Months
Ended
September 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
(dollars
in thousands)
|
|
|
Operating
activities
|
|
$
|
13,765.5
|
|
$
|
10,174.2
|
|
|
Investing
activities
|
|
|
(49,997.0
|
)
|
|
(31,486.4
|
)
|
|
Financing
activities
|
|
|
36,083.0
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
Net change
in cash
|
|
$
|
(148.5
|
)
|
$
|
(21,312.2
|
)
|
|
|
|
|
|
|
|
|
|
Cash
Flows for the Nine Months Ended September 30, 2007 and 2006.
In
the table shown above, increases in net cash provided by operating activities
generally result from collected premiums while decreases in net cash flow
provided by investing activities generally are a result of the investment of
collected premiums. Policy and contract liabilities increase when premiums
collected are retained to establish policy reserves. The portions of these
liabilities that are reinsured by reinsurance companies are reflected in
reinsurance balances recoverable.
As
a function of our third party administration business, we manage insurance
funds for our clients. These funds are held in suspense accounts pending
appropriate disposition, and the balances held in suspense vary on a day-to-day
basis as insurance funds are received and applied by us.
39
Table of Contents
Other
changes in cash flows for the nine months ended September 30, 2007 and
September 30, 2006, are as follows:
We
held approximately $21.7 million in cash and cash equivalents at December 31,
2006, primarily consisting of investments in short term commercial paper. We
also had $36.1 million net cash provided from financing activities as the
result of the issuance of subordinated debt securities discussed previously in
the Liquidity and Capital Resources section. We invested a significant portion
of these funds in longer term securities, resulting in the net cash outflow
from investing activities of $50.0 million for the nine months ended September
30, 2007. This produced a corresponding increase in invested assets.
Other
assets increased by $0.5 million in the nine months ended September 30, 2007
compared to an increase of $2.3 million in the nine months ended September 30,
2006. These variances occurred primarily as a result of fluctuations in claims
reimbursements due from self funded Administrative Services Only (“ASO”)
clients. These claims are not actually disbursed until receipt of these funds,
so there is nothing at risk with these assets, and fluctuations from day to day
are typical. In addition, there was a receivable for securities awaiting
settlement of $0.7 million at September 30, 2007.
Accounts
payable and accrued expenses increased $5.2 million in the nine months ended
September 30, 2007, compared to an increase of $2.2 million in the nine months
ended September 30, 2006. The increase in 2006 and $2.4 million of the increase
in 2007 is due to fluctuations in our reinsurance settlements payable. In
addition, there was a payable for securities awaiting settlement of $2.0
million at September 30, 2007.
Federal
income tax recoverable decreased by $0.4 million from the December 31, 2006
balance, while the deferred tax asset decreased by $6.3 million, the federal
income taxes payable decreased by $0.3 million, and the deferred tax liability
decreased by $4.2 million. The combination of these items resulted in a net
decrease in tax assets of $2.2 million, inclusive of an increase of $3.4
million related to the change in fair market value of invested assets.
Exclusive of the change relating to the increase in fair market value, the net
deferred tax asset decreased by $5.6 million, which consists of tax payments
made in the current year and tax credits on current year losses offset by the
$7.6 valuation allowance discussed in the provision for income taxes section of
this document.
Investments
The
following table summarizes the unrealized gains and losses in our investment
portfolio as of September 30, 2007.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortized
Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Fair
Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Available for sale securities at September
30, 2007:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Treasuries
|
|
$
|
7,573,501
|
|
$
|
10,285
|
|
$
|
54,117
|
|
$
|
7,529,669
|
|
|
U.S. Government Agencies
|
|
|
19,392,517
|
|
|
63,937
|
|
|
110,550
|
|
|
19,345,904
|
|
|
States and Political Subdivisions
|
|
|
15,162,172
|
|
|
77,602
|
|
|
332,212
|
|
|
14,907,562
|
|
|
Foreign Bonds
|
|
|
40,354,195
|
|
|
194,199
|
|
|
1,566,908
|
|
|
38,981,486
|
|
|
Corporate Bonds
|
|
|
244,817,107
|
|
|
581,675
|
|
|
12,495,531
|
|
|
232,903,251
|
|
|
Mortgage/Asset-Backed Securities
|
|
|
222,626,280
|
|
|
373,337
|
|
|
5,584,116
|
|
|
217,415,501
|
|
|
Preferred Stocks—Redeemable
|
|
|
29,359,398
|
|
|
14,402
|
|
|
1,708,596
|
|
|
27,665,204
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Subtotal, Fixed Maturity Securities
|
|
$
|
579,285,170
|
|
$
|
1,315,437
|
|
$
|
21,852,030
|
|
$
|
558,748,577
|
|
|
Equity Securities
|
|
|
10,000
|
|
|
—
|
|
|
3,300
|
|
|
6,700
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities Available For Sale
|
|
$
|
579,295,170
|
|
$
|
1,315,437
|
|
$
|
21,855,330
|
|
$
|
558,755,277
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
40
Table of Contents
We
regularly monitor our investment portfolio to ensure that investments that may
be other than temporarily impaired are identified in a timely fashion and
properly valued and that any impairment is charged against earnings in the
proper period. Our investment portfolio is managed by external asset management
firms, with the exception of certain invested assets that are managed
internally. Our methodology used to identify potential impairments requires
judgment by us in conjunction with our investment managers.
Changes
in individual security values are monitored on a monthly basis in order to
identify potential problem credits. In addition, pursuant to our impairment
testing process, each month the portfolio holdings are reviewed with additional
screening for securities whose market price is equal to 80% or less of their
original purchase price. Management then makes an assessment as to which, if
any, of these securities is other than temporarily impaired. Assessment factors
include, but are not limited to, the financial condition and rating of the
issuer, any collateral held and the length of time the market value of the
security has been below cost. Each month the watch list is distributed to our
investment committee and the outside investment managers, and discussions are
held as needed in order to make any impairment decisions. Each quarter any
security deemed to have been other than temporarily impaired is written down to
its then current market value, with the amount of the write-down reflected in the
statement of income for that quarter. Previously impaired issues are also
monitored monthly, with additional write-downs taken quarterly if necessary.
The
substantial majority of our unrealized losses at September 30, 2007, can be
attributed to increases in interest rates that caused the value of the fixed
income securities in our investment portfolio to decrease.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Number of
Issues
|
|
Aggregate
Unrealized
Loss
|
|
Aggregate Estimated Fair Value
|
|
|
|
|
|
|
|
|
|
|
|
(dollars in thousands)
|
|
|
Securities
at a loss for 12 months or less
|
|
|
205
|
|
$
|
9,560.5
|
|
$
|
210,344.8
|
|
|
Securities
at a loss for more than 12 months
|
|
|
323
|
|
$
|
12,294.8
|
|
$
|
265,078.1
|
|
Management
has reviewed these securities which either have been in an unrealized loss
position for more than twelve months or have significant unrealized loss
relative to cost and have concluded that these securities have not experienced
any other than temporary impairment. Factors considered in making this
evaluation included issue specific drivers of the decrease in price, near term
prospects of the issuer, the length of time and degree of volatility of the
depressed value, and the financial condition of the industry. Based on this
review, no unrealized losses were considered to be other than temporary during
the nine months ended September 30, 2007.
As
a result of purchase accounting adjustments as required in connection with our
acquisition of Kanawha as of December 31, 2004, the mark to market adjustments
to the investment portfolio occurred at a time when very low market interest
rates prevailed. Therefore, as interest rates rise, we would expect substantial
unrealized investment losses. Due to the long range nature of our liabilities,
the majority of these interest related unrealized losses are not expected to
materialize into realized losses, and therefore should not have an adverse
effect on our operations.
As
of September 30, 2007, the Company held investments in mortgage-backed
securities collateralized by subprime mortgages with a carrying value of $4.5
million, representing approximately 0.7% of the Company’s cash and invested
assets. These securities have an average S&P rating of AA.
41
Table of Contents
Reserves
The
following table presents insurance policy benefit and contract-related
liabilities information as of the dates indicated, by reserve type:
|
|
|
|
|
|
|
|
|
|
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
|
|
|
|
|
|
|
|
|
(dollars in thousands)
|
|
|
Life and
annuity reserves
|
|
$
|
246,257.9
|
|
$
|
252,658.2
|
|
|
Accident and
health reserves
|
|
|
320,495.6
|
|
|
294,581.0
|
|
|
Policy and
contract claims
|
|
|
22,077.1
|
|
|
14,530.8
|
|
|
Other
policyholder liabilities
|
|
|
10,673.5
|
|
|
10,594.2
|
|
|
|
|
|
|
|
|
|
|
|
Total policy
liabilities
|
|
$
|
599,504.1
|
|
$
|
572,364.2
|
|
|
|
|
|
|
|
|
|
|
Life
and annuity reserves decreased by $6.4 million, or 2.5%, to $246.3 million as
of September 30, 2007, from $252.7 million as of December 31, 2006. A large
portion of the life and annuity reserves relates to acquired blocks of business
that are lapsing at a steady pace because no new blocks of business have been
acquired since 1999, and therefore represents a significant portion of the
decrease in reserves for the nine months ended September 30, 2007. Accident and
health reserves increased by $25.9 million, or 8.8%, to $320.5 million as of
September 30, 2007 from $294.6 million as of December 31, 2006. These reserve
increases are consistent with growth in the underlying business, with the
majority of the reserve growth being accumulated from long-term care renewal
premiums received. Policy and contract claims, which represent liabilities for
actual claims incurred, increased by $7.6 million, or 52.4%, to $22.1 million
as of September 30, 2007 from $14.5 million as of December 31, 2006. This
primarily represents the significant increase in new premiums in the stop loss
book of business, combined with higher anticipated claims described below.
After
a comprehensive review of its stop loss book of business, the Company
recognized a $6 million charge in the first quarter of 2007 for increased
claims and reserves that reflects recent experience on stop loss cases. The
Company began writing annually renewable stop loss insurance in mid-2005, and
initially relied on pricing assumptions, a common industry practice relative to
new books of stop loss business, to establish expected loss ratios due to a
lack of credible actual claim experience. As a contrast, companies with mature
books of stop loss business typically establish claim reserves as a function of
experience studies of its business. Because actual claims on stop loss cases
typically are not fully reported until after the end of the policy period, it
is a common practice to increase or decrease claims reserves once the actual
claims experience becomes known.
As
experience emerged, the Company recognized additional claims and reserves
reflecting the recent adverse claims experience. The Company also decided to
increase claims assumptions on business prospectively, reflecting a more
conservative estimate of future claims on this business. The Company’s
experience has been that it takes four quarters after a case has been written
before a clear picture becomes apparent regarding claims for that case. While
some of the unfavorable claims data began to emerge late in the fourth quarter
of 2006 and guided our reserving at year-end, new more meaningful data came to
the Company’s attention late in the first quarter of this year after the
year-end books were closed and earnings reported. As a result of the new data that
became available in the first quarter of 2007, the Company concluded that it
would be prudent to increase the estimated loss ratios on newer cases for
claims before credible claims experience has developed on this business. As a
result of these first quarter 2007 actions, the Company believes its current
claim reserves on stop loss business adequately reflect both the development of
recent experience and the Company’s more conservative outlook on loss
experience related to current premiums.
Other
policyholder liabilities, which are comprised primarily of dividend
accumulations and advance premiums, increased by $0.1 million, or 0.9%, to
$10.7 million as of September 30, 2007 from $10.6 million as of December 31,
2006.
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Table of Contents
The
following table sets forth reinsurance recoverables by category as of the dated
indicated:
|
|
|
|
|
|
|
|
|
|
|
|
As of
September 30, 2007
|
|
As of
December 31, 2006
|
|
|
|
|
|
|
|
|
|
|
|
(dollars in thousands)
|
|
|
Ceded future
policyholder benefits and expense
|
|
$
|
89,713.0
|
|
$
|
86,296.1
|
|
|
Ceded claims
and benefits payable
|
|
|
2,877.4
|
|
|
2,795.1
|
|
|
|
|
|
|
|
|
|
|
|
Reinsurance
recoverables
|
|
$
|
92,590.4
|
|
$
|
89,091.2
|
|
|
|
|
|
|
|
|
|
|
Reinsurance
recoverables increased by $3.5 million, or 3.9%, to $92.6 million as of
September 30, 2007, from $89.1 million as of December 31, 2006. The increase in
the recoverable balance is attributable to underlying business growth,
specifically the growth in long-term care and excess risk business reinsured.
Critical Accounting Policies and
Estimates
Our
consolidated financial statements and certain disclosures made in this report
have been prepared in accordance with GAAP and require us to make estimates and
assumptions that affect reporting amounts of assets and liabilities and
contingent assets and contingent liabilities at the dates of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. The estimates most susceptible to material changes due to
significant judgment (identified as the “critical accounting policies”) are
those used in determining investment impairments, the reserves for future
policy benefits and claims, deferred acquisition costs and value of business
acquired, and the provision for income taxes. The results of these estimates are
critical because they affect our profitability and may affect key indicators
used to measure our performance. These estimates have a material effect on our
results of operations and financial condition.
We
consider the following accounting policies to be critical due to the amount of
judgment and uncertainty inherent in the application of these policies. In
calculating financial statement estimates, the use of different assumptions
could produce materially different estimates. In addition, if factors such as
those described in Item 1A of this report cause actual events to differ from
the assumptions used in applying the accounting policies and calculating
financial estimates, our business, results of operations, financial condition
and liquidity could be materially adversely affected.
Reserves.
Policy benefit reserves and other claim reserves are established according to
generally accepted actuarial principles and are based on a number of factors.
Policy benefit reserves are estimated and include assumptions made when the
policy is issued as to the expected investment yield, inflation, mortality,
morbidity, claim termination rates, awards for social security and withdrawal
rates, as well as other assumptions that are based on our experience. These
assumptions reflect anticipated trends and include provisions for possible
unfavorable deviations. Throughout the life of the policy, reserves are based
on these original assumptions and cannot be modified pursuant to GAAP unless
policy reserves prove inadequate. Claim reserves are based on factors that
include historical claim payments experience and actuarial assumptions used to
estimate expected future claims experience. These assumptions and other factors
include trends in claims severity, frequency and other factors discussed below,
the incidence of incurred claims, the extent to which all claims have been
reported and internal claims processing changes. The methods of making these
estimates and establishing the related reserves are periodically reviewed and
updated. Since claim reserve estimates are refined as experience develops, they
are subject to some variability of assumptions. Relative to policy benefit
reserves, claim reserves represent a small part of the Company’s overall
reserve liabilities. Claim reserves were 2.5% of the total reserve liability at
December 31, 2006.
Policy
benefit and claim reserves do not represent an exact calculation of our
ultimate liability, but instead represent our probability-based estimate of what
we expect the ultimate settlement and administration of a claim or group of
claims will cost based on our assessment of facts and circumstances then known.
Policy benefit reserves represent reserves established for claims not yet
incurred. Claim reserves represent liabilities established for claims that have
been incurred and have future benefits to be paid as of the balance sheet date.
The adequacy of reserves will be impacted by future trends in claims severity,
frequency and other factors including:
43
Table of Contents
|
|
|
|
|
|
•
|
changes in
the economic cycle;
|
|
|
|
|
|
|
•
|
the level of
market interest rates and inflation;
|
|
|
|
|
|
|
•
|
emerging
medical perceptions regarding physiological or psychological causes of
disability;
|
|
|
|
|
|
|
•
|
emerging
health issues and new methods of treatment or accommodation;
|
|
|
|
|
|
|
•
|
legislative
changes and changes in taxation;
|
|
|
|
|
|
|
•
|
inherent
claims volatility in a new book of business, such as our employer excess risk
insurance; and
|
|
|
|
|
|
|
•
|
claims
handling procedures.
|
Many
of these items are not directly quantifiable, particularly on a prospective
basis. Claims reserve estimates are refined as experience develops. Adjustments
to reserves, both positive and negative, are reflected in the consolidated
statements of operations of the period in which such estimates are updated.
Because establishment of reserves is an inherently uncertain process involving
estimates of future losses, there can be no certainty that ultimate losses will
not exceed existing reserves. Future loss development could require reserves to
be increased, which could have a material adverse effect on earnings in the
periods in which such increases are made.
Particularly
with respect to new lines of business, there is some inherent uncertainty as to
how claims experience will emerge so, initially before actual claim experience
develops, we must rely more heavily on estimates in setting the claim reserves.
The line of business which is exposed to the greatest degree of uncertainty
relative to those estimates is the annually renewable stop loss business which
we began issuing in mid-2005. Claim reserves for this line of business
represent a short-term liability but are subject to greater variability than
other lines of business. Initially
,
we relied on pricing assumptions, a
common industry practice relative to new books of stop loss business, to
establish expected loss ratios on which our claim reserves were based.
The
Company uses actual claims data as it emerges, to re-evaluate the expected loss
ratios used to determine future claim liabilities relative to in force business
and, if necessary, would modify the estimated loss ratios on new cases as well.
To the extent that emerging experience varies from the loss ratio assumptions,
the claim reserves could be increased or decreased which could have a material
effect on earnings in the periods in which such increases or decreases are
made.
Reserving
Methodology. Policy benefit reserves for life insurance, long-term care
insurance, individual and group accident and health insurance, disability
insurance and group life and health insurance are recorded at the present value
of future benefits to be paid to policyholders less the present value of the
future net premiums (this method is called the “net level premium method”).
These amounts are estimated and include assumptions made when the policy is
issued as to the expected investment yield, inflation, mortality, morbidity,
claim termination rates, awards for social security and withdrawal rates, as
well as other assumptions that are based on our experience. These assumptions
reflect anticipated trends and include provisions for possible unfavorable
deviations. Throughout the life of the policy, reserves are based on these
original assumptions and cannot be modified pursuant to GAAP unless policy
reserves prove inadequate. We also record an unearned premium reserve which
represents the portion of premiums collected or due and unpaid which is
intended to pay for insurance coverage in a period after the current accounting
period.
Loss
recognition testing of our policy benefit reserves is performed annually. This
testing involves a comparison of our actual net liability position (all
liabilities less DAC and VOBA) to the present value of future net cash flows
calculated using then-current assumptions. These assumptions are based on our
best estimate of future experience. To the extent a premium deficiency exists,
it would be recognized immediately by a charge to the statement of operations
and a corresponding reduction in DAC or VOBA. Any additional deficiency would
be recognized as a premium deficiency reserve. Historically, loss recognition
testing has not resulted in an adjustment to DAC or reserves. These adjustments
would occur only if economic, mortality and/or morbidity conditions
significantly deviated from the underlying assumptions.
In
accordance with GAAP purchase accounting requirements, our predecessor’s policy
and contract reserves were recorded at fair value upon the closing of the Kanawha
acquisition. The policy and contract reserves were calculated as the present
value of future benefits and expenses less the present value of future net
premiums. These values were actuarially determined and were based upon assumed
future interest rates, administrative
44
Table of Contents
expenses,
mortality, morbidity and policy lapse rates as appropriate for the particular
benefit on the purchase date. For long-term care insurance, assumptions for the
present value of net premiums in the fair value calculation are consistent with
current and anticipated premium increases, including those approved in the last
twelve to eighteen months in certain jurisdictions for policies currently in
force. These assumptions now serve as the original assumptions described in the
first paragraph above under the caption “Reserving Methodology”.
Reserve
interest assumptions (i.e., discount rates) used by us in establishing our
current policy benefit reserves were modified on the purchase date. The
valuation interest rate is determined by taking into consideration actual and
expected earned rates on our asset portfolio. Benefit reserves for limited
payment policies take into account, where necessary, any deferred profits to be
recognized in income over the policy term. Policy benefit claims are charged to
expense in the period that the claims are incurred.
The
discount rate is the interest rate at which future net cash flows are
discounted to determine the present value of such cash flows. If the discount
rate chosen is higher than actual future investment returns, our investment
returns will be insufficient to support the interest rate assumed when reserves
were established. In this case, the reserves may eventually be insufficient to
support future benefit payments. Alternatively, if a discount rate is chosen
that is lower than actual future investment results, the reserves, and, for
products such as long-term care insurance, the claims incurred in the current
period will be overstated and profits will be accumulated in the reserves
rather than reported as current earnings. We set our discount rate assumptions
in conjunction with the current and expected future investment income rate of
the assets supporting the reserves. If the investment yield at which new
investments are purchased is below or above the investment yield of the
existing investment portfolio, it is likely that the discount rate chosen at
future financial reporting dates will vary accordingly.
Deferred
Acquisition Costs. The costs of acquiring new business that vary with and are
primarily related to the production of new business have been deferred to the
extent that these costs are deemed recoverable from future premiums or gross
profits and are amortized into income as discussed below. Acquisition costs
primarily consist of commissions, policy issuance expenses and some direct
marketing expenses.
For
most insurance products, amortization of DAC is recognized in proportion to the
ratio of annual premium revenue to the total anticipated premium revenue, which
gives effect to expected terminations. DAC is amortized over the premium-paying
period of the related policies. Anticipated premium revenue is determined using
assumptions consistent with those utilized in the determination of liabilities
for insurance reserves, and as such can not be subsequently modified once
established. Absent a premium deficiency, as described in the following
paragraph, variability in amortization after policy issuance is caused only by
variability in persistency (which is the annual rate at which policies remain
in effect or in force). If actual persistency is higher than assumed, then
actual amortization will be slower. In this event, premiums, claims and policy
reserves would also be higher, which when netted together would generally
increase operating profits. Conversely, if actual persistency is lower than
assumed, then actual amortization will be faster. In this event, premiums,
claims and policy reserves would also be lower, which when netted together would
generally decrease operating profits. The Company is unable to predict the
movement or impact of these offsetting items over time.
A
premium deficiency is recognized immediately by a charge to the statement of
operations as a reduction of DAC to the extent that future policy premiums,
including anticipated interest income, are not adequate to recover all DAC and
related claims, benefits and expenses. If the premium deficiency is greater
than unamortized DAC, a liability will be accrued for the excess deficiency.
The Company has never had a premium deficiency.
We
eliminated all of our predecessor’s DAC upon the closing of the Kanawha
acquisition as part of the application of GAAP purchase accounting
requirements. We began recording DAC prospectively on January 1, 2005.
Value
of Business Acquired. VOBA is the value assigned to the insurance in force of
acquired insurance companies or blocks of business at the date of acquisition.
The amortization of VOBA is recognized using amortization schedules established
at the time of the acquisitions based upon expected patterns of premiums,
mortality, policy lapses, and morbidity as adjusted to take into account
variances between expected and actual costs. VOBA is amortized over the expected
life of the underlying business reinsured (or acquired).
45
Table of Contents
We
eliminated all of our predecessor’s historical VOBA upon the closing of the
Kanawha acquisition as part of our application of GAAP purchase accounting
requirements. We simultaneously re-established VOBA for the value of our
predecessor’s in force business. VOBA interest rate assumptions to amortize the
VOBA were also reset upon the closing of the Kanawha acquisition and the rate
was approximately 6.0% on both December 31, 2005 and December 31, 2006.
Under
our assumptions as of December 31, 2006, we estimate that the amortization of
VOBA, for the next five years will be as follows:
|
|
|
|
|
|
|
Year Ended December 31:
|
|
Amortization
|
|
|
2007
|
|
4.96
|
%
|
|
|
2008
|
|
4.93
|
|
|
|
2009
|
|
5.24
|
|
|
|
2010
|
|
5.23
|
|
|
|
2011
|
|
5.14
|
|
|
Absent
a premium deficiency, variability in amortization after policy acquisition is
caused only by variability in persistency. If actual persistency is higher than
assumed, then actual amortization will be slower. In this event, premiums,
claims and policy reserves would also be higher, which when netted together
would generally increase operating profits. Conversely, if actual persistency
is lower than assumed, then actual amortization will be faster. In this event,
premiums, claims and policy reserves would also be lower, which when netted
together would generally decrease operating profits. The Company is unable to
predict the movement or impact of these offsetting items over time.
A
premium deficiency is recognized immediately by a charge to the statement of
operations as a reduction of VOBA to the extent that future policy premiums,
including anticipated interest income, are not adequate to recover all VOBA and
related claims, benefits and expenses. If the premium deficiency is greater
than unamortized VOBA, a liability will be accrued for the excess deficiency.
The Company has never had a premium deficiency.
Investments.
We regularly monitor our investment portfolio to ensure that investments that may
be other than temporarily impaired are identified in a timely fashion and
properly valued and that any impairment is charged against earnings in the
proper period. Our investment portfolio is managed by an external asset
management firm, with the exception of certain invested assets that are managed
internally. Our methodology used to identify potential impairments requires
judgment by us in conjunction with our investment managers.
Changes
in individual security values are monitored on a monthly basis in order to
identify potential problem credits. In addition, pursuant to our impairment
testing process, each month the portfolio holdings are reviewed with additional
screening for securities whose market price is equal to 80% or less of their original
purchase price. Management then makes an assessment as to which of these
securities are other than temporarily impaired. Assessment factors include, but
are not limited to, the financial condition and rating of the issuer, any
collateral held and the length of time the market value of the security has
been below cost. Each month the watch list is distributed to our investment
committee and the outside investment managers, and discussions are held as
needed in order to make any impairment decisions. Each quarter any security
deemed to have been other than temporarily impaired is written down to its then
current market value, with the amount of the write-down reflected in the
statement of operations for that quarter. Previously impaired issues are also
monitored monthly, with additional write-downs taken quarterly if necessary.
There
are risks and uncertainties involved in making these judgments. Changes in
circumstances and critical factors such as a continued weak economy, a
pronounced economic downturn or unforeseen events which affect one or more
companies, industry sectors or countries could result in additional write-downs
in future periods for impairments that are deemed to be other-than-temporary.
Effective
December 31, 2004, our investments were recorded at fair value, thereby
eliminating all unrealized gains and losses, as part of the application of GAAP
purchase accounting requirements. Since that time, the Company has recognized
impairment charges of $0.0 million and $0.2 million in 2006 and 2005,
respectively.
46
Table of Contents
Reinsurance.
As part of our overall risk and capacity management strategy, we purchase
reinsurance for loss protection to manage individual and aggregate risk
exposure and concentration, to free up capital to allow us to write additional
business and, in some cases, effect business dispositions. We utilize ceded
reinsurance for those product lines where there is exposure on a per risk basis
or in the aggregate which exceeds our internal risk retention and concentration
management guidelines.
Reinsurance
recoverables represent the portion of the policy and contract liabilities that
are covered by reinsurance. These liabilities include reserves for life,
annuity, accident and health, policy and contract claims and other policyholder
liabilities as shown in the consolidated balance sheets. The cost of
reinsurance is accounted for over the terms of the underlying reinsured
policies using assumptions consistent with those used to account for the
policies reinsured. Amounts recoverable from reinsurers are estimated in a
manner consistent with the methods used to determine the underlying liabilities
reported in our and our predecessor’s consolidated balance sheets.
Under
indemnity reinsurance transactions in which we are the ceding insurer, we
remain liable for policy claims if the assuming company fails to meet its
obligations. In the event one or more assuming companies were to default on its
obligations, it could have an adverse effect on our business, results of
operations and financial condition. To limit this risk, we have implemented
procedures to evaluate the financial condition of reinsurers and to monitor the
concentration of credit risk to minimize this exposure. In some cases, the
reinsurers have placed amounts in trust that would be the equivalent of the
recoverable amount and for which we are the beneficiary. The selection of
reinsurance companies is based on criteria related to solvency and reliability
and, to a lesser degree, diversification. An estimated allowance for doubtful
accounts is recorded on the basis of periodic evaluations of balances due from
reinsurers, reinsurer solvency, management experience and current economic
conditions. As of December 31, 2006, 2005 and 2004, there were no allowances
for doubtful accounts. The Company has never written off any amounts due to
unrecoverable reinsurance.
Forward-Looking
Statements
Forward-looking
statements in the foregoing Management’s Discussion and Analysis of Financial
Condition and Results of Operations include statements that are identified by
the use of words or phrases including, but not limited to, the following: “will
likely result”, “expected to”, “will continue”, “is anticipated”, “estimated”,
“project”, “believe”, “expect” and words or phrases of similar import. Changes
in the following important factors, among others, could cause our actual
results to differ materially from those expressed in any such forward-looking
statements: competitive products and pricing; fluctuations in demand; possible
recessionary trends in the United States economy; governmental policies and
regulations; interest rates; our shareholders may not approve and adopt the
proposed Merger agreement with Humana; the parties to the Merger may be unable
to obtain governmental and regulatory approvals required for the Merger;
required governmental or regulatory approvals may delay the Merger or result in
the imposition of conditions that could cause the parties to abandon the
Merger; the parties may be unable to complete the Merger because, among other
reasons, conditions to the closing of the Merger may not be satisfied or
waived; risks disclosed in Part I Item 1A to Annual Report of Form 10-K for the
year ended December 31, 2006 and in Part II, Item IA of this report and our
Quarterly Report on Form 10Q for the quarter ended March 31, 2007; and other
risks that are detailed from time to time in reports we file with the
Securities and Exchange Commission. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise.