ITEM 1. DESCRIPTION OF BUSINESS
General
Unless otherwise indicated, the terms "we," "us," "our" and "CII Financial" refer to CII Financial, Inc. and its subsidiaries.
We are a holding company whose subsidiaries, California Indemnity Insurance Company, Commercial Casualty Insurance Company, Sierra Insurance Company of Texas and CII Insurance Company are primarily engaged in writing workers' compensation insurance in nine Western and Midwestern states. The four insurance subsidiaries are also referred to as the Sierra Insurance Group. Substantially all of our assets and our operations are conducted through our subsidiaries. In addition, we had other smaller subsidiaries that we consider immaterial to our overall results.
Our parent is Sierra Health Services, Inc., or Sierra, a publicly traded (NYSE: SIE) managed healthcare company located in Las Vegas, Nevada. We were acquired by Sierra on October 31, 1995 in a transaction treated as a pooling of interests.
Our subsidiaries write workers' compensation insurance in the states of California, Colorado, Nevada, Texas, Nebraska, Kansas, Missouri, New Mexico and Utah primarily through independent insurance agents and brokers, and have licenses in 36 states and the District of Columbia and applications pending for licenses in other states. California, Colorado and Nevada represented approximately 72%, 9% and 10%, respectively, of our direct written premiums for the year ended December 31, 2001.
We focus on writing lower-severity classes of workers' compensation insurance for primarily small and mid-sized employers although we actively pursue accounts of all sizes. This strategy allows us to direct our managed care expertise to employers that may lack the in-house resources needed to manage costs effectively and to return injured workers to work safely and quickly. These techniques include the use of specialized preferred provider networks, utilization review by our board certified occupational medicine physician and the employment of nurse case managers, medical bill reviewers, and job developers to facilitate early return to work. In particular, our Return to Work, or RTW, Program has brought a large number of injured workers back to the job more quickly and at a lower cost than would have otherwise been possible.
By focusing primarily on small and mid-sized employers, we seek to target under-served segments of the workers' compensation market and avoid the price competition associated with large accounts. As of December 31, 2001, we had 11,679 policies inforce and an average annualized premium policy size of approximately $14,419.
The following table sets forth the percentages of our premiums inforce at December 31, 2001, 2000 and 1999 attributable to the listed risk classifications identified as the insureds' governing class:
December 31, 2001 2000 1999 ---- ---- ----
Construction.................. 24.9% 30.5% 29.7% Manufacturing................. 15.7 15.2 16.3 Service Industry.............. 12.8 12.6 13.1 Hospitality................... 12.8 8.6 8.6 Agriculture................... 10.4 12.5 10.9 Other (1)..................... 23.4 20.6 21.4 ----- ----- ----- Total......................... 100.0% 100.0% 100.0% ===== ===== =====
(1) Includes all other risk classifications insured by us, none of which accounted for more than 7.5% of our written premiums inforce as of any of the above dates.
Debentures
At September 30, 2000, we had outstanding approximately $47.1 million of subordinated debentures that were due on September 15, 2001. These subordinated debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. In December 2000, we commenced an offer to exchange the subordinated debentures for cash and/or new debentures. On May 7, 2001, we closed our exchange offer on $42.1 million of our outstanding subordinated debentures. We purchased $27.1 million in principal amount of subordinated debentures for $20.0 million in cash and issued $15.0 million in new 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in subordinated debentures. The transaction was accounted for as a restructuring of debt; therefore all future cash payments, including interest, related to the debentures will be reductions of the carrying amount of the debentures and no future interest expense will be recognized. Accordingly, the new 9 1/2% senior debentures have a carrying amount of $19.2 million, which consists of principal of $15.0 million and $4.2 million in future accrued interest.
In September 2001, the California Department of Insurance gave approval to California Indemnity to pay a dividend of $5.0 million to CII Financial. CII Financial used these funds to pay the remaining $5.0 million in subordinated debentures at maturity. CII Financial expects to service the new 9 1/2% senior debentures from future cash flows, primarily from dividends that will be paid by its insurance subsidiaries from their future earnings.
Other
Our principal executive offices are located at 2716 North Tenaya Way, Las Vegas, Nevada 89128, and our telephone number is (702) 242-7040.
Our fiscal year period is the same as the calendar year and unless otherwise indicated, any year designated will refer to the year ended December 31.
Underwriting
Prior to insuring a particular risk, we review, among other factors, the employer's prior loss experience and other pertinent underwriting information. Additionally, we determine whether the employer's employment classifications are among the classifications that we have elected to insure and if the amounts of the premiums for the classifications are within our guidelines. We review these classifications periodically to evaluate whether they are profitable. We are willing to insure approximately one-half of the approximately 500 employment classifications in California. The remaining classifications are either excluded by our reinsurance treaty or are believed by us to be too hazardous or not profitable. In addition, we increase our underwriting requirements for certain classifications to increase the likelihood of profitability.
Once an employer has been insured by us, our loss control department may assist the insured in developing and maintaining safety programs and procedures to minimize on-the-job injuries and industrial health hazards. The safety programs and procedures vary from insured to insured. Depending upon the size, classifications and loss experience of the employer, our loss control department will periodically inspect the employer's places of business and may recommend changes that could prevent industrial accidents. In addition, severe or recurring injuries may also warrant on-site inspections. In certain instances, members of our loss control department may conduct special educational training sessions for insured workers to assist in the prevention of on-the-job injuries. For example, employers engaged in contracting may be offered a training session on general first aid and prevention of injuries from specific work exposures.
Claims
Our claims operation is organized into a centralized claims/managed care service office in Las Vegas, Nevada, and four regional claims service offices. Major claims, those of high severity, complex nature and/or which are expected to exceed applicable reinsurance retention levels, are handled directly, or supervised, by the reinsurance claims staff.
Our approach to claims administration relies upon a high level of interaction with the injured worker and the insured to resolve claims in an efficient and cost effective manner. Claims personnel act as the contact point with the insured and refer the claim to the appropriate support services within our managed care and RTW functions.
Sierra Health and Life Insurance Company. Effective December 2000, for all claims other than from our Texas operation, we have contracted our medical management, bill review and return to work functions with Sierra Health and Life Insurance Company's Workers' Compensation Managed Care Division. The arrangement is at cost. The staff of the Managed Care Division consists of 83 employees who were previously employed by California Indemnity Insurance Company in the same capacity. Sierra Health and Life Insurance Company is a wholly-owned subsidiary of Sierra.
We have sought to reduce medical and indemnity costs by minimizing litigation and litigation expense, returning workers to work safely and quickly, and having access to medical attention at competitive prices. We have sought to accomplish this by:
o using statewide medical provider networks, in which the members have agreed to provide hospital and physician services at reduced fee schedules;
o utilizing medical bill review services, which advise us of any excess charges submitted by providers;
o facilitating early return to work and managing vocational rehabilitation costs;
o improving customer service to allow for faster reporting; and
o outsourcing legal defense.
Use of Managed Care. We use managed care techniques to manage claim costs. Except where limited by law, our managed care strategy directs injured workers to preferred provider organizations, which we refer to as PPOs, to take advantage of rates negotiated by the PPOs with participating providers and to utilize doctors who understand the procedures and communication required to allow injured workers to return to work safely and quickly. This strategy has led us to spend substantially less on medical costs than otherwise payable under state established fee schedules. In 2001, our use of PPOs as a percentage of total medical bills where a saving was achieved, known as "PPO penetration," averaged 44% and the savings from state established fee schedules averaged 28%.
Management of the medical portion of any claim assists the employer in managing the cost of the indemnity benefit. Our staff of nurses evaluates lost-time cases and directs the injured worker to preferred providers. We utilize a board certified occupational medicine physician as medical director to provide prospective, concurrent, and retrospective review of inpatient admissions. The medical director can communicate directly with treating physicians to assist with the direction of appropriate and timely medical care. By requesting the treating provider to obtain authorization prior to the administration of medical care, we seek to receive medical justification for proposed treatments, which often leads to more accurate medical diagnoses. We have used the medical authorization process to reduce the costs associated with over-treating or under-treating by medical care providers.
Medical Bill Review. We use medical bill reviewers to manage costs. By performing the bill review work, we have increased our bill review savings as a percentage of state fee schedules from 25% for 1995 to 43% for the year ended December 31, 2001.
Return to Work, or "RTW", Program. A critical component of our claims administration approach and our accompanying efforts to reduce indemnity costs is our RTW Program. The program assigns certain claims to a RTW technician, who contacts the injured worker's physician and employer to ascertain functional capacity restrictions and determines whether the worker can perform modified or temporary work. In an unmanaged environment, the doctor typically relies upon the injured worker's description of job duties and bases the medical impairment and disability status upon that subjective description. Such reliance on the worker's description can lead to increased amounts of lost time and, therefore, much higher indemnity payments by us. The RTW technician's task is to work with the doctor and the employer to formally define job duties and to compare those against functional capacity restrictions. This process allows the RTW technician to determine the extent of job disability and the need for vocational rehabilitation as required by the state. By being directly involved with the assessment process, we not only strive to obtain an objective disability diagnosis, but also provide a valuable service to our smaller insureds, who typically do not have formalized processes for return to work.
Customer Service. Early claims reporting allows us to direct the injured worker to in-network medical care providers, to enroll those workers in the RTW program, and to reduce the chance of litigation. We have instituted a 24-hour per day, seven days per week, toll free "800" telephone number that allows employers to notify us of a potential claim as quickly as possible.
Our customer service call center directs policyholders and injured workers to the nearest preferred health care facility and provides assistance to claims examiners by asking specific investigative questions which allows the examiner to make prompt claim decisions. The customer service representatives additionally answer questions relating to provider bill status, pharmacy authorization, and agent/employer requests for information.
California Health Care Organization ("HCO"). In December 2000, Sierra Health and Life Insurance Company was licensed in California as a Health Care Organization by the California Department of Managed Care.
A California Health Care Organization assists in the coordination of the health care delivery system for the injured worker and provides certain quality assurance, medical management and return to work assistance. We began utilizing Sierra Health and Life as a California Health Care Organization in the first quarter of 2001 and to date have enrolled 16% of our California inforce premiums in the HCO. Over 60% of our California January 2002 new and renewal premiums will participate in the HCO. The California Health Care Organization improves the number of days of medical management from 30 days to 90, 180 and in some instances 365 days. In February 2002, new California legislation reduced the maximum number of days of medical management to 180.
Competition
Workers' compensation is a statutory system that requires an employer to provide its workers with medical care and other specified benefits for work-related injuries, even though the injuries may have resulted from the negligence or wrongs of a person, including the worker. Employers typically purchase workers' compensation insurance to provide these benefits. The benefits payable are generally established by statute.
The California workers' compensation insurance industry is extremely competitive. Approximately 160 companies wrote workers' compensation insurance in California in 2001, including the State Compensation Insurance Fund, which is the largest writer in California and the dominant competitor. Many of these companies have been in business longer, have a larger volume of business, offer a more diversified line of insurance coverage, have greater financial resources and have greater distribution capabilities than us. We concentrate on insuring workers' compensation accounts in the small to medium-size range, where we compete primarily on the basis of price and service and where policyholder dividends are not a significant factor.
Based on 2000 direct written premiums, we were the 11th largest writer of workers' compensation insurance in California, with a 2.3% market share. Our insurance subsidiaries are currently rated B by the A.M. Best Company and BBB by Fitch Ratings.
The following table provides an illustration of the top 10 workers' compensation writers in the state of California for 2000:
California Workers' Compensation Market
Based on 2000 Direct Written Premium (dollars in millions)
Direct Written Market Insurer Premiums Share ------- -------- -----
State Compensation Fund ............. $ 1,799.0 26.5%
Fremont Comp Insurance Group......... 453.4 6.7
Liberty Mutual Group................. 429.6 6.3
Zurich US ........................... 368.5 5.4
Legion Insurance Group............... 292.1 4.3
American International Group......... 276.8 4.1
Superior National Ins. Group......... 262.4 3.9
Kemper Insurance Companies........... 252.2 3.7
Great American P&C (Republic)........ 198.1 2.9
Allianz/Fireman's Fund............... 170.0 2.5
Sierra Insurance Group............... 155.6 2.3
Source: California Workers' Compensation Institute
Prior to 1995, California law set minimum premium rates. This minimum rate law was repealed by the California legislature with policies issued or renewed on or after January 1, 1995. From 1995 until the end of 1999, our pricing declined significantly as competitors sought to write more business by cutting their prices. Beginning in December 1999, we began achieving rate increases on renewing policies. Our average rate increase on renewal policies in 2001 and 2000 was 23% and 38%, respectively. This increasing rate trend has continued through February 2002 where we have averaged a 33% increase.
In other states in which we are currently writing business, competition for workers' compensation insurance is primarily driven by pricing, dividend plans and agents' commission. In these states, the National Council on Compensation Insurance, or NCCI, is usually the designated rating organization. The NCCI accumulates statistical information and recommends pure loss cost rates to each state's department of insurance who has final approval authority. We then add loss cost multipliers or expense loads to derive premium rates for each filed company. Rating plans in NCCI states are more "standardized" pricing models based upon plans (algorithms) developed by the NCCI and approved by departments of insurance.
Colorado has a competitive and dominant state insurance fund, Pennacol Insurance Company, which represents the major competition. In Nevada, Employers Insurance Company of Nevada, formerly a state fund but now a private mutual insurer is the largest carrier. In addition to these two organizations, there are approximately 200 other companies competing for business in states outside of California. Two competitive tools in NCCI states are participating policies, which pay policyholders' dividends, and policies with retrospective rated premium. We currently offer participating policies or policies with retrospective rated premiums in Colorado, Nevada, Missouri, Nebraska, New Mexico and Kansas. Nevada changed to an open rating environment from a minimum rate law beginning July 2001. The average rates on renewal policies from July 2001 through December 2001 have increased 3%.
Losses and Loss Adjustment Expenses
Often, several years may elapse between the occurrence of a loss and the final settlement of the loss. To recognize liabilities for unpaid losses, we establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses for insured events. We also establish reserves for events that have been incurred but have not yet been reported to us, which we refer to as "incurred but not reported" or "IBNR".
When a claim is reported, our claims personnel initially establish reserves on a case-by-case basis for the estimated amount of the ultimate payment. These estimates reflect the judgment of the claims personnel based on their experience and knowledge of the nature and value of the specific type of claim and the available facts at the time of reporting as to severity of injury and initial medical prognosis. Included in these reserves are estimates of the expenses of settling claims, including legal and other fees. Claims personnel adjust the amount of the case reserves as the claim develops and as the facts warrant.
IBNR reserves are established for unreported claims and loss development relating to current and prior accident years. In the event that a claim that occurred during a prior accident year was not reported until the current accident year, the case reserve for such claim typically will be established out of previously established IBNR reserves for that prior accident year.
The National Association of Insurance Commissioners requires that we submit a formal actuarial opinion concerning loss reserves with each statutory annual report. The annual report must be filed with each applicable state department of insurance on or before March 1 of the succeeding year. The actuarial opinion must be signed by a qualified actuary as determined by the California Insurance Commissioner. We retain the services of a qualified independent actuary to periodically review our loss reserves.
Our average cost per claim has increased each year since 1995 and the majority of our claims occur in California. The entire California workers' compensation industry has been adversely affected by higher claim severity. According to a published estimate by the Workers' Compensation Insurance Rating Bureau of California in December 2001, the average ultimate loss per indemnity claim in California increased 69% from accident year 1995 to accident year 2000. Factors influencing this increase include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical control of claimant's treatment. According to the California Workers' Compensation Institute, an industry association, industry-wide workers' compensation medical costs in California have far outstripped medical inflation, rising 15.3% in 1997, 15.8% in 1998, 13.6% in 1999 and 14.7% in 2000.
In 2001, we continued to see adverse reserve development on prior accident years. The total net adverse reserve development on prior accident years through December 31, 2001 was $8.7 million. The reserve deficiency was related to adverse reserve development on California claims primarily in accident years 1995 to 1998 and was due to continuing increases in average claim costs. In February 2002, new legislation was enacted in California that will increase benefits to injured workers starting January 1, 2003. The Workers' Compensation Insurance Rating Bureau of California has preliminarily estimated that the 2003 loss costs will increase by approximately 7%.
We and an independent actuary test the adequacy of our reserves using standard actuarial methods. Both paid loss and incurred loss methods are used to estimate the amount of the ultimate reserves. We also test our reserves by comparing our paid losses and incurred losses to similar data provided by the California Workers Compensation Insurance Rating Bureau for all California workers' compensation insurance companies.
We review the adequacy of our reserves with our independent actuary periodically and consider external forces such as changes in the rate of inflation, the regulatory environment, the judicial administration of claims, medical costs and other factors that could cause actual losses and loss adjustment expenses, or LAE, to change. The actuarial projections include a range of estimates reflecting the uncertainty of projections. Management evaluates the reserves in the aggregate, based upon the actuarial indications and makes adjustments where appropriate. Our consolidated financial statements provide for reserves based on the anticipated ultimate cost of losses. Due to the inherent uncertainty in projecting reserves, it is not only possible but probable that there will be differences between the projections and the actual developed reserves. Any difference would be reflected in our current results of operations.
The following table sets forth the number of claims reported to us for the years ended December 31, 2001, 2000 and 1999, and related direct earned premiums and claims frequency, or the number of claims per million dollars of direct earned premium.
Years Ended December 31, 2001 2000 1999 ---- ---- ----
Number of claims reported during year.......... 13,600 20,600 17,500 Direct earned premiums (in millions)........... $186.3 $203.1 $146.7 Claims frequency............................... 73.0 101.4 119.3
The following table sets forth, for the years ended December 31, 2001, 2000 and 1999, the cumulative loss ratio, net of reinsurance, for each accident year and also shows how the net loss ratios have developed during each of these three years.
Cumulative Net Loss Ratios Years Ended December 31, Accident Year 2001 2000 1999 ------------- ---- ---- ---- 1995 and prior...... 72.91% 72.30% 72.05% 1996 ............. 95.54 93.00 89.60 1997................ 99.44 96.22 90.42 1998................ 90.52 88.44 83.64 1999................ 65.02 66.53 62.13 2000................ 65.00 69.07 2001................ 76.02
The following table sets forth, for the years ended December 31, 2001, 2000 and 1999, the cumulative loss ratio, gross of reinsurance, for each accident year and also shows how the gross loss ratios have developed during each of these three years.
Cumulative Gross Loss Ratios Years Ended December 31, Accident Year 2001 2000 1999 ------------- ---- ---- ----
1995 and prior 73.13% 72.37% 71.98% 1996 94.75 91.71 88.41 1997 101.63 96.17 90.08 1998 106.55 102.50 92.08 1999 121.68 116.23 96.48 2000 109.23 105.57 2001 83.51
The liabilities for losses and loss adjustment expense, which we refer to as LAE, are determined using actuarial loss evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of trends in claim severity and frequency and are continually reviewed and adjusted to reflect new experience and information, as it becomes known. Such adjustments, if any, are reflected in current operations. Notwithstanding the fact that the claims for which reserves are established may not be paid for many years, the reserves for losses and LAE payments are not discounted, except to calculate the liability for federal income taxes. The anticipated price or cost increases due to inflation are considered in estimating ultimate claim costs. Historical trends, adjusted to reflect anticipated changes in underwriting standards, policy provisions and general economic trends, provide the basis and assumptions for predicting the severity of future claims. Actual developments are monitored and anticipated trends are modified, if necessary.
The following table provides a reconciliation of beginning and ending liability balances for the years ended December 31, 2001, 2000 and 1999.
Reconciliation of Liability for Loss and Loss Adjustment Expenses (In thousands)
Years Ended December 31, 2001 2000 1999 ---- ---- ----
Net Beginning Loss and LAE Reserves.................... $155,797 $134,305 $174,467
Net Provision for Insured Events Incurred in: Current Year..................................... 131,923 86,587 51,541 Prior Years...................................... 8,691 23,293 9,920 ------- ------- ------- Total Net Provision.................................. 140,614 109,880 61,461 ------- ------- -------
Net Payments for Loss and LAE Attributable to Insured Events Incurred in: Current Year..................................... 28,560 26,867 21,207 Prior Years...................................... 69,599 61,521 80,416 ------- ------- ------- Total Net Payments................................... 98,159 88,388 101,623 ------- ------- -------
Net Ending Loss and LAE Reserves 198,252 155,797 134,305 Reinsurance Recoverable................................ 187,453 218,757 110,089 ------- ------- -------
Gross Ending Loss and LAE Reserves..................... $385,705 $374,554 $244,394 ======= ======= =======
During the years ended December 31, 2001 and 2000, we experienced prior year net adverse loss development of $8.7 million and $23.3 million, respectively. In 2001, estimated losses and LAE incurred in accident years 1996 to 1999 have developed significantly due to the continuation of increasing claim severity patterns on our California book of business. This trend continued into 2001 where estimated losses and LAE incurred on accident years 1995 to 1998 adversely developed. Many workers' compensation insurance carriers in California are also experiencing high claim severity. Factors influencing the higher claim severity include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical management of a claimant's treatment. In February 2002, new legislation was enacted in California that will largely negate the adverse court decisions related to medical control.
For claims occurring on and after July 1, 1998, we have reinsured a percentage of the higher claim severity under our low level reinsurance agreement. The low level reinsurance agreement expired on June 30, 2000; however, we opted to continue ceding premiums and losses under the low level agreement on a run-off basis for all policies inforce on June 30, 2000. Effective January 1, 2000, we entered into a three year reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. We intend to elect a run-out option that will cover claims on policies inforce as of December 31, 2002. On July 1, 2000, we entered into a reinsurance agreement that covered losses on claims in excess of $250,000 up to $500,000 for policies issued after June 30, 2000. This agreement terminated on a cut-off basis and covered claims occurring through June 30, 2001.
For the year ended December 31, 1999, we recorded net adverse loss development on prior accident years of $9.9 million, primarily for accident years 1996 to 1998. This adverse development was largely due to the higher average California claim severity patterns that we experienced in the last half of 1999.
The following table discloses our development of the liability for losses and LAE for each of the ten year periods ended December 31, 2001. The information is prepared using accounting principles generally accepted in the United States of America. The information shown in each of the year columns represent cumulative development data on the reserves reported on the balance sheets at December 31 of each year. The table does not show individual accident year loss development as it includes reserves on open claims from prior accident years. For example, if an open claim has a reported reserve at December 31, 1993 and the reserve is increased by $5,000 in the year ended December 31, 1998, the $5,000 development will be reflected in the cumulative development in each of the years 1993 through 1998.
The first line shows the loss and LAE reserves reported on the balance sheet. From this is deducted reinsurance recoverables on ceded loss and LAE reserves and the result is the net loss and LAE reserves. The section titled "Net Reserve Re-estimated" shows how these net reserves have changed each year, as more information becomes available. We refer to these changes as loss development and the loss development on all years is reflected in the current results of operations. The section titled "Cumulative Net Paid" shows the cumulative payments, net of reinsurance, made on these reserves in each of the succeeding years. The line "Cumulative (Deficiency) Redundancy" shows the aggregate change between the net loss and LAE reserves and the last amount shown as net re-estimated reserves. The impact on the results of operations for each of the three most recent years is shown in the preceding "Reconciliation of Liability for Losses and Loss Adjustment Expenses" table as a "Net Provision for Insured Events Incurred in Prior Years." The bottom section of the following table shows the cumulative development on a gross reserve basis, before deducting reinsurance.
Conditions and trends that have historically affected our reserves may not necessarily occur in the future and it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
ANALYSIS OF LOSSES AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT (In thousands)
Years ended December 31, 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Losses and LAE Reserve...... $385,705 $374,554 $244,394 $212,264 $202,699 $187,776 $182,318 $190,962 $200,356 $178,460 $112,749 Less Reinsurance Recoverables (1).......... 187,453 218,757 110,089 37,797 21,056 15,676 25,871 29,342 25,841 20,207 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------
Net Loss and LAE Reserves... 198,252 155,797 134,305 174,467 181,643 172,100 156,447 161,620 174,515 158,253
Net Reserve Re-estimated as of: 1 Year Later................ 164,488 157,598 184,386 172,000 163,130 141,163 139,741 160,562 154,388 140,815 2 Years Later............... 171,136 204,029 173,596 146,987 132,193 125,279 141,100 147,167 142,447 3 Years Later............... 218,626 186,794 140,563 113,766 117,792 126,483 134,747 143,433 4 Years Later............... 198,403 146,266 102,652 102,955 122,517 132,193 137,143 5 Years Later............... 153,423 104,249 95,997 114,443 131,112 135,249 6 Years Later............... 108,208 95,954 112,284 127,258 135,299 7 Years Later............... 98,482 111,883 125,936 133,729 8 Years Later............... 113,929 125,907 132,696 9 Years Later............... 127,225 132,836 10 Years Later.............. 133,425
Cumulative Net Paid as of: 1 Year Later................ 69,599 61,522 80,416 71,933 56,977 45,731 44,519 50,210 50,360 57,611 2 Years Later............... 103,855 124,191 117,794 91,765 70,854 68,619 79,788 84,465 89,177 3 Years Later............... 159,335 143,369 113,054 83,674 80,645 94,865 104,569 108,849 4 Years Later............... 164,584 125,024 91,115 86,381 102,395 114,293 120,539 5 Years Later............... 135,421 95,609 89,601 106,012 119,462 126,100 6 Years Later............... 100,365 91,676 107,850 122,000 129,060 7 Years Later............... 93,789 109,201 123,291 130,649 8 Years Later............... 110,743 124,220 131,346 9 Years Later............... 125,147 131,898 10 Years Later.............. 132,506
Cumulative (Deficiency) Redundancy .............. (8,691) (36,831) (44,159) (16,760) 18,677 48,239 63,138 60,586 31,028 (20,676)
Net Reserve................. 198,252 155,797 134,305 174,467 181,643 172,100 156,447 161,620 174,515 Reins. Recoverables......... 187,453 218,757 110,089 37,797 21,056 15,676 25,871 29,342 25,841 ------- ------- ------- ------- ------- ------- ------- ------- ------- Gross Reserve............... $385,705 374,554 244,394 212,264 202,699 187,776 182,318 190,962 200,356 ======= ------- ------- ------- ------- ------- ------- ------- -------
Net Re-estimated Reserve.... 164,488 171,136 218,626 198,403 153,423 108,208 98,482 113,929 Re-estimated Reins. Recoverables............. 248,856 146,890 49,260 22,910 16,847 26,989 30,037 26,092 ------- ------- ------- ------- ------- ------- ------- ------- Gross Re-estimated Reserve.................. 413,344 318,026 267,886 221,313 170,270 135,197 128,519 140,021 ------- ------- ------- ------- ------- ------- ------- ------- Gross Cumulative (Deficiency) Redundancy............ $(38,790) $(73,632) $(55,622) $(18,614) $ 17,506 $ 47,121 $ 62,443 $ 60,335 ======= ======= ======= ======= ======= ======= ======= =======
(1) Amounts reflect reinsurance recoverable under prospective reinsurance contracts and the cumulative amortization of retroactive reinsurance recoverable. Unamortized retroactive reinsurance recoverable is excluded as it does not reduce incurred losses under accounting principles generally accepted in the United States of America. We adopted Financial Accounting Standards Board Statement No. 113, "Accounting and Reporting for Short-Duration and Long-Duration Reinsurance Contracts" for the year ended December 31, 1992. As permitted, prior financial statements have not been restated. Reinsurance recoverables on unpaid losses and LAE are shown as an asset on the balance sheets. However, for purposes of the reconciliation and development tables, loss and LAE information are shown net of reinsurance.
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Our average cost per claim has increased each year since 1995. The majority of our claims occur in California. The entire California workers' compensation industry has been adversely affected by higher claim severity. The average ultimate loss per indemnity claim for California increased 69% from accident year 1995 to accident year 2000, according to a published estimate of the California Workers Compensation Insurance Rating Bureau in December 2001. Two of the factors influencing this increase are medical inflation and adverse court decisions related to medical control of claimant's treatment. In February 2002, California enacted new legislation that gives the employer and insurance companies more input into the claimant's medical treatment where the claimant has not pre-designated a treating physician for claims occurring on or after January 1, 2003. Unallocated loss adjustment expense reserves are established for the estimated costs related to the general administration of the claims adjustment process. We review the adequacy of our reserves on a periodic basis and consider external forces such as changes in the rate of inflation, the regulatory environment, the judicial administration of claims, medical costs and other factors that could cause actual losses and loss adjustment expenses to change. Reserves are reviewed with our independent actuary at least annually and usually semi-annually. The actuarial projections include a range of estimates reflecting the uncertainty of projections. Management evaluates the reserves in the aggregate, based upon the actuarial indications, and makes adjustments where appropriate. Our financial statements provide for reserves based on the anticipated ultimate cost of losses.
Investments
As of December 31, 2001, our bond and preferred stock portfolio is invested primarily in high quality investment grade securities, which represent approximately 99% of total bond and preferred stock investments. The total bond and preferred stock portfolio is comprised of approximately 23% in U.S. Treasury securities; approximately 59% in U.S. Government-sponsored Agency securities; approximately 13 % in AA-rated corporate bonds; approximately 4% in A-rated corporate bonds; and approximately 1% in BAA-rated or lower corporate bonds.
In addition to our cash and cash equivalents, preferred stocks and fixed income bond portfolio, other investments include mortgage loans with a book value of $12.4 million, a $7.5 million secured note receivable from Sierra, an investment in income producing property of $1.6 million, and a real estate limited partnership with a book value of $767,000. The mortgage loan investments are comprised of approximately $9.0 million in commercial mortgages on real business properties in Las Vegas, Nevada extended to unaffiliated third parties and approximately $3.4 million in relocation mortgages extended to our current and former employees prior to our 1995 merger with Sierra. While mortgages and mortgage-backed securities usually have a higher rate of return than rated corporate and government bonds, we do face the potential risk associated with having to reinvest these funds if interest rates drop and the mortgages are prepaid. Since these mortgages are typically prepaid when rates are lower we would probably have to reinvest in other securities with a lower rate of return. The real estate limited partnership represents our interest in the partnership which owned our Las Vegas headquarters. In December 2000, the real estate that the limited partnership owned was sold to an unaffiliated third party. Approximately $14 million of our investment assets as of December 31, 2001 are booked as "assets held to maturity" according to SFAS No. 115. Assets held to maturity are carried at amortized cost; changes in the market value of these assets do not affect their book value for reporting purposes under accounting principles generally accepted in the United States of America.
We manage our investment portfolio to provide liquidity for claims and other liabilities and to maximize total return within the financial constraints of applicable regulatory guidelines and requirements. We manage liquidity by estimating the timing of claims and operating expense payments and premium revenues received as well as the timing of payments to and from our reinsurers. During 2000, we had to reduce our estimates of premiums receipts and increase our estimates of claims payments during the year. This was primarily due to negative cash flow resulting from paying more ceded premiums to our reinsurers than had previously been projected. We successfully met these revised estimates by selling a portion of our investment portfolio while trying to minimize net realized capital losses to $620,000. In 2001, we decided to make slight modifications in the mix of our corporate, municipal and government agencies bond portfolio which resulted in our realizing net capital gains of $392,000.
The following table reflects investments, interest earned thereon and the average annual yield on investments for the periods indicated:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (Dollars in thousands) Total cash, cash equivalents and invested assets at end of period........................ $261,285 $247,151 $226,572 Net investment income including net realized gains and losses before taxes......... 15,867 14,454 15,395 Average annual yield on investment portfolio (before realized gains and losses and taxes).............................. 6.1% 6.3% 6.2%
The following table sets forth information concerning the composition of our investment portfolio at December 31, 2001:
Percent of Amount Portfolio (Dollars in thousands) ------ --------- Fixed maturities, at fair value: U.S. government and government agencies..................... $190,194 78% AAA......................................................... 911 0 AA.......................................................... 27,067 11 A........................................................... 6,169 3 Less than A................................................. 1,723 1 ------- --- Total fixed maturities, at fair value....................... 226,064 93
Equity securities, at fair value............................ 5,884 2 Mortgage loans receivable................................... 12,390 5 Real estate partnership..................................... 767 0 -------- --- Total investments........................................... $245,105 100% ======= ===
The following table sets forth the contractual maturity profile of our debt and mortgage loan investments at December 31, 2001:
Fair Value Percent of Maturity Amount Portfolio -------- ------ --------- (Dollars in thousands) One year or less............................................ $19,605 8% More than one year, through five years...................... 24,428 10 More than five years, through ten years..................... 28,956 12 More than ten years, through fifteen years.................. 17,778 8 More than fifteen years..................................... 147,687 62
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Reinsurance
Our insurance subsidiaries purchase reinsurance to reduce our liability on individual policies and claims and catastrophic losses. However, we are still responsible for the direct payment of all policy benefits and claims. We pay our reinsurers a ceded premium, which is a reduction of our revenues, and the amount is primarily calculated as a percentage of our earned premiums. Ceded incurred losses are determined in a manner that is consistent with how we determine our gross incurred losses and reduce the amount of our gross incurred losses and loss adjustment expenses. Under generally accepted accounting principles, ceded unpaid losses are recorded as a reinsurance recoverable asset. Our reinsurers do not have to pay us for ceded losses until we have made payments on a claim and our payment may have to exceed certain pre-determined levels before our reinsurers become obligated to pay us. As of December 31, 2001, we had over $187 million of reinsurance recoverables from our reinsurers. A single reinsurer, Travelers Indemnity Company of Illinois, which is rated AA and A++ by Fitch Ratings and the A.M. Best Company, respectively, accounted for approximately 79% of this amount. All of the recoverables are due from reinsurers rated AA or A+ or better by Fitch Ratings and the A.M. Best Company, respectively, and all reinsurance recoverables are considered to be collectible.
We historically and currently have excess of loss reinsurance agreements at pre-determined amounts or retention levels that have varied throughout the years depending on our statutory capital and the protection we believed to be prudent. Prior to 2000, the non-catastrophic excess of loss layer, which we define to be below $10 million per occurrence, was placed with General Reinsurance Corporation, which is rated AAA and A++ by Fitch Ratings and the A.M. Best Company, respectively. At December 31, 2001, reinsurance recoverable balances due from this reinsurer represented approximately 13% of the total.
Effective July 1, 1998, all claims with dates of injury occurring on or after that date were reinsured under a quota share and excess of loss agreement, which we refer to as "low level" reinsurance, with Travelers Indemnity Company of Illinois. The low level reinsurance provided quota share protection for 30% of the first $10,000 of each loss, and excess of loss protection of 75% of the next $40,000 of each loss, and 100% of the next $450,000 on a per occurrence basis. The maximum net loss retained on any one claim ceded under this treaty was $17,000. This agreement continued until June 30, 2000, when we executed an option for a twelve month extension relating to the run-off of policies inforce as of June 30, 2000, which covered claims arising under such policies during the term of the extension.
In addition to the low level reinsurance, effective January 1, 2000, we entered into a three year reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. There is a twelve month run out provision in the contract which we expect to execute that will cover claims on policies inforce as of December 31, 2002. The reinsurer, National Union Fire Insurance Company, is rated AAA and A++ by Fitch Ratings and the A.M. Best Company, respectively. In the wake of the September 11 events and the ensuing limited reinsurance market, we expect our future reinsurance costs to increase and our coverage limits to decrease. We cannot currently estimate what the impact to our operating results will be when we obtain replacement coverage in January 2003. However, any increases in our reinsurance costs, including our retaining more of the risk, will most likely be factored into our premium rates. However, we are not able to predict whether such rates will be adequate.
When the low level reinsurance agreement expired on June 30, 2000, as a result of a general tightening of the reinsurance market as well as the impact of the increased loss experience in California, a comparable type of reinsurance program was unavailable in the market. Those reinsurers which were offering other forms of lower retention programs were charging premiums that we believed were not cost justified. Therefore, effective July 1, 2000, we entered into a reinsurance contract with National Union Fire Insurance Company that provided $250,000 of coverage for workers' compensation claims in excess of $250,000 per occurrence. The contract was in effect for claims occurring on policies with effective dates beginning July 1, 2000 and thereafter and for claims incurred prior to July 1, 2001. In total, reinsurance recoverable balances due from this reinsurer at December 31, 2001 represented approximately 8% of the total.
Marketing
Our insurance policies are sold primarily through independent insurance agents and brokers, who may also represent other insurance companies. We believe that independent insurance agents and brokers choose to market our insurance policies because of the quality of service that we provide, the commissions we pay and the price of the insurance product. We currently have relationships with approximately 756 agents and brokers and pay our agents and brokers commissions based on a percentage of the gross written premium produced by such agents and brokers. In 2001, we reduced by approximately 5% the number of agents due to more stringent volume and profitability standards we imposed.
We maintain standard commission plans that vary by state for our agents and brokers. In addition to the standard commission plans, agents and brokers may be eligible to receive additional commissions in certain instances. Commissions are negotiated on an individual policy basis. No one agent or broker accounted for more than 2.2% of our total premiums inforce on December 31, 2001, and no one policy accounted for more than 1.0% of our total premiums inforce on December 31, 2001. Our top 10 agents and brokers accounted for 12.6% of our total premiums inforce December 31, 2001. From time to time, we advertise and participate in insurance trade association functions to maintain existing relationships and develop new ones.
Geographic Distribution of Premiums and Policy
The following tables set forth information concerning the percentages of premiums and policies inforce with us by geographic area as of December 31, 2001, 2000 and 1999. Inforce premiums are the total estimated annual premiums of all policies inforce at a point in time.
December 31, 2001 2000 1999 ---- ---- ---- Percent of premiums inforce: California.................................................. 71% 74% 80% Nevada...................................................... 11 9 4 Colorado.................................................... 10 9 8 Other States................................................ 8 8 8 --- --- ---
Total....................................................... 100% 100% 100% === === ===
Total premiums inforce (In thousands):...................... $168,402 $178,673 $154,963
Percent of policies inforce: California.................................................. 68% 72% 79% Nevada...................................................... 11 8 3 Colorado.................................................... 8 7 6 Other States................................................ 13 13 12 --- --- ---
Total....................................................... 100% 100% 100% === === ===
Total policies inforce...................................... 11,679 15,292 15,485
Government Regulation and Recent Legislation
We are subject to extensive governmental regulation and supervision in each state in which we conduct workers' compensation business. The primary purpose of such regulation and supervision is to provide safeguards for policyholders and injured workers rather than protect the interests of shareholders or creditors. The extent and form of the regulation may vary, but generally has its source in statutes that establish regulatory agencies and delegate to the regulatory agencies broad regulatory, supervisory and administrative authority. Typically, state regulations extend to such matters as licensing companies; restricting the types or quality of investments; requiring triennial financial examinations and market conduct surveys of insurance companies; licensing agents; regulating aspects of a company's relationship with its agents; restricting use of some underwriting criteria; regulating premium rates, forms and advertising; limiting the grounds for cancellation or nonrenewal of policies; solicitation and replacement practices; and specifying what might constitute unfair practices.
In the normal course of business, we and the various state agencies that regulate our activities may disagree on interpretations of laws and regulations, policy wording and disclosures or other related issues. These disagreements, if left unresolved, could result in administrative hearings and/or litigation. We attempt to resolve all issues with the regulatory agencies, but are willing to litigate issues where we believe we have a strong position. The ultimate outcome of these disagreements could result in sanctions and/or penalties and fines assessed against us. Currently, there are no litigation matters pending with any department of insurance.
State holding company acts also regulate changes in control of insurance holding companies and insurers. Although the specific provisions vary, holding company acts generally prohibit a person from acquiring a controlling interest in an insurer unless the insurance authority has approved the proposed acquisition pursuant to applicable regulations. In many states, including California and Texas, where our insurance subsidiaries are incorporated, "control" is presumed to exist if 10% or more of the voting securities of the insurance holding company are owned or controlled by one person or entity. In addition, the insurance authority may find that "control" in fact does or does not exist where one person or entity owns or controls either a lesser or greater amount of securities. The holding company acts also impose standards on certain transactions with related companies and individuals which include, among other requirements, that all transactions are to be fair and reasonable and that transactions exceeding specified limits receive prior regulatory approval.
Typically, states mandate participation in insurance guaranty associations, which assess solvent insurance companies in order to fund claims of policyholders of insolvent insurance companies. Under this arrangement, insurers can be assessed up to 1%, or 2% in certain states, of premiums written for workers' compensation insurance in that state each year to pay losses and LAE on covered claims of insolvent insurers. In certain states, insurance companies are allowed to recoup such assessments from policyholders while several states allow an offset against premium taxes. In California, insurance companies are required to recoup guaranty fund assessments from policyholders. California assessments are recorded as an asset and all other assessments are expensed as incurred.
Starting in 2000, the California Insurance Guarantee Association, or CIGA, issued assessments as a result of the insolvency of the insurers owned by Superior National Insurance Group and other insolvent workers' compensation insurance companies. The assessments are initially made on direct written premiums reported in the prior year and are subsequently adjusted to the actual direct premiums written in the following year. For example, CIGA issued an assessment in 2000 using the 1999 direct premiums written as the initial assessment. We began recouping the assessment on policies effective January 1, 2001. Our initial assessment will be adjusted to our actual premiums written in 2001. Any difference between the actual and initial premiums written would be either refunded to the member insurer, in the case of lower actual premiums, or an additional assessment imposed, in the case of higher actual premiums. In addition, any excess assessments that we recoup would have to be paid to CIGA. The CIGA assessments are recorded as an asset, which is reduced as we recoup the assessments. On an on-going basis, we evaluate the asset for impairment. In 2000, CIGA assessed us 1% of the 1999 direct premiums written for $1.2 million. In 2001, CIGA assessed us 2% of the 2000 direct premiums written for $3.1 million. In January 2002, CIGA assessed an additional 2% of the 2000 direct written premiums for $3.1 million. These assessments are being recouped starting with policies effective January 1, 2001 through December 31, 2003.
There were no assessments by non-California states in 2000 and total assessments by all other states were less than $300,000 in 2001. It is likely that guarantee fund assessments related to insolvent workers' compensation insurance companies will continue for the next several years.
In February 2002, California enacted Assembly Bill 749, or AB749. This legislation will be effective for policies incepting on or after January 1, 2003 and will raise benefits paid to injured workers over a four-year period. In addition, under an existing insurance statute, certain temporary total disability claims incurred prior to January 1, 2003 will automatically be increased to the new AB749 benefit levels on January 1, 2003. AB749 also changes an earlier court decision that presumed that an injured worker's primary treating provider's diagnosis and assessment of disability was correct and could not be challenged. Under AB749, this presumption will only apply to claims where the injured worker has pre-designated, prior to the occurrence of an injury, a primary treating provider. The primary treating provider presumption has been one of the major reasons for the significant escalation of California workers' compensation claim costs over the past few years. AB749 also limits the number of days of medical control by an employer or insurance company who uses a HCO to a maximum of 180 days. Previously, under certain circumstances, a HCO could give up to 365 days of medical control. On February 28, 2002, the Workers' Compensation Insurance Rating Bureau of California, or WCIRB, has estimated that the impact of AB749, including the effect of increased utilization, will increase claims costs by approximately 7% in 2003, 7.8% in 2004, 3.5% in 2005 and 2.9% in 2006. The WCIRB intends to include the impact of AB749 in future pure premium rates that are proposed to the California Department of Insurance.
Besides state insurance laws, we are subject to general business and corporation laws, federal and state securities laws, consumer protection laws, fair credit reporting acts and other laws regulating the conduct and operation of our subsidiaries.
Dividends
Our insurance subsidiaries are restricted by state law as to the amount of dividends that can be declared and paid to us. Moreover, insurance companies domiciled in California and Texas generally may not pay extraordinary dividends without providing the state insurance commissioner with 30 days' prior notice, during which period the commissioner may disapprove the payment. An "extraordinary dividend" is generally defined as a dividend whose fair market value together with that of other dividends or distributions made within the preceding 12 months exceeds the greater of ten percent of the insurer's surplus as of the preceding December 31 or the income of such insurer for the 12-month period ending on the preceding December 31.
In addition, our insurance subsidiaries may not pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year exceeds the amount shown as unassigned funds (reduced by any unrealized gains included in such amount) on the insurer's statutory statement as of the previous December 31. Based on its financial position as of December 31, 2001, California Indemnity can pay $2.1 million in shareholder dividends to CII Financial during calendar year 2002 without the prior approval of the California Insurance Commissioner. Commercial Casualty, CII Insurance and Sierra Texas can pay $1,278,000, $369,000 and $194,000, respectively to California Indemnity without prior approval of the applicable state insurance commissioner. On February 22, 2001 and September 6, 2001, the California Department of Insurance approved dividends of $5.0 million each by California Indemnity to us to finance a portion of our debenture exchange offer and bond retirement. We are not in a position to assess the likelihood of obtaining future approval for the payment of dividends other than those specifically allowed by law in each of our subsidiaries' state of domicile.
No prediction can be made as to whether any legislative proposals relating to dividend rules in the domiciliary states of our subsidiaries will be made or adopted in the future, whether the insurance departments of such states will impose either additional restrictions in the future or a prohibition on the ability of our regulated subsidiaries to declare and pay dividends or as to the effect of any such proposals or restrictions on our regulated subsidiaries.
Deposits and Other Requirements
Our insurance subsidiaries are required by state regulatory agencies to maintain certain deposits for the benefit of policyholders or claimants and must also meet certain net worth and reserve requirements. Our insurance subsidiaries have assets on deposit for the benefit of policyholders in various states, at fair value, totaling $153,268,000 at December 31, 2001.
Employees
At December 31, 2001, we had a total of 317 full-time equivalent employees, which we refer to as FTEs, grouped into underwriting, claims, marketing and administrative functions. With the completion of our 1997-1998 restructuring and the commencement of Nevada operations in 1999, 130 of our FTEs are located at the headquarters in Las Vegas, while 87 work at the Pleasanton, California office, and 63 work at the Burbank, California office. In addition, we have full-service branch offices in Denver, Colorado and Dallas, Texas, which employ 18 and 16 FTEs respectively. We have two FTEs in Reno, Nevada, and one FTE in Kansas City, Missouri. In December 2000, we transferred our managed care employees to the workers' compensation Health Care Organization unit of Sierra Health and Life Insurance Company, which at December 31, 2001 totaled 83 FTEs.
Note on Forward-Looking Statements and Risk Factors
Forward-Looking Statements
This 2001 Form 10-K contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended.
The forward-looking statements regarding CII Financial's business and results of operations should be considered by our debenture holders or any reader of our business or financial information along with the risk factors discussed below. All statements other than statements of historical fact are forward-looking statements for purposes of federal and state securities laws. The cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, as amended, and identify important factors that could cause our actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to us. These forward-looking statements are identified by their use of terms and phrases such as "anticipate," "believe," "could," "estimate," "expect," "hope," "intend," "may," "plan," "predict," "project," "seeks," "will," "continue," and other similar terms and phrases, including references to assumptions. Such forward-looking statements may be contained in the sections "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business," among other places.
Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements.
In making these statements, we disclaim any intention or obligation to address or update each factor in future filings or communications regarding our business or results, and we do not undertake to address how any of these factors may have caused changes to discussions or information contained in previous filings or communications. In addition, any of the matters discussed below may have affected our past results and may affect future results, so that our actual results may differ materially from those expressed here and in prior or subsequent communications.
We urge you to review carefully the section below, "Risk Factors," in this 2001 Form 10-K for a discussion of the risks associated with an investment in our securities.
Risk Factors Relating to CII Financial
We may not be able to service our debt because of our operations structure. We are highly dependent upon dividends from our insurance subsidiaries to service our debt. Our insurance subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the debentures, whether by dividends, loans or other payments. In addition, the payment of dividends and the making of loan advances to us by our subsidiaries are, and will continue to be, subject to statutory and regulatory restrictions. In calendar year 2002, without seeking the prior approval of the California Department of Insurance, California Indemnity Insurance Company, which is our only direct subsidiary, can pay limited dividends to us that will be adequate to service the interest due on our debentures.
A variety of factors beyond our control could affect the profitability of our insurance subsidiaries. The profitability of our insurance subsidiaries could be adversely affected by the following:
o Loss of premiums due to heightened competition;
o Inadequate premium rates, especially due to heightened competition, and miscalculations in the underlying loss costs and other factors in our rate filings and in underwriting accounts;
o Terrorist acts that directly affect our policyholders or our ability to operate our business;
o A sustained and severe economic recession, either in California, which accounts for approximately 70% of our premium revenue, or which affects the construction industry, which accounts for approximately 25% of our premium revenue;
o Adverse loss development resulting from unanticipated increases or changes in our claims costs;
o Inability or unwillingness of our reinsurers to honor their contractual obligations;
o Significant increases in our reinsurance costs without a corresponding increase in our premium rates;
o Inability to maintain our current level of reinsurance coverage at cost effective rates;
o Reduced reinsurance coverage, which exposes us to greater retained risks;
o Significant declines in investment rates;
o New legislation or regulations, including the impact of new legislation enacted in California in 2002 that will increase benefits to injured workers starting January 1, 2003, which increase our costs without a corresponding increase in premium revenues;
o A ratings downgrade from insurance rating agencies such as A.M. Best Company or Fitch Ratings; or
o Power interruptions in California, where our main computer systems reside.
We are controlled by Sierra Health Services, Inc. and Sierra's interests may not be the same as the interests of the holders of our debentures. We are a wholly owned subsidiary of Sierra, who can elect our board of directors and thereby indirectly control our policies and those of our subsidiaries, including mergers, sales of assets and similar transactions. Sierra could cause CII Financial to pledge shares of its subsidiaries, subject to certain regulatory restraints and those contained in the indenture for our debentures. CII Financial has guaranteed Sierra's obligations under its credit facility; however, this guarantee is subordinated to our debentures. Sierra is also the holder of certain promissory notes payable by CII Financial Inc. aggregating $17.0 million under which principal and interest are due on demand. These notes are subordinated to both our debentures and the guarantee of the secured credit facility. The interests of Sierra may not be the same as the interests of the debenture holders.
Because of its commitment to the Sierra credit facility and its indebtedness, CII Financial may be restricted in its ability to obtain financing and pursue various business opportunities. CII Financial is a guarantor of the Sierra credit facility, which at December 31, 2001 had a maximum limit of $117.0 million. In addition, CII Financial had outstanding indebtedness totaling $36.2 million, consisting of the debentures and promissory notes payable to Sierra. This commitment and the debt level may restrict CII Financial's ability to obtain financing and pursue various business opportunities.
ITEM 2.
ITEM 2. PROPERTIES
Our principal executive offices and the Las Vegas, Nevada branch office are comprised of 41,005 square feet of office space subleased from Sierra through December 31, 2002. We have the option to renew yearly up to the term of the underlying Sierra lease which as of December 31, 2001 had 13 more years before it expires. Our Northern California branch office, comprised of approximately 34,975 square feet of office space leased through October 31, 2002, is located in Pleasanton, California. Our Southern California branch office, comprised of 23,250 square feet of office space leased through September 30, 2003, is located in Burbank, California. We also lease space in other locations where we have operations and believe our facilities are adequate for our current needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are subject to various claims and other litigation in the ordinary course of our business. Such litigation includes workers' compensation claims by injured workers and by providers for payment for medical services rendered to injured workers. In the opinion of our management, the ultimate resolution of pending legal proceedings is not expected to have a material adverse effect on our financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
All of our common stock is owned by Sierra Health Services, Inc.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The table below presents our selected consolidated financial information for the years indicated. The table should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other information which appears elsewhere in this 2001 Form 10-K. The selected consolidated financial data below, as of December 31, 2001, 2000, 1999 and 1998 and for each of the years in the five-year period ended December 31, 2001, has been derived from our audited Consolidated Financial Statements. The consolidated financial data at December 31, 1997 was derived from our unaudited consolidated financial statements for that year.
Years Ended December 31, 2001 2000 1999 1998 1997 (In thousands) ---- ---- ---- ---- ---- Income Statement Data: Direct written premiums................. $187,129 $203,268 $148,824 $153,914 $135,580 ======= ======= ======= ======= =======
Net written premiums.................... $174,048 $125,748 $ 85,097 $134,147 $130,597 ======= ======= ======= ======= =======
Net earned premiums..................... $173,215 $125,555 $ 82,955 $134,274 $129,197 Net investment income and net realized gains............... 15,867 14,454 15,395 20,229 17,361 ------- ------- ------- ------- -------
Total revenues....................... 189,082 140,009 98,350 154,503 146,558
Total costs and expenses................ 186,012 152,061 91,255 136,625 135,745 ------- ------- ------- ------- -------
Income (loss) before federal income taxes and extraordinary gain............... 3,070 (12,052) 7,095 17,878 10,813
Federal income tax expense (benefit).... 1,447 (3,669) 3,602 4,166 272 ------- ------- ------- ------- -------
Income (loss) before extraordinary gain. 1,623 (8,383) 3,493 13,712 10,541
Extraordinary gain from debt extinguishment, net of tax.......... 362 654 111 48 2 ------- ------- ------- ------- -------
Net income (loss)....................... $ 1,985 $ (7,729) $ 3,604 $ 13,760 $ 10,543 ======= ======= ======= ======= =======
Years Ended December 31, 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- Combined Ratios: GAAP Combined Ratio: Loss and LAE ratio.................. 81.18% 87.52% 74.08% 70.26% 72.24% Underwriting expense ratio.......... 24.05 26.61 31.32 28.45 29.67 Policyholders dividends............. .85 1.73 .13 ------ ------ ------ ----- ------ Combined ratio...................... 106.08% 115.86% 105.53% 98.71% 101.91% ====== ====== ====== ===== ======
Statutory Combined Ratio: Loss and LAE ratio.................. 82.74% 91.65% 78.73% 71.03% 72.24% Underwriting expense ratio.......... 24.18 28.30 32.48 28.92 29.56 Policyholders dividends............. 1.39 .34 ------ ------ ------ ----- ------ Combined ratio...................... 108.31% 120.29% 111.21% 99.95% 101.80% ====== ====== ====== ===== ======
December 31, 2001 2000 1999 1998 1997 (In thousands) ---- ---- ---- ---- ---- Balance Sheet Data: Total cash, cash equivalents and invested assets..................... $261,285 $247,151 $226,572 $283,509 $278,479 Total assets.......................... 521,473 533,602 404,338 379,880 343,022 Total debt............................ 19,187 47,059 50,498 51,251 54,467 Total liabilities..................... 456,037 470,250 338,285 305,933 285,452 Total stockholder's equity............ 65,436 63,352 66,053 73,947 57,570 Dividends paid........................ None 2,637 None None None
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. The information contained below may be subject to risk factors. We urge you to review carefully the section "Risk Factors" in this 2001 Form 10-K for a more complete discussion of the risks associated with an investment in our securities. See "Note on Forward-Looking Statements and Risk Factors" under Item 1.
Our operating results are primarily the results of our workers' compensation insurance subsidiaries and consist of underwriting profit/loss, net investment income, net realized gains/losses, other income/expense, interest expense on the old junior subordinated debentures and intercompany debt, and income taxes.
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we are required to make judgments, assumptions and estimates, which we believe are reasonable and prudent based on the available facts and circumstances. These judgments, assumptions and estimates affect certain of our revenues and expenses and their related balance sheet accounts and the disclosure of our contingent assets and liabilities. We base our assumptions and estimates primarily on past historical experience and factor in known and projected trends. On an on-going basis, we re-evaluate our selection of assumptions and the method of calculating our estimates. Actual results, however, may differ from our calculated estimates and this difference would be reported in our current operations. The following discusses our most critical accounting policies and estimates.
Loss and loss adjustment expenses, or LAE, are based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. We use a variety of actuarial projection methods to make these estimates and we must use our judgment in selecting development factors and assumed trends. Workers' compensation claims can be paid out over a substantial number of years due to certain lifetime benefits. In addition, the period between when a claim is reported to us and when the injury occurred could be longer than one year and when we are no longer insuring the account. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although our reserves are established on the basis of a reasonable estimate, it is not only possible but probable that our reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns, unanticipated inflationary trends affecting the services covered by the insurance contract, adverse legal outcomes and new interpretations of legislation or of disputed contract provisions that result in our having to provide new or extended benefits. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results.
Reinsurance recoverable primarily represents the estimated amount of unpaid loss and LAE reserves that would be recovered from our reinsurers and, to a lesser extent, amounts billed to the reinsurers for their portion of paid losses and LAE claims. Reinsurance receivable for ceded paid claims is recorded in accordance with the terms of the agreements and reinsurance recoverable for unpaid losses and LAE is estimated in a manner consistent with the claim liability associated with the reinsurance policy. Any significant changes in the underlying claim liability could directly affect the amount of reinsurance recoverable. Reinsurance recoverable, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reinsurance contracts do not relieve us from our obligations to injured workers or policyholders. If our reinsurers were to fail to honor their obligations because of insolvency or disputed contract provisions, we could incur significant losses. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies.
Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Our temporary differences arise principally from certain net operating losses, accrued expenses, reserves that are discounted for tax return purposes and depreciation. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income and the expected timing of the reversals of the existing temporary differences. We have established a valuation allowance to reflect our inability to fully use tax benefits from certain prior operating losses currently or in the near future.
In addition to the most critical accounting policies and estimates discussed above, other areas requiring us to use judgment, assumptions and estimates include, but are not limited to, earned but unbilled premiums, allowances for doubtful receivables, litigation and legal settlement costs and accruals, other accrued liabilities, accrued payroll and taxes, unearned premium revenue, policyholders' dividends and retrospective rated premium accruals and contingent assets and liabilities.
For a more extensive discussion of our accounting policies, see Note 2 "Summary of Significant Accounting Policies", in the Notes to the Consolidated Financial Statements.
Results of Operations for the Year Ended December 31, 2001 Compared to the Year Ended December 31, 2000
Our income before taxes and extraordinary gains increased by $15.1 million for the year ended 2001 compared to 2000. The major components of the change were:
o $47.7 million increase in net earned premiums;
o $1.4 million increase in investment income, including net realized gains;
o $30.7 million increase in net loss and loss adjustment expenses;
o $7.9 million increase in policy acquisition costs; and
o $4.6 million decrease in general, administrative and other expenses.
Revenues:
Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 35% for the year ended December 31, 2001 compared to 2000. The increase was largely due to a reduction in the amounts ceded to our reinsurers offset by a decrease in written premiums. The components driving the decrease in written premiums included a 29% decrease in production growth partially offset by a 31% composite increase in premium rates for all states.
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, plus premiums assumed, less premiums ceded to reinsurers. Our direct written premiums decreased by 7.9% due primarily to the decline in production growth in California, which is attributable to our rising premium rates. Offsetting the decrease in direct written premiums was an 82.7% decrease in premiums ceded to our reinsurers, which was due primarily to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded.
As compared to the low level reinsurance agreement that expired on June 30, 2000, the new reinsurance agreements will result in higher net earned premium revenues, as we retain more of the premium dollars, but also will lead to our keeping more of the incurred losses. This resulted in a higher loss and loss adjustment expense, or LAE, ratio as the percentage increase in the additional incurred losses was greater than the percentage increase in the additional premiums retained. The effect on the balance sheet of the new reinsurance agreements compared to the low level reinsurance agreements has resulted in a lower amount of reinsurance recoverables, and due to the length of time that it typically takes to fully pay a claim, we have already seen an increase in our operating cash flow and amounts available to be invested.
The following table shows a comparison of direct written premiums, by state, for the years ended December 31, 2001 and 2000:
Years Ended December 31, 2001 % of Total 2000 % of Total ---- ---------- ---- ---------- (dollars in millions) California........................... $134.8 72.1% $155.6 76.5% Colorado............................. 17.5 9.4 16.7 8.2 Nevada............................... 18.6 9.9 15.5 7.6 Texas................................ 9.6 5.1 7.8 3.9 Other States......................... 6.6 3.5 7.7 3.8 ----- ----- ----- ----- Total.............................. $187.1 100.0% $203.3 100.0% ===== ===== ===== =====
As shown in the preceding table, our largest premium state, California, had the largest decrease in written premiums. The decrease was primarily due to a 28% decline in the number of inforce policies during 2001. The drop in our item count was offset by average premium rate increases on California renewing policies of approximately 38% for the year ended December 31, 2001. The market-pricing environment in California has become more favorable since 1999 in reaction to industry-wide losses in the workers' compensation line, increased reinsurance costs and from competitors exiting the market and firming their pricing. Countering the decline in California, Nevada, Colorado and Texas written premiums increased by 20%, 5%, and 23%, respectively.
Premiums inforce are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies inforce at a point in time. Total inforce premiums decreased by 5.7% to $168.4 million at December 31, 2001 compared to the prior year. This decline supports the slowing trend in premiums written, especially in California, due largely to business lost because of the higher premium rate increases we have been trying to obtain. The number of inforce policies at December 31, 2001 also dropped by 23.6% during the past twelve months.
Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio, as we ceded a significant amount of losses to the reinsurer. Since the low level agreement began run-off in July 2000, the amount of premium ceded has declined and we have been receiving payments from the reinsurer over the past year which has resulted in a positive cash flow from operations during 2001.
The $401,000 or 3% increase, in net investment income for the year ended December 31, 2001, compared to the prior period, is a direct result of our positive cash flow offset by a decrease in our average investment yield.
We had net realized gains of $392,000 for the year ended December 31, 2001 compared to net realized losses of $620,000 in 2000. We have tried to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments.
Losses and Loss Adjustment Expenses:
The $30.7 million increase in net losses and LAE is attributable to the following:
o Approximately $32.9 million in additional loss and LAE is related to the increase in net earned premiums in 2001 compared to 2000.
o In 2001, we recorded $8.7 million of net adverse loss development for prior accident years compared to net adverse loss development of $23.3 million recorded in 2000. The net adverse development recorded was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. See our discussion above in Item 1, "Business - Losses and Loss Adjustment Expenses."
o We are establishing a higher loss and LAE ratio for the 2001 accident year, which has resulted in an increase of approximately $12.4 million. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE.
Under our low level reinsurance agreement, we reinsured 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement was $17,000. This agreement covered all policies inforce at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies inforce as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. This agreement terminated after one year on a cut-off basis and covered claims with dates of injury to June 30, 2001. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract that will expire December 31, 2002. We intend to exercise an option to extend coverage for claims occurring on policies inforce at December 31, 2002.
As a percentage of net earned premiums, the loss and LAE ratio for the year ended December 31, 2001 was 81.2% compared to 87.5% for 2000. The 2001 calendar year net loss ratio was impacted by the $8.7 million net adverse development, which represents 5.0 percentage points of the loss ratio, compared to $23.3 million of net adverse development recorded during 2000, which represents 18.6 percentage points of the loss ratio. In addition, the expiration of the low level reinsurance agreement is resulting in a higher loss and LAE ratio on policies effective after June 30, 2000 as we are keeping more of the losses.
Underwriting Expenses:
Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $7.9 million for the year ended December 31, 2001 compared to 2000 is primarily attributable to reductions in ceded commissions received relating to the low level reinsurance agreement. As a percentage of net earned premiums, the underwriting expense ratio, including policyholders' dividends, was 24.9% in 2001 compared to 28.3% in 2000. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, smaller growth in personnel expenses and lower agents' commissions and allowances.
General, Administrative and Other Expenses:
Included in general, administrative and other expenses are other underwriting expenses of $12.3 million for the year ended December 31, 2001 compared to $12.0 million for the prior year period. Also included are policyholders' dividends of $1.5 million for the year ended December 31, 2001 compared to $2.2 million in 2000. The majority of the dividends are for Nevada participating policies and represent 0.8% of 2001 net earned premiums compared to 1.7% of 2000 net earned premiums. In addition, during 2000, we wrote-off capitalized costs of $3.0 million on an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations.
Combined Ratio:
The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 106.1% for the year ended December 31, 2001 compared to 115.8% for the same period in 2000. The decrease was primarily due to a lower loss and LAE ratio of 6.3 percentage points, a lower underwriting expense ratio of 2.5 percentage points, and a lower policyholders' dividend ratio of 0.9 percentage points.
Income Taxes:
For the year ended December 31, 2001, we recorded a tax provision of $1.5 million compared to a tax benefit of $3.7 million in 2000. The effective tax rate was 45% for 2001 compared to 33% for 2000. The effective tax rate differs from the statutory tax rate primarily as a result of tax preferred investments and the valuation allowance.
In 2001, we recorded a valuation allowance benefit of $0.4 million compared to a valuation allowance provision of $1.1 million in 2000. Under the tax sharing agreement with Sierra, valuation allowances have been established for the net deferred tax assets of CII Financial as they can only utilize these benefits to the extent they generate or realize separate return income. We believe that it is more likely than not that CII Financial will have insufficient income to fully utilize these benefits. During 2001, as a result of the gain from the debenture exchange described under "Debentures" below, CII Financial was able to realize a portion of the previously valued deferred tax assets, resulting in the valuation allowance benefit described above.
Results of Operations for the Year Ended December 31, 2000 Compared to the Year Ended December 31, 1999
Our income before taxes and extraordinary gains decreased by $19.1 million for the year ended 2000 compared to 1999. The major components of the change were:
o $42.6 million increase in net earned premiums;
o $0.9 million decrease in investment income, including realized losses;
o $48.4 million increase in loss and loss adjustment expenses;
o $10.1 million increase in policy acquisition costs; and
o $2.4 million increase in general, administrative and other expenses.
Revenues:
Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 42% for the year ended December 31, 2000 compared to 1999. The increase was largely due to a larger amount of written premiums. The components increasing written premiums included a 18% composite increase in premium rates for all states and a 24% increase in production growth.
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums increased by 37% due primarily to growth in California and Nevada. Partially offsetting the growth in direct written premiums was an increase in premiums ceded to reinsurers, which increased by 22%. The growth in ceded reinsurance premiums was lower than the growth in direct written premiums primarily due to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded.
As compared to the low level reinsurance agreement that expired on June 30, 2000, the new lower cost reinsurance agreements will result in higher net earned premium revenues, as we will be retaining more of the premium dollars, but also lead to our keeping more of the incurred losses. This may result in a higher loss and LAE ratio if the percentage increase in the additional incurred losses should be greater than the percentage increase in the additional premiums we retained. The effect on the balance sheet will result in a lower amount of reinsurance recoverables. However, due to the length of time that it typically takes to fully pay a claim, we should see an increase in cash flow and amounts available to be invested.
The following table shows a comparison of direct written premiums, by state, for the years ended December 31, 2000 and 1999:
Years Ended December 31, 2000 % of Total 1999 % of Total ---- ---------- ---- ---------- (dollars in millions) California........................... $155.6 76.5% $120.5 80.9% Colorado............................. 16.7 8.2 12.3 8.3 Nevada............................... 15.5 7.6 2.6 1.8 Texas................................ 7.8 3.9 7.2 4.8 Other States......................... 7.7 3.8 6.2 4.2 ----- ----- ----- ----- Total.............................. $203.3 100.0% $148.8 100.0% ===== ===== ===== =====
As shown in the preceding table, our largest premium state, California, had the largest increase in written premiums. We have obtained an average premium rate increase on California renewing policies of approximately 26% for the year ended December 31, 2000 and approximately 36% for policies that renewed in the second half of the year. The market-pricing environment in California has become more favorable to insurers since 1999 in reaction to industry-wide losses in the workers' compensation line, increased reinsurance costs and from competitors exiting from the market and firming their pricing. In Nevada, we began writing premiums on July 1, 1999, which was the first date private carriers were allowed to issue workers' compensation policies in the state.
Premiums inforce are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies inforce at a point in time. Total inforce premiums increased by 15% to $178.7 million at December 31, 2000 compared to the prior year. Total inforce premiums have dropped by 6% from its highest point in the last twelve months which was in August 2000. This indicates a potential slowing trend in premiums written, especially in California, due largely to business lost because of the higher premium rate increases we have been trying to obtain. The number of inforce policies at December 31, 2000 has also dropped by 6.6% from its highest point in the last twelve months, which was also August 2000.
Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio as we reinsured a significant amount of losses to the reinsurer. However, the ceded premiums we paid the reinsurer reduced the cash available for investment and temporarily created negative cash flow for us. The $702,000 or 4% reduction in net investment income for the year ended December 31, 2000, compared to the prior period, is due to a reduction in investments primarily because of higher ceded premiums paid to reinsurers in 2000.
We had net realized losses of $620,000 for the year ended December 31, 2000 compared to net realized losses of $381,000 for the prior period. We have tried to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments.
Losses and Loss Adjustment Expenses:
The $48.4 million increase in losses and LAE is attributable to the following:
o Approximately $26.4 million of the increase is related to our premium growth.
o For the year ended December 31, 2000 compared to 1999, we recorded an increase of $13.4 million in net adverse loss development for prior accident years. For the year ended December 31, 2000, we recorded $23.3 million of net adverse loss development, primarily for 1996 to 1999 accident years, compared to net adverse loss development of $9.9 million recorded in 1999, primarily for 1996 to 1998 accident years. The net adverse development recorded in 1999 and 2000 for the prior accident years was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. See our discussion above in Item 1, "Business - Losses and Loss Adjustment Expenses."
o We established a higher loss and LAE ratio for the 2000 accident year, which has resulted in a year over year increase in loss and LAE of approximately $8.6 million. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE. In addition, in light of the net adverse loss development we recorded in the fourth quarter of 1999 of $9.9 million, the lower premium rates on policies written in 1999 and trends in health care costs, we believed it prudent to establish the 2000 accident year reserves at a higher rate.
Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies inforce at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies inforce as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000.
As a percentage of net earned premiums, the loss and LAE ratio for the year ended December 31, 2000 was 87.5% compared to 74.1% for 1999. The 2000 loss ratio was significantly impacted by the $23.3 million net adverse development, which represents 18.6% of net earned premiums compared to the $9.9 million net adverse development in 1999, which represents 12.0% of net earned premiums. In addition, the expiration of the low level reinsurance agreement is resulting in a higher loss and LAE ratio on policies effective after June 30, 2000 as we are keeping more of the losses.
Underwriting Expenses:
Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $10.1 million for the year ended December 31, 2000 compared to 1999 is primarily attributable to the increase in net earned premiums. Included in the 2000 expenses are the effects of the run-off of the low level reinsurance agreement and its related reduction in ceding commissions, which has resulted in an increase in policy acquisition costs of $3.2 million in 2000. Other underwriting expenses decreased by $2.7 million for the year ended December 31, 2000 compared to 1999 due to cost containment measures that we initiated. As a percentage of net earned premiums, the underwriting expense ratio, including policyholders' dividends, was 28.3% in 2000 compared to 31.5% in 1999. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, smaller growth in personnel expenses and lower agents' commissions and allowances.
General, Administrative and Other Expenses:
Included in general, administrative and other expenses are other underwriting expenses of $12.0 million for the year ended December 31, 2000 compared to $14.7 million for the prior year period. Also included are policyholders' dividends of $2.2 million for the year ended December 31, 2000 compared to $0.1 million in 1999. The majority of the dividends are for Nevada participating policies and represent 1.7% of 2000 net earned premiums compared to 0.1% in 1999. In addition, in 2000, we wrote-off capitalized costs of $3.0 million on an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations.
Combined Ratio:
The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 115.8% for the year ended December 31, 2000 compared to 105.5% for the same period in 1999. The increase was primarily due to a higher loss and LAE ratio of 13.4 percentage points and policyholders' dividends ratio of 1.6 percentage points, offset slightly by a decrease in the underwriting expense ratio of 4.7 percentage points. The increase in the loss and LAE ratio was due to:
o Increase in net adverse loss development which represents 6.6 percentage points of the change in the loss and LAE ratio; and
o Higher loss and LAE ratio on the 2000 accident year of $8.6 million, which represents 6.8 percentage points of the change in the loss and LAE ratio.
Income Taxes:
For the year ended December 31, 2000, we recorded a tax benefit of $3.7 million compared to a tax provision of $3.6 million in 1999. The effective tax rate was 33% for the 2000 period compared to 50% for the 1999. The decrease in the effective tax rate for 2000 relates primarily to the decrease in tax preferred investments and the change in valuation allowances as a percentage of pre-tax income compared to 1999.
For the years ended December 31, 2000 and 1999, we recorded valuation allowances of $1.1 million and $1.2 million, respectively. Under the tax sharing agreement with Sierra, valuation allowances have been established for the net deferred tax asset of CII Financial as they can only utilize these benefits to the extent they generate or realize separate return income. We believe that it is more likely than not that CII Financial will have insufficient future income to fully utilize these tax benefits.
Liquidity and Capital Resources
Our insurance subsidiaries require liquidity to pay policy claims and benefits, operating expenses, income taxes and to purchase fixed assets to maintain and enhance their operations. The source of our insurance subsidiaries' funds come from the premiums they collect, the investment income they earn and receipts from their reinsurers. The liquidity requirements of our non-insurance operations, which are essentially the holding company, CII Financial, are substantially all related to the servicing of interest payments on our debentures and the payment of our debentures at maturity.
Our insurance subsidiaries are required to maintain sufficient liquid assets to pay claims and other policy obligations. Workers' compensation insurance is referred to as a "long-tail" business because of the length of time that typically occurs between when the premium is collected and when a claim is fully paid and settled due to life-time benefits that could be provided to a claimant. The excess of premiums collected over claims and expenses paid are invested until needed. State regulations dictate the kinds of investments we can have and we try to match the maturity of our investments with expected future cash needs.
Cash Flows
We had positive cash flows from operating activities of $27.6 million and $16.2 million for the years ended December 31, 2001 and 2000, respectively. The primary source of cash for 2001 was due to the decrease in the balance of our reinsurance recoverable on paid and unpaid losses of $29.1 million and $11.2 million from an increase in loss and LAE reserves. This was offset by a use of cash of $11.1 million due to the decrease in the ceded reinsurance premium payable. The decrease in reinsurance recoverable and ceded reinsurance premiums payable is due to the expiration of the low level reinsurance agreement. Our positive cash flow for 2000 was largely due to an increase in loss and LAE reserves of $130.2 million plus an increase of $4.5 million for depreciation, amortization and asset impairment, which were partially offset by a net loss of $7.7 million and an increase in reinsurance recoverable on paid and unpaid losses of $115.3 million.
Our net cash used in investing activities was $37.5 million for the year ended December 31, 2001 compared to net cash provided by investing activities of $700,000 for 2000. Net capital expenditures in 2001 were $2.2 million and $839,000 in 2000. We anticipate our capital expenditures to approximate $2 million to $4 million per year over the next several years. Net cash used for the purchase of investments was $27.8 million during 2001.
Our net cash used in financing activities was $10.2 million in 2001 and $5.1 million in 2000. We used $21.5 million for the exchange offer on our old junior subordinated debentures described below under "Debentures" and $5.7 million for the retirement of the remaining $5.0 million of our old junior subordinated debentures and the payment of interest. We obtained loans from Sierra of $17.0 million in 2001 that were used for the exchange offer. The cash used in 2000 was for the repurchase of our old junior subordinated debentures in the open market and a dividend of $2.6 million paid to Sierra.
Debentures
In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "old junior subordinated debentures") of which $47.1 million were outstanding at March 31, 2001. The old junior subordinated debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. Interest on the old junior subordinated debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share.
CII Financial anticipated that it would not have readily available sources of cash to pay the old junior subordinated debentures when they were scheduled to mature in September 2001 and initiated a proposed exchange offer in December 2000. To facilitate the exchange, CII Financial received loans of $17.0 million from Sierra and California Indemnity Insurance Company, a wholly owned subsidiary of CII Financial, and obtained approval from the California Department of Insurance to pay a dividend of $5.0 million to CII Financial. On May 7, 2001, CII Financial closed its exchange offer for $42.1 million of its outstanding old junior subordinated debentures. CII Financial purchased $27.1 million in principal amount of old junior subordinated debentures for $20.0 million in cash and issued $15.0 million in our 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in old junior subordinated debentures. The transaction resulted in an extraordinary gain of $557,000 and a corresponding tax provision of $195,000. See Note 7 of the Notes to Consolidated Financial Statements for an explanation of the accounting treatment of the transaction.
In September 2001, California Indemnity Insurance Company, or California Indemnity, received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used these funds to fully pay the remaining $5.0 million in old junior subordinated debentures that matured on September 15, 2001.
Our 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. CII Financial expects to service the 9 1/2% senior debentures from cash flows, primarily from dividends that will be paid by its insurance subsidiaries from their future earnings.
Under the terms of the indenture relating to the 9 1/2% senior debentures, the debentures may be redeemed by CII Financial at any time at premiums starting at 110% and declining to 100% for redemptions after April 1, 2004. In the event of a change in control of CII Financial, the debenture holders may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest. The indenture also places limitations on incurring certain types of debt, creating liens, disposing of assets, making certain dividend payments or other distributions and entering into transactions with affiliates. In addition, any excess cash flow, as defined in the indenture, is to be offered to debenture holders to redeem the 9 1/2% senior debentures at 100% of the principal amount (without premium) plus accrued and unpaid interest.
Sierra Revolving Credit Facility
Sierra has a bank credit facility and, at June 30, 2000, was in breach of certain of its financial covenants (leverage ratio, consolidated net worth and fixed charges coverage ratio). In consideration of the banks granting a waiver of compliance, in August 2000, CII Financial became a guarantor of the Sierra credit facility debt. The guaranty of the bank debt ranked senior to the old junior subordinated debentures. The waivers expired on October 31, 2000 and Sierra received a notice of default from the banks on November 8, 2000. The credit facility was amended and restated on December 15, 2000. In May 2001, to facilitate the exchange offer, the credit facility was amended to subordinate the credit facility debt to our 9 1/2% senior debentures.
Under the terms of the revolving credit facility, capital contributions to us from Sierra in excess of $12 million that we used to repay the old junior subordinated debentures required Sierra to reduce permanently an equal amount of the outstanding balance of its credit facility commitment. Subject to normal qualifications and exceptions, Sierra has covenants that, among other things, will restrict the ability of Sierra and its subsidiaries, including CII Financial, to dispose of assets, incur indebtedness, pay dividends, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and which otherwise restrict certain corporate activities. In addition, Sierra is required to comply with specified financial ratios, as defined in the new credit agreement, including minimum interest coverage ratios and leverage ratios. Since December 15, 2000, Sierra believes it has been in compliance with the financial covenants of the new credit agreement.
Other
CII Financial is a holding company and its only significant assets are its investment in California Indemnity Insurance Company. Of the $8.6 million in cash and cash equivalents held at December 31, 2001, approximately $8.1 million were designated for use only by the regulated insurance companies.
CII Financial has limited sources of cash and is dependent upon dividends paid by California Indemnity. Our insurance subsidiaries are restricted by state law as to the amount of dividends that can be declared and paid to us.
Moreover, insurance companies domiciled in California and Texas generally may not pay extraordinary dividends without providing the state insurance commissioner with 30 days' prior notice, during which time the commissioner may disapprove the payment. An "extraordinary dividend" is generally defined as a dividend whose fair market value together with that of other dividends or distributions made within the preceding 12 months exceeds the greater of ten percent of the insurer's surplus as of the preceding December 31 or the income of such insurer for the 12-month period ending on the preceding December 31.
In addition, our insurance subsidiaries may not pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year exceeds the amount shown as unassigned funds (reduced by any unrealized gains included in such amount) on the insurer's statutory statement as of the previous December 31. California Indemnity, which is our only direct subsidiary, can pay dividends to us in calendar year 2002 of up to $2.1 million without the prior approval of the California Department of Insurance. On February 22, 2001 and September 6, 2001, the California Department of Insurance approved the payment of dividends of $5.0 million each by California Indemnity to us to finance a portion of our debenture exchange offer and bond retirement. We are not in a position to assess the likelihood of obtaining future approval for the payment of dividends other than those specifically allowed by law in each of our subsidiaries' state of domicile.
No prediction can be made as to whether any legislative proposals relating to dividend rules in the domiciliary states of our subsidiaries will be made or adopted in the future, whether the insurance departments of such states will impose either additional restrictions in the future or a prohibition on the ability of our regulated subsidiaries to declare and pay dividends or as to the effect of any such proposals or restrictions on our regulated subsidiaries.
Since our acquisition by Sierra in October 1995, we have paid dividends to Sierra totaling $2.6 million. Since the acquisition, Sierra has contributed $3.7 million to us by purchasing in the open market old junior subordinated debentures and contributing them to us for retirement.
Obligations and Commitments
The following schedule represents our obligations and commitments for long-term debt and operating leases. We do not have any capital leases outstanding. The amounts below represent the entire payment, principal and interest, on our outstanding obligations.
Long-Term Operating Debt (1) Leases Total -------- ------ ----- (In thousands) Payments due on demand (2)............................. $17,000 $17,000 Payments due in less than 1 year....................... 1,421 $2,452 3,873 Payments due in 1 to 3 years........................... 17,766 633 18,399 Payments due in 4 to 5 years........................... 146 146 Payments due after 5 years............................. ------ ----- ------ Total............................................. $36,187 $3,231 $39,418 ====== ===== ======
(1) We are a guarantor under Sierra's revolving credit facility which facility had an outstanding balance of $89.0 million at December 31, 2001. (2) We have issued two demand notes in an aggregate amount of $17.0 million to Sierra Health Services, Inc.
Inflation
Inflation can be expected to affect our operating performance and financial condition in several aspects. Inflation can reduce the market value of our investment portfolio; however, we try to manage our investment portfolio to minimize unplanned sales. Inflation can adversely affect the portion of loss and LAE reserves that relate to hospital and medical expenses, although some medical expenses are established by statute. Loss reserves related to indemnity benefits for lost wages are indirectly affected by inflation as these amounts are established by statute. In February 2002, California enacted new legislation that will increase benefits paid to injured workers starting January 1, 2003. Some benefits will be tied to the average national weekly wage. We do not believe that inflation has had a material effect on our results of operations.
Recent Issued Accounting Standards
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", or SFAS No. 142, which is effective January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. We do not have any recorded goodwill and do not anticipate any impact from this pronouncement.
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", or SFAS No. 144, which is effective for fiscal years beginning after December 15, 2001 with early adoption recommended. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. We believe that the implementation of this standard will not have a material impact on our consolidated financial position, results of operations or cash flows.
ITEM 7a.
ITEM 7a. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk for the impact of interest rate changes and changes in the market value of our investments. We have not utilized derivative financial instruments in our investment portfolio.
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt. At December 31, 2001, we had $261.3 million in cash, cash equivalents and invested assets of which $260.8 million is designated for use only by our regulated insurance subsidiaries. Our invested assets consist of debt securities of $226.1 million, of which $212.3 million were classified as available-for-sale and $13.8 million was classified as held-to-maturity. These investments are substantially investment grade securities. Our investment policies emphasize return of principal and liquidity and are focused on fixed returns that limit volatility and risk of principal. Our primary market risk associated with our investment portfolio is interest rate risk.
Assuming interest rates were to increase by a factor of 1.1, the net hypothetical loss in fair value of shareholder's equity related to financial instruments would be approximately $4.1 million after tax. This would represent approximately 6% of shareholder's equity. We believe that if interest rates were to increase by this amount, it would not have a material impact on our future earnings or cash flows, as it is unlikely that we would need or choose to substantially liquidate our investment portfolio.
The effect of interest rate risk on potential near-term net income, cash flow and fair value was determined based on commonly used sensitivity analyses. The models project the impact of interest rate changes on a wide range of factors, including duration and prepayment. Fair value was estimated based on the net present value of cash flows or duration estimates, assuming an immediate 10% increase in interest rates. Because duration is estimated, rather than a known quantity, for certain securities, other market factors may impact security valuations and there can be no assurance that our portfolio would perform in line with the estimated values.
As of December 31, 2001, CII Financial had $15.0 million in senior debentures outstanding which trade on the New York Stock Exchange. The fair market value of the outstanding debentures was estimated to be approximately $13.0 million at December 31, 2001, based on the last trade in 2001. If interest rates were to fluctuate by a factor of 1.1, we do not anticipate a material change in the fair value of the debentures based on the current market for them.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CII Financial, Inc. and Subsidiaries Page ----
Management Report on Consolidated Financial Statements............................................... 33 Independent Auditors' Report......................................................................... 34 Consolidated Financial Statements as of December 31, 2001 and 2000 and for each of the three years in the period ended December 31, 2001: Consolidated Balance Sheets.......................................................................... 35 Consolidated Statements of Operations................................................................ 36 Consolidated Statements of Stockholder's Equity...................................................... 37 Consolidated Statements of Cash Flows................................................................ 38 Notes to Consolidated Financial Statements........................................................... 39
MANAGEMENT REPORT ON CONSOLIDATED FINANCIAL STATEMENTS
The management of CII Financial, Inc. is responsible for the integrity and objectivity of the accompanying consolidated financial statements. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment.
The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against losses from unauthorized use or disposition. Management believes that for the year ended December 31, 2001, such systems and controls were adequate to meet the objectives discussed herein.
The accompanying consolidated financial statements have been audited by independent certified public accountants, whose audits thereof were made in accordance with auditing standards generally accepted in the United States of America and included a review of internal accounting controls to the extent necessary to design audit procedures aimed at gathering sufficient evidence to provide a reasonable basis for their opinion on the fairness of presentation of the consolidated financial statements taken as a whole.
Kathleen M. Marlon Chairman and Chief Executive Officer
John F. Okita Chief Financial Officer
Independent Auditors' Report ----------------------------
To the Board of Directors and Stockholder of CII Financial, Inc.:
We have audited the accompanying consolidated balance sheets of CII Financial, Inc. and its subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statement schedules listed in the Index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CII Financial, Inc. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP Las Vegas, Nevada January 30, 2002
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2001 and 2000 (In thousands except share data)
2001 2000 ---- ---- ASSETS Invested assets: Debt securities, available-for-sale, at fair value.............. $212,294 $177,671 Debt securities, held-to-maturity, at amortized cost ........... 13,809 21,258 Preferred stock, at fair value.................................. 5,884 5,130 Mortgage loans on non-affiliated real estate.................... 11,398 12,362 ------- ------- Total invested assets........................................... 243,385 216,421 ------- -------
Cash and cash equivalents....................................... 8,641 28,666 Reinsurance recoverable......................................... 218,079 247,205 Premiums receivable (net of allowances of $1,404 and $1,449).... 10,669 11,785 Investment income receivable.................................... 2,794 2,712 Deferred policy acquisition costs............................... 2,236 2,015 Mortgage loans on affiliated real estate........................ 992 1,257 Real estate limited partnership................................. 767 807 Note receivable affiliate....................................... 7,500 Federal income taxes receivable................................. 614 1,945 Deferred income taxes........................................... 16,305 16,251 Property and equipment, net..................................... 4,955 4,126 Other assets.................................................... 4,536 412 ------- ------- TOTAL ASSETS.................................................... $521,473 $533,602 ======= =======
LIABILITIES Reserve for loss and loss adjustment expenses................... $385,705 $374,554 Unearned premiums............................................... 14,327 13,493 Ceded reinsurance premiums payable.............................. 11,073 Senior Debentures............................................... 19,187 Convertible subordinated debentures............................. 47,059 Accounts payable and other accrued expenses..................... 15,284 19,708 Notes payable affiliate......................................... 17,000 Payable to affiliates........................................... 3,018 1,708 Income tax payable.............................................. 156 1,413 Deferred tax liability.......................................... 1,360 1,242 ------- ------- TOTAL LIABILITIES............................................... 456,037 470,250 ------- -------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; 100 shares issued and outstanding................... 3,604 3,604 Additional paid-in capital...................................... 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments.. (4,436) (4,535) Retained earnings (accumulated deficit)......................... 1,818 (167) ------- ------- TOTAL STOCKHOLDER'S EQUITY...................................... 65,436 63,352 ------- -------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY...................... $521,473 $533,602 ======= =======
See the accompanying notes to consolidated financial statements.
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2001, 2000 and 1999 (In thousands)
2001 2000 1999 ---- ---- ---- REVENUES Direct written premiums, gross..................... $187,129 $ 203,268 $148,824 Changes in direct unearned premiums................ (833) (193) (2,142) ------- -------- --------
Direct earned premiums, gross...................... 186,296 203,075 146,682 Add: premiums assumed............................ 299 Less: premiums ceded.............................. 13,380 77,520 63,727 ------- -------- -------
Net earned premiums................................ 173,215 125,555 82,955 Net investment income.............................. 15,475 15,074 15,776 Net realized investment gains (losses)............. 392 (620) (381) ------- -------- -------
Total revenues................................. 189,082 140,009 98,350 ------- -------- -------
COSTS AND EXPENSES Loss and loss adjustment expenses.................. 194,648 274,280 157,424 Reinsurance recoveries............................. (54,034) (164,400) (95,963) ------- -------- -------
Net loss and loss adjustment expenses.............. 140,614 109,880 61,461 Policy acquisition costs........................... 29,272 21,386 11,260 General, administrative and other.................. 13,816 14,196 14,828 Asset impairment................................... 3,000 Interest expense................................... 2,310 3,599 3,706 ------- -------- -------
Total costs and expenses....................... 186,012 152,061 91,255 ------- -------- -------
INCOME (LOSS) BEFORE FEDERAL INCOME TAX EXPENSE (BENEFIT) AND EXTRAORDINARY GAIN................................... 3,070 (12,052) 7,095
Federal income tax expense (benefit)................. 1,447 (3,669) 3,602 ------- --------- -------
INCOME (LOSS) BEFORE EXTRAORDINARY GAIN................................. 1,623 (8,383) 3,493
Extraordinary gain from debt extinguishment (net of income tax of $195, $353 and $59).......... 362 654 111 ------- -------- -------
NET INCOME (LOSS).................................... $ 1,985 $ (7,729) $ 3,604 ======= ======== =======
See the accompanying notes to consolidated financial statements.
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY For the Years Ended December 31, 2001, 2000 and 1999 (In thousands except share data)
Accumulated Retained Common Stock Additional Other Earnings Total Number of Paid-in Comprehensive Comprehensive (Accumulated Stockholder's Shares Amount Capital Income (Loss) Income (Loss) Deficit) Equity ---------------------- ----------- -------------- ------------- ------------ -------------
BALANCE, JANUARY 1, 1999 100 $3,604 $64,450 $ (702) $ 6,595 $ 73,947
Comprehensive income: Net income $ 3,604 3,604 3,604 Unrealized loss on available-for-sale investments, net of tax (11,746) (11,746) (11,746) Reclassification adjustment for losses included in net income 248 248 248 ------- Comprehensive income (loss) $ (7,894) --- ----- ------ ------- ======= ------ ------- BALANCE, DECEMBER 31, 1999 100 3,604 64,450 (12,200) 10,199 66,053
Comprehensive income: Net loss $(7,729) (7,729) (7,729) Unrealized gain on available-for-sale investments, net of tax 7,262 7,262 7,262 Reclassification adjustment for gains included in net loss 403 403 403 ------- Comprehensive income (loss) $ (64) ======= Dividend paid to parent (2,637) (2,637) --- ----- ------ ------- ------ ------- BALANCE, DECEMBER 31, 2000 100 3,604 64,450 (4,535) (167) 63,352
Comprehensive income: Net income $ 1,985 1,985 1,985 Unrealized gain on available-for-sale investments, net of tax 491 491 491 Reclassification adjustment for gains included in net income (392) (392) (392) ------- Comprehensive income (loss) $2,084 ===== --- ---- ------ ------- ------ ------- BALANCE, DECEMBER 31, 2001 100 $3,604 $64,450 $ (4,436) $ 1,818 $ 65,436 === ===== ====== ======= ====== =======
See the accompanying notes to consolidated financial statements.
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2001, 2000 and 1999 (In thousands)
2001 2000 1999 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)...................................................... $ 1,985 $ (7,729) $ 3,604 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Extraordinary gain................................................... (557) (1,007) (170) Depreciation and amortization........................................ 1,330 1,514 1,220 Provision for asset impairment....................................... 3,000 Provision for losses on premiums..................................... (144) Change in assets and liabilities: Premiums receivable............................................... 236 (2,393) 1,365 Investment income receivable...................................... (82) 74 (3) Deferred policy acquisition costs................................. (221) 363 (574) Payable to affiliates............................................. 2,374 (360) 662 Reinsurance recoverable........................................... 29,126 (115,343) (73,438) Federal income taxes receivable................................... (1,311) 236 (4,404) Deferred income taxes............................................. 1,396 (403) 5,887 Reserve for loss and loss adjustment expense...................... 11,151 130,160 32,130 Unearned premiums................................................. 834 193 2,142 Accounts payable and other accrued expenses....................... (4,712) 4,443 (3,523) Ceded reinsurance premiums payable................................ (11,073) 1,752 582 Other assets...................................................... (2,870) 1,703 5,142 -------- -------- -------- Net cash provided by (used in) operating activities.................. 27,606 16,203 (29,522) -------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures, Net.............................................. (2,193) (839) (4,176) Note receivable from Sierra............................................ (7,500) Purchase of available-for-sale investments ............................ (718,432) (171,369) (291,863) Proceeds from sales/maturities of available-for-sale investments....... 683,336 169,103 291,919 Purchase of held-to-maturity investments............................... (1,265) (1,662) (7,133) Proceeds from maturities of held-to-maturity investments............... 8,585 5,466 36,077 -------- -------- -------- Net cash (used in) provided by investing activities.................. (37,469) 699 24,824 -------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of convertible subordinated debentures...................... (27,162) (2,432) (583) Dividend to Sierra..................................................... (2,637) Notes payable to Sierra................................................ 17,000 -------- -------- -------- Net cash used in financing activities................................ (10,162) (5,069) (583) -------- -------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS.................................. (20,025) 11,833 (5,281) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD......................... 28,666 16,833 22,114 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD............................... $ 8,641 $ 28,666 $ 16,833 ======== ======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW DATA Cash paid during the year for interest (net of amount capitalized)..... $ 3,303 $ 3,713 $ 3,724 Cash paid during the year for income taxes............................. 7 1,834 Non-cash Financing Activities: Debentures exchanged................................................... 19,692
See the accompanying notes to consolidated financial statements.
CII FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 2001, 2000 and 1999
1. Business
CII Financial, Inc. ("CII Financial") was incorporated in the State of California on September 15, 1988. On October 31, 1995, Sierra Health Services, Inc. ("Sierra") acquired CII Financial for approximately $76.3 million of common stock in a transaction accounted for as a pooling of interests. CII Financial is a holding company primarily engaging in writing workers' compensation insurance through its wholly-owned subsidiaries, California Indemnity Insurance Company ("California Indemnity"), Commercial Casualty Insurance Company ("Commercial Casualty"), CII Insurance Company ("CII Insurance") and Sierra Insurance Company of Texas ("Sierra Texas").
As used herein, the term "the Company" means CII Financial, Inc. and its subsidiaries, and the term "CII Financial" means CII Financial, Inc., exclusive of such subsidiaries.
2. Summary of Significant Accounting Policies
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. The consolidated financial statements of CII Financial, Inc. include the accounts of all of its wholly-owned subsidiaries, California Indemnity, Commercial Casualty, Sierra Texas, CII Insurance and Financial Assurance Company, Ltd. CII Leasing, Inc. and CII Premium Finance Company were liquidated in previous years and in 2001, Financial Assurance Company, Ltd., was liquidated.
Premium Revenues. Revenue from workers' compensation premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Premiums written in excess of premiums earned are recorded as unearned premium revenue. The premium for workers' compensation insurance is calculated as a factor of an insured's payroll dollars during the period of coverage. At the inception of the policy, annual payroll dollars are estimated and the policy is issued with estimated annual premiums which are billed based on this estimate. Actual premiums for past interim coverage periods are periodically determined through payroll reporting and interim premium audits. The final actual premium is not determined until a final premium audit is performed, which occurs after the policy has expired. Direct premiums earned but not billed at the end of each accounting period are estimated and accrued, based on historical premium audit trends. Differences between such estimates and final billings are included in current operations. Accrued earned but unbilled premiums are included with premiums receivable. The number and dollar amount of issued workers' compensation insurance policies that are subject to retrospective adjustments based on incurred or paid claims or experienced rated premiums are not significant.
General and Administrative Expenses. Policyholder's dividends and management fees are included in general and administrative expenses.
Deferred Policy Acquisition Costs. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business, and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed.
Cash and Cash Equivalents. The Company considers cash and cash equivalents as all highly liquid instruments with an original maturity of three months or less at the time of purchase. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of these instruments.
Investments. Available-for-sale debt securities and preferred stocks are stated at fair value with unrealized gains and losses recorded as a separate component of other comprehensive income (loss), net of deferred income taxes. Held-to-maturity debt securities are carried at amortized cost.
The insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company and its subsidiaries are in compliance with the applicable minimum regulatory and capital requirements.
Investment income is recognized when earned. Gains and losses on disposition are based on net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
The Company has an investment in a real estate limited partnership that is accounted for under the equity method. Under the equity method, original investments are recorded at cost and adjusted by the Company's share of earnings, losses and distributions of the Partnership.
Property and Equipment. Property and equipment, consisting of buildings and leasehold improvements, furniture and fixtures, data processing equipment and vehicles, is stated at cost less accumulated depreciation. Depreciation is computed on a straight-line basis over periods ranging from 5 to 10 years with leasehold improvements depreciated over the term of the lease.
Reinsurance. In the normal course of business, insurance companies seek to reduce the effects of events that may cause unfavorable underwriting results by reinsuring certain levels of risk in various levels of exposure with reinsurers. Amounts recoverable from the reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance receivables, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities.
Reserve for Loss and Loss Adjustment Expenses. The reserve for workers' compensation loss and loss adjustment expense ("loss and LAE") consists of estimated costs of each unpaid claim reported to the Company prior to the close of the accounting period as well as those incurred but not yet reported. The methods for establishing and reviewing such liabilities are continually reviewed and adjustments are reflected in current operations. The Company does not discount its loss and LAE reserves.
Income Taxes. The Company accounts for income taxes using the liability method. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. The Company's temporary differences arise principally from certain net operating losses, accrued expenses, reserves for loss and LAE and depreciation. A valuation allowance is recorded for estimated deferred tax assets that cannot be fully realized in current or future periods. Federal income taxes are calculated pursuant to a tax allocation agreement between Sierra and the Company. Income taxes are allocated on a separate return basis for each company and tax benefits are recorded only to the extent that an entity could recoup taxes paid in prior years.
Derivatives. The Company does not currently have any derivative instruments. As of January 1, 2001, the Company implemented Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). The implementation did not result in an adjustment. The Company's policy is to account for derivative instruments on the balance sheet at fair value with changes in fair values reported as part of net income.
Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of investments and accounts receivable. The Company maintains cash and cash equivalents and investments with various financial institutions. These financial institutions are located in many different regions, and Company policy is designed to limit exposure with any one institution.
Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising the Company's customer base and their dispersion across many different industries. These customers are primarily located in the states in which the Company operates, principally California, Colorado, Nevada and Texas. However, the Company is licensed in and does business in several other states. The Company also has receivables from certain reinsurers. Reinsurance contracts do not relieve the Company from its obligations to injured workers and policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All reinsurers that the Company has reinsurance recoverables from are rated AA and A+ or better by Fitch Ratings and the A.M. Best Company, respectively.
Recently Issued Accounting Standards. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"), which is effective January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. The Company does not have any recorded goodwill and does not anticipate any impact from this pronouncement.
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), which is effective for fiscal years beginning after December 15, 2001 with early adoption recommended. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. The Company believes that the implementation of this standard will not have a material impact on its consolidated financial position, results of operations or cash flows.
Business Segment. For each of the three years in the period ended December 31, 2001, the Company operated in a single business segment, workers' compensation insurance.
Use of Estimates in the Preparation of Financial Statements. The preparation of the Company's financial statements requires management to make estimates and assumptions that affect the amounts of reported assets and liabilities, particularly loss and LAE reserves and incurred loss and LAE reported in the financial statements. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although reserves are established on the basis of a reasonable estimate, it is not only possible but probable that reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns and unanticipated inflationary trends affecting the services provided by the insurance contract. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results.
3. Property and Equipment
Property and equipment at December 31, consists of the following:
2001 2000 (In thousands) ---- ---- Land............................................ $ 116 Buildings and leasehold improvements............ 2,350 $ 974 Furniture, fixtures and equipment............... 2,620 3,071 Data processing equipment and software.......... 5,345 3,920 Construction in progress........................ 93 1,544 Less: accumulated depreciation................. (5,569) (5,383) ------ ------ Net property and equipment.................... $ 4,955 $ 4,126 ====== ======
Depreciation expense in 2001, 2000 and 1999 was $1,362,000, $1,368,000 and $1,075,000, respectively.
During the second quarter of 2000, the Company wrote-off capitalized costs of $3.0 million related to the application development of an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off include software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
4. Investments
The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 2001:
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ---- ----- ------ ---------- (In thousands) Available-for-Sale: U.S. Government and its Agencies............... $186,001 $1,391 $6,271 $181,121 Municipal Obligations.......................... 3,064 42 65 3,041 Corporate Bonds................................ 30,067 116 2,051 28,132 ------- ----- ----- ------- Total Debt Securities.......................... 219,132 1,549 8,387 212,294 Preferred Stock................................ 5,871 34 21 5,884 ------- ----- ----- ------- Total Available-for-Sale.................... $225,003 $1,583 $8,408 $218,178 ======= ===== ===== =======
Held-to-Maturity U.S. Government and its Agencies............... $ 6,234 $ 24 $ 258 $ 6,000 Municipal Obligations.......................... 964 44 920 Corporate Bonds................................ 6,611 239 6,850 ------- ----- ----- ------- Total Held-to-Maturity....................... $ 13,809 $ 263 $ 302 $ 13,770 ======= ===== ===== =======
The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 2000:
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ---- ----- ------ ---------- (In thousands) Available-for-Sale: U.S. Government and its Agencies............... $134,143 $313 $5,393 $129,063 Municipal Obligations.......................... 13,510 44 280 13,274 Corporate Bonds................................ 36,874 70 1,664 35,280 Other.......................................... 54 54 ------- --- ----- ------- Total Debt Securities.......................... 184,581 427 7,337 177,671 Preferred Stock................................ 5,212 82 5,130 ------- --- ----- ------- Total Available-for-Sale..................... $189,793 $427 $7,419 $182,801 ======= === ===== =======
Held-to-Maturity U.S. Government and its Agencies............... $ 12,776 $278 $ 688 $ 12,366 Municipal Obligations.......................... 2,886 66 2,952 Corporate Bonds................................ 4,981 139 160 4,960 Other.......................................... 615 615 ------- --- ----- ------- Total Held-to-Maturity....................... $ 21,258 $483 $ 848 $ 20,893 ======= === ===== =======
The contractual maturities of available-for-sale debt securities at December 31, 2001 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Amortized Estimated Cost Fair Value ---- ---------- (In thousands) Due in one year or less.................................... $ 6,291 $ 6,299 Due after one year through five years...................... 19,863 20,254 Due after five years through ten years..................... 27,715 27,703 Due after ten years through fifteen years.................. 16,908 16,885 Due after fifteen years.................................... 148,355 141,153 ------- ------- Total.................................................. $219,132 $212,294 ======= =======
The contractual maturities of held-to-maturity debt securities at December 31, 2001 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations:
Amortized Estimated Cost Fair Value ---- ---------- (In thousands) Due in one year or less.................................... $ 4,065 $ 4,111 Due after one year through five years...................... 3,171 3,389 Due after five years through ten years..................... Due after ten years through fifteen years.................. Due after fifteen years.................................... 6,573 6,270 ------ ------ Total.................................................. $13,809 $13,770 ====== ======
Gross realized gains on investments for the years ended December 31, 2001, 2000 and 1999 were $1,071,000, $450,000 and $261,000, respectively. Gross realized losses on investments for the years ended December 31, 2001, 2000 and 1999 were $679,000, $1,070,000 and $642,000, respectively.
Investment income, by major category of investments, is summarized as follows:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Interest from debt securities...................... $14,051 $14,035 $14,387 Dividend income from preferred stock............... 507 335 411 Mortgage interest.................................. 1,169 842 1,130 Other.............................................. 45 ------ ------ ------ Total investment income.......................... 15,727 15,257 15,928 Less investment expenses........................... 252 183 152 ------ ------ ------ Net investment income............................ $15,475 $15,074 $15,776 ====== ====== ======
Of the total debt securities and cash equivalents, $153,268,000, $161,618,000 and $171,639,000, at fair value, were on deposit with regulatory authorities in compliance with certain legal requirements related to the insurance operations at December 31, 2001, 2000 and 1999, respectively.
The Company holds certain mortgage notes on residential and commercial real estate. In connection with CII Financial's relocation of its principal executive offices to Pleasanton, California in July 1992, to retain key officers and other employees, the Company extended mortgage loans for the purchase of such employees' principal residences. In 1994, the terms of the loans were amended and the interest rate was reduced to a fixed rate of 3% per annum; the maturity date was fixed to March 2009; and each loan can be assumed, one time, by a qualified purchaser of the employee's residence. The interest rate, upon assumption, increases to 3.5% per annum. As of December 31, 2001 and 2000, the outstanding balances on relocation loans to active employees, which are included on the balance sheet as mortgage loans on affiliated real estate, were $992,000 and $1,257,000, respectively. Relocation loans to non-active employees are included on the balance sheet as mortgage loans on non-affiliated real estate and as of December 31, 2001 and 2000, the outstanding balances were $2,363,000 and $3,327,000, respectively.
The Company also holds two non-affiliated commercial mortgage loans. One of the commercial mortgage loans is currently in default; the principal balance outstanding was $1,635,000 at December 31, 2001. The property has been appraised at a value that exceeds book value. The interest rate is at the default rate of 16.25%; however, no interest income has been accrued since the default date. The Company has asserted the priority of its lien on the property and is currently in the process of selling the underlying real estate.
The second commercial mortgage loan of $7.4 million was originally financed to Sierra in 2000 but was assumed by a non-affiliated buyer in conjunction with a sale-leaseback of Sierra's Las Vegas real estate portfolio. The loan to value based on the purchase price was 64%. The interest rate varies each month based on LIBOR plus a margin and the interest rate at December 31, 2001 was 5.48%. The loan was scheduled to mature on December 31, 2001; however, the buyer exercised the option to extend the maturity date for six months and paid a fee of .5% of the outstanding balance. The buyer can extend the loan for an additional six months with proper notice to California Indemnity and payment of an additional fee.
5. Reinsurance
The Company has reinsurance agreements or treaties in effect with unrelated entities. Effective January 1, 2000, the Company entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. In 1999 and 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence were 100% reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence were reinsured under quota share and excess of loss reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, the Company reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this treaty was $17,000. The Company received a 9.25% ceding commission from the reinsurer as a partial reimbursement of its operating expenses. The low level reinsurance agreement expired on June 30, 2000; however, the Company opted to continue ceding premiums and losses under the low level agreement on a run off basis for all policies inforce on June 30, 2000. On July 1, 2000, the Company entered into a reinsurance agreement that covered losses on claims in excess of $250,000 to $500,000 for policies issued after June 30, 2000. The agreement terminated after one year on a cut-off basis and covered losses with dates of injury up to June 30, 2001.
The low level reinsurance agreement was consummated early in the fourth quarter of 1998 but coverage was made retroactive to July 1, 1998. Therefore, this agreement contained both retroactive (covering claims occurring in the third calendar quarter of 1998) and prospective reinsurance coverage (covering claims occurring after September 30, 1998) and, in accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS No. 113"), the Company bifurcated the low level reinsurance agreement to account for the different accounting treatments. The amount by which the estimated ceded liabilities exceeded the amount paid for the retroactive coverage was reported as a deferred gain and amortized to income as a reduction of incurred losses over the estimated remaining settlement period using the interest method. Any subsequent changes in estimated or actual cash flows related to the retroactive coverage are accounted for by adjusting the previously recorded deferred gain to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transactions, with a corresponding charge or credit to income. The Company recorded an adjustment to increase its deferred gain related to retroactive reinsurance coverage by $2,996,000, $3,662,000 and $4,615,000 in 2001, 2000 and 1999, respectively. For the years ended December 31, 2001, 2000 and 1999, the Company amortized deferred gains of $2,696,000, $5,199,000 and $3,850,000, respectively. Such amortization is included as a reduction in loss and loss adjustment expenses on the accompanying consolidated statements of operations.
In accordance with SFAS No. 113, losses ceded under prospective reinsurance reduce direct incurred losses and amounts recoverable are reported as an asset. At December 31, 2001 and 2000, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid loss and LAE was $187,453,000 and $218,757,000, respectively. At December 31, 2001 and 2000, the amount of reinsurance recoverable under the retroactive reinsurance contract was $8,781,000 and $10,863,000, respectively. The amount of reinsurance receivable for paid loss and LAE was $21,845,000 and $17,585,000 at December 31, 2001 and 2000, respectively.
Reinsurance contracts do not relieve the Company from its obligations to injured workers or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All of the reinsurance recoverables are due from reinsurers rated AA and A+ by Fitch Ratings and the A.M. Best Company, respectively, and all amounts are considered to be collectible.
The following table provides workers' compensation prospective reinsurance information for the periods ended:
Change in Recoveries Recoverable on Paid or Unpaid Premiums Loss / LAE Loss / LAE Ceded ---------- ---------- ----- (In thousands) Year Ended December 31, 2001: Low level reinsurance carrier................... $80,932 $(40,430) $ 9,136 Excess of loss reinsurance carriers............. 4,407 9,125 4,244 ------ ------- ------ Total.......................................... $85,339 $(31,305) $13,380 ====== ======= ======
Year Ended December 31, 2000: Low level reinsurance carrier................... $53,408 $100,240 $74,071 Excess of loss reinsurance carriers............. 2,324 8,428 3,449 ------ ------- ------ Total.......................................... $55,732 $108,668 $77,520 ====== ======= ======
Year Ended December 31, 1999: Low level reinsurance carrier................... $21,941 $ 69,104 $60,702 Excess of loss reinsurance carriers............. 1,730 3,188 3,025 ------ ------- ------ Total.......................................... $23,671 $ 72,292 $63,727 ====== ======= ======
6. Loss and Loss Adjustment Expenses
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid loss and LAE. The loss estimates are subject to change in subsequent accounting periods and any change to the current reserve estimates would be accounted for in future results of operations.
While management of the Company believes that current estimates are reasonable, significant adverse or favorable loss development could occur in the future.
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Net beginning loss and LAE reserve.............. $155,797 $134,305 $174,467
Net provision for insured events incurred in: Current year.............................. 131,923 86,587 51,541 Prior years............................... 8,691 23,293 9,920 ------ ------- ------- Total net provision........................... 140,614 109,880 61,461 ------- ------- -------
Net payments for loss and LAE Attributable to insured events incurred in: Current year.............................. 28,560 26,867 21,207 Prior years............................... 69,599 61,521 80,416 ------ ------- ------- Total net payments............................ 98,159 88,388 101,623 ------ ------- -------
Net ending loss and LAE reserve................. 198,252 155,797 134,305 Reinsurance recoverable......................... 187,453 218,757 110,089 ------- ------- -------
Gross ending loss and LAE reserve............... $385,705 $374,554 $244,394 ======= ======= =======
During the years ended December 31, 2001 and 2000, the Company experienced prior year net adverse loss development of $8.7 million and $23.3 million, respectively. In 2000, estimated losses and LAE incurred in accident years 1996 to 1999 have developed significantly due to the continuation of increasing claim severity patterns on the Company's California book of business. This trend continued into 2001 where estimated losses and LAE incurred on accident years 1995 to 1998 adversely developed. Many workers' compensation insurance carriers in California are also experiencing high claim severity. Factors influencing the higher claim severity include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical control of a claimant's treatment. In February 2002, new legislation was enacted in California that will largely negate the adverse court decisions related to medical control.
For claims occurring on and after July 1, 1998, the Company has reinsured a percentage of the higher claim severity under the Company's low level reinsurance agreement. The low level reinsurance agreement expired on June 30, 2000; however, the Company opted to continue ceding premiums and losses under the low level agreement on a run-off basis for all policies inforce on June 30, 2000. Effective January 1, 2000, the Company entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 up to $500,000 for policies issued after June 30, 2000. This agreement terminated after one year on a cut-off basis and covered losses with dates of injury to June 30, 2001.
For the year ended December 31, 1999, the Company recorded net adverse loss development on prior accident years of $9.9 million, primarily for accident years 1996 to 1998. This adverse development was largely due to the higher average California claim severity patterns that the Company experienced in the last half of 1999.
7. Debentures
In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "Subordinated Debentures") of which $47,059,000 were outstanding at March 31, 2001. Interest on the Subordinated Debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share. During 2000 and 1999, the Company repurchased $3,457,000 and $753,000 of the Subordinated Debentures in the open market resulting in an extraordinary gains of $1,007,000 and $170,000 and corresponding tax provisions of $353,000 and $59,000, respectively.
In December 2000, CII Financial commenced an offer to exchange the Subordinated Debentures for cash and/or new debentures. To facilitate the exchange, CII Financial borrowed $17.0 million from Sierra and California Indemnity obtained the necessary approval from the California Department of Insurance to pay a dividend of $5.0 million to CII Financial. On May 7, 2001, CII Financial closed its exchange offer on $42.1 million of its outstanding Subordinated Debentures. CII Financial purchased $27.1 million in principal amount of Subordinated Debentures for $20.0 million in cash and issued $15.0 million in 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in Subordinated Debentures.
In September 2001, California Indemnity received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used the funds to fully pay the remaining $5.0 million in Subordinated Debentures at maturity.
The exchange offer contained concessions by the holders of the Subordinated Debentures, including extending the maturity and accepting an interest rate that may have been lower than what CII Financial could have obtained from other lenders. In accordance with accounting principles generally accepted in the United States of America, the exchange of the 9 1/2% senior debentures for the Subordinated Debentures was treated as a restructuring of debt. Additionally, the Subordinated Debentures were considered to represent one payable, even though there were many debenture holders. Although some of the debenture holders exchanged the Subordinated Debentures for cash, some exchanged them for new 9 1/2% senior debentures and others a combination of the two, this did not change the substance of the transaction for CII Financial; accordingly, the exchange was considered to be a single transaction.
In the transaction, total future cash payments (interest and principal) on the remaining Subordinated Debentures and the 9 1/2% senior debentures were less than the balance of the Subordinated Debentures at the time of the exchange less the cash consideration given in the exchange. Accordingly, a gain on restructuring was recognized for the difference and the carrying amount of the remaining Subordinated Debentures and 9 1/2% senior debentures is the total future cash payments on the debentures. Costs incurred in connection with the exchange were used to offset the gain on restructuring. All future cash payments related to the debentures are reductions of the carrying amount of the debentures; therefore, no future interest expense will be recognized for the debentures. Accordingly, the 9 1/2% senior debentures have a carrying amount of $19.2 million, which consists of principal amount of $15.0 million and future accrued interest of $4.2 million. The transaction resulted in an extraordinary gain of $557,000 and a corresponding tax provision of $195,000.
The 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. The 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums starting at 110% and declining to 100% for redemptions after April 1, 2004. In the event of a change in control of CII Financial, the holders of these 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest.
8. Commitments and Contingencies
Leases. The Company is the lessee under several operating leases most of which relate to office facilities and equipment. The rentals on these leases are charged to expense over the lease term and, where applicable, provide for rent escalations based on certain costs and price index factors. The Company has a sublease from Sierra for its Las Vegas, Nevada branch office through December 31, 2002. The Company has the option to renew yearly up to the term of the underlying Sierra lease, which as of December 31, 2001 had 13 more years before it expires. The following is a schedule, by year, of the future minimum lease payments under existing operating leases:
(In thousands) Years Ending December 31, 2002................................................... $2,452 2003................................................... 493 2004................................................... 140 2005................................................... 99 2006................................................... 47 Thereafter............................................. 0 ----- Total............................................. $3,231 =====
Rent expense totaled $2,986,000, $2,867,000 and $2,602,000 in 2001, 2000 and 1999, respectively.
Guaranty of Sierra's Credit Facility Debt. At June 30, 2000, Sierra was not in compliance with certain financial covenants relating to its line of credit. The lenders provided Sierra with waivers effective June 30, 2000 and expiring October 31, 2000. In consideration for the banks granting one of the waivers, in August 2000, CII Financial became a guarantor of Sierra's credit facility debt. The waivers expired on October 31, 2000 and Sierra received a Notice of Default from the banks on November 8, 2000. No demand was made by the banks to perform on the guaranty and Sierra was able to amend its credit facility agreement on December 15, 2000. The new Sierra credit facility agreement expires on September 30, 2003. In the amended agreement, CII Financial continues to provide a guaranty of the debt in the event of a default by Sierra. However, the 9 1/2% senior debentures rank senior to CII Financial's guarantee of Sierra's revolving credit facility.
Litigation and Legal Matters. The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. In the opinion of the Company's management, the ultimate resolution of pending legal proceedings should not have a material adverse effect on the Company's financial condition.
9. Federal Income Taxes
A summary of the provision for income taxes for the years ended December 31, 2001, 2000 and 1999 is as follows:
Years Ended December 31, 2001 2000 1999 (In thousands) ---- ---- ---- Provision (benefit) for income taxes: Current tax on operating results................... $1,437 $ 862 $(2,286) Deferred tax on operating results ................ 10 (4,531) 5,888 ----- ------ ------ Total tax on operating results................ 1,447 (3,669) 3,602 Current tax on extraordinary gain.................. 195 353 59 ----- ------ ------ Total......................................... $1,642 $(3,316) $ 3,661 ===== ====== ======
The following reconciles the difference between the 2001, 2000 and 1999 reported and statutory (benefit) provision for income taxes:
Years Ended December 31, 2001 2000 1999 ---- ---- ----
Statutory rate................................................ 35% (35%) 35% Tax preferred investments..................................... (6%) (3%) (6%) Change in valuation allowance................................. 10% 9% 16% Other......................................................... 6% (4%) 5% --- ---- --- Provision (benefit) for income taxes....................... 45% (33%) 50% === ==== ===
Under the tax sharing agreement with Sierra, the amount and expiration dates of CII Financial's net operating losses as of December 31, 2001 are as follows:
Year Generated Amount Expires --------- ------ ------- 1993 $ 4,966,000 2007 1994 4,419,000 2008 1995 2,356,000 2009 1995 1,930,000 2010 1996 3,338,000 2011 1997 4,114,000 2012 1998 3,685,000 2018 1999 3,250,000 2019 2000 2,931,000 2020 ---------- $30,989,000 ==========
The tax effects of significant items comprising the Company's net deferred tax assets at December 31, 2001 and 2000 are as follows:
December 31, 2001 2000 (In thousands) ---- ---- Deferred tax assets: Loss and LAE reserves......................................... $ 5,409 $ 3,653 Accruals not currently deductible............................. 1,949 412 Compensation accruals......................................... 784 948 Bad debt allowances........................................... 491 507 Loss carryforwards and credits................................ 12,549 14,767 Unearned premiums............................................. 1,554 1,874 Policyholders' dividends...................................... 114 613 Depreciation and amortization................................. 0 424 Deferred reinsurance gains.................................... 2,022 1,917 Unrealized investment losses.................................. 2,389 2,442 ------- ------ Total.................................................... 27,261 27,557
Deferred tax liabilities: Deferred policy acquisition costs............................. 783 705 Depreciation and amortization................................. 256 0 Other......................................................... 321 537 ------- ------ Total.................................................... 1,360 1,242
Net deferred tax asset before valuation allowance................. 25,901 26,315 Valuation allowance............................................... (10,956) (11,306) ------- -------
Net deferred tax asset............................................ $ 14,945 $ 15,009 ======= =======
In accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS No. 109"), the Company has established a valuation allowance for the net deferred tax asset of CII Financial. Under the tax sharing agreement with Sierra, CII Financial can only utilize these deferred tax benefits to the extent of separate return income. With the exception of 2001, CII Financial, on a stand alone basis, has historically had significant net operating losses each year. During 2001, CII Financial had taxable income as a result of the refinancing of its Subordinated Debentures. As a result, for the year ended December 31, 2001, the Company decreased the valuation allowance by $350,000 as compared to an increase of $1,079,000 for the year ended December 31, 2000.
In lieu of state franchise and corporate income taxes, California Indemnity, Commercial Casualty, CII Insurance and Sierra Texas pay premium taxes based upon direct written premiums to the states in which they write business. Premium tax expense of $5,437,000, $5,441,000 and $4,078,000 is included in policy acquisition costs in the Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999, respectively.
Current tax receivable balances were $614,000 and $1,945,000 as of December 31, 2001 and 2000, respectively. These amounts are due from Sierra as the administrative agent under the tax sharing agreement.
10. Dividend Restrictions - Insurance Subsidiaries
Under California insurance company statutes and regulations, California Indemnity, Commercial Casualty and CII Insurance are restricted as to the amount of dividends they may pay on their common stock to their respective parent companies. Sierra Texas is regulated by Texas insurance statutes and regulations that are similar to California in terms of paying dividends. No dividends may be paid without at least ten business days prior notice to the Insurance Commissioner. Unless approved by the Insurance Commissioner prior to payment, dividends may be paid only out of accumulated earned surplus, excluding any earned surplus attributable to unrealized appreciation in assets or an exchange of assets.
If a dividend or other distribution is contemplated which, along with all other dividends or distributions made within the preceding twelve months, exceeds the greater of 10% of the insurance company's policyholders' surplus as of the end of the prior calendar year or net income for such calendar year, at least 30 days prior notice to the Commissioner must be given, and no payment of the dividend or distribution may be made unless and until (i) the Commissioner has approved it or (ii) the 30 days have elapsed and the Commissioner has not disapproved the proposed payment.
Net income and capital and surplus (equity) of domestic insurance subsidiaries, as filed with regulatory authorities on the basis of statutory accounting practices, are summarized as follows:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Statutory net income (loss) for the years ended......... $ 2,427 $ (6,108) $ 12,283 Statutory capital and surplus at year end................ 106,781 108,178 118,278
Based on its financial position as of December 31, 2001, California Indemnity can pay $2.1 million in shareholder dividends to CII Financial during calendar year 2002 without the prior approval of the California Insurance Commissioner. Commercial Casualty, CII Insurance and Sierra Texas can pay $1,278,000, $369,000 and $194,000, respectively to California Indemnity without prior approval of the applicable state insurance commissioner.
CII Financial, Inc. paid dividends of $2,637,000, in March 2000, to Sierra. California Indemnity paid dividends to CII Financial of $10,000,000 and $6,800,000, during 2001 and 2000, respectively. During 2001 and 2000, Commercial Casualty paid $3,000,000 and $1,685,000, respectively, in dividends to California Indemnity. CII Insurance Company paid $250,000 and $375,000 during 2001 and 2000, respectively, in dividends to California Indemnity. Due notice was filed with the California Department of Insurance, and all payments were made after the expiration of the required waiting period in accordance with California Insurance regulations.
The National Association of Insurance Commissioners ("NAIC") adopted risk-based capital guidelines for property-casualty insurance companies whereby required statutory surplus would be based, in part, on a formula based risk assessment of the individual investments held in the insurance company's portfolio. The Company's risk-based capital results for the years ended December 31, 2001, 2000 and 1999 exceeded the minimum surplus required under the regulations.
In March 1998, the NAIC adopted the Codification of Statutory Accounting Principles (the "Codification"). The Codification, which is intended to standardize regulatory accounting and reporting for the insurance industry, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The insurance subsidiaries were required to implement the Codification, with certain applicable state modifications, for the preparation of statutory financial statements effective January 1, 2001. The adoption of the Codification, as modified by the applicable state, increased the Company's insurance subsidiaries' statutory capital and surplus as of January 1, 2001, by approximately $7.0 million, which was primarily due to prescribed statutory accounting principles under the Codification regarding income taxes, earned but unbilled premiums and electronic data processing equipment.
11. Employee Compensation and Benefit Plans
Defined Contribution Plan. All employees who meet minimum requirements can participate in Sierra's defined contribution pension and 401(k) plan (the "Plan"). The Plan covers all employees who meet certain age and length of service requirements. For the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS statute. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral and the maximum Company match is 6% of a participant's annual compensation, subject to Internal Revenue Service limits. The Plan does not require additional Company contributions. For the years ended December 31, 2001, 2000 and 1999, the Company expensed $585,000, $500,000 and $601,000, respectively, to this plan.
Executive Retirement Plans. The Company offered key employees and officers a Supplemental Executive Retirement Plan and Supplemental Senior Executive Retirement Plan. Eligibility for participation in both plans was limited to officers and key employees selected and approved by the Board of Directors. These plans were terminated effective October 31, 1995, and there have been no further contributions. Pursuant to contractual obligations under the plans, the Company paid $258,000, $250,000 and $250,000 to former plan participants in the years ended December 31, 2001, 2000 and 1999, respectively.
Employment Contracts. The Company currently has an employment contract with its Chief Executive Officer expiring December 2003. Minimum aggregate cash compensation obligations under this contract is $240,000, per year.
Employee Stock Purchase Plan. The Company offers employee stock purchase plans through Sierra (the "Purchase Plan") whereby employees may purchase newly issued shares of Sierra stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan.
Stock Option Plans. The Company offers several plans, through Sierra, that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of Sierra options, stock, and other stock-based awards. Awards are granted by a committee appointed by the Sierra Board of Directors and no specific amount has been reserved for the Company's employees. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of Sierra stock on the date of grant. Stock options generally vest at a rate of 20% - 33% per year. Options generally expire from one to seven years after the end of the vesting period.
The following table reflects the activity of the stock option plans for the Company's employees:
Number of Option Weighted Shares Price Average Price ------ ----- -------------
Outstanding January 1, 1999 ................ 323,000 $ 6.31 - $24.50 $16.56
Granted.................................. 152,000 6.69 - 21.00 8.87 Exercised................................ (1,000) 6.31 - 11.71 7.81 Canceled................................. (19,000) 11.71 - 24.50 13.87 -------- Outstanding December 31, 1999............... 455,000 6.31 - 24.50 14.12
Granted.................................. 149,000 3.25 - 6.19 3.97 Canceled................................. (164,000) 3.25 - 24.50 19.43 -------- Outstanding December 31, 2000............... 440,000 3.25 - 24.50 8.89
Granted................................... 163,000 4.24 - 8.93 6.72 Exercised................................. (30,000) 3.75 - 8.00 5.87 Canceled.................................. (57,000) 3.75 - 24.50 13.53 -------- Outstanding December 31, 2001............... 516,000 3.25 - 24.50 7.87 ========
Exercisable at December 31, 2001 ........... 150,000 $ 3.25 - $24.50 $10.28 ========
The following table summarizes information about stock options outstanding at December 31, 2001:
Weighted Average Weighted Average Range of Exercise Contractual Life Options Exercise Price Prices Remaining in Days Outstanding Exercisable Outstanding Exercisable --------------------- ----------------- ----------- ----------- ----------- -----------
$ 3.25 - $ 5.73 3,224 216,000 30,000 $ 4.58 $ 5.04 6.19 - 8.93 2,337 201,000 54,000 7.74 7.04 9.91 - 20.75 4,052 67,000 46,000 11.74 12.07 21.00 - 24.50 937 32,000 20,000 22.78 23.15
Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its employee stock option plans nor the Purchase Plan. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income for the years ended December 31 would have been reduced to the pro forma amounts indicated below:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Net Income (Loss): As reported............ $1,985 $(7,729) $3,604 Pro forma.............. 1,522 (8,049) 3,188
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 82%, 52% and 43%; risk-free interest rates of 4.34%, 6.72% and 5.86%; and expected lives of three to five years. The weighted average fair value of options granted in 2001, 2000 and 1999 was $5.70, $2.76 and $3.82, respectively.
The fair value of the look-back option implicit in each offering of the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 85%, 46% and 45%; risk-free interest rates of 4.36%, 5.79% and 4.66%; and expected lives of six months for all years.
During 1999, Sierra extended by three years the expiration date for 6,000 options covering shares that would have expired in 1999 and 2000. The exercise price per share for these options ranges from $12.08 to $19.08. No expense was recognized in the consolidated statement of operations related to these options. Expense of $31,000 is included in the pro forma information presented.
Due to the fact that the Company's stock option programs vest over many years and additional awards are made each year, the above pro forma numbers are not indicative of the financial impact had the disclosure provisions of Statement of Financial Accounting Standards No. 123 been applicable to all years of previous option grants. The above numbers do not include the effect of options granted prior to 1995.
12. Other Related Party Transactions
Effective January 1, 1999, the Company entered into an investment services agreement with Sierra. Under this agreement, Sierra manages the investments of the Company. Sierra is, however, subject to the Company's investment guidelines and the ultimate control of each insurer's board of directors. The management fee is a percentage of the total amount under management. The annual investment fees paid by the Company in 2001, 2000 and 1999 were approximately $265,000, $400,000 and $335,000, respectively.
Effective January 1, 1999, Sierra and California Indemnity entered into a management agreement where Sierra would furnish services, including accounting, human resources, systems and other administrative services. The fee for the services is based on the actual direct and allocable cost. The services are subject to the ultimate control of California Indemnity Insurance Company's board of directors. The annual fees for these services were approximately $1,335,000, $1,201,000 and $1,003,000 in 2001, 2000 and 1999, respectively. The Company did not have a management agreement with Sierra prior to January 1, 1999.
The Company purchases employee health insurance from its affiliates, Health Plan of Nevada, Inc., Sierra Health and Life Insurance Company, Inc. and Texas Health Choice, L.C. The Company paid $885,000, $672,000 and $642,000 to the aforementioned affiliates for years ended December 31, 2001, 2000 and 1999, respectively. The premiums paid to its affiliates were determined on an arms-length basis.
At January 1, 1999, California Indemnity and Commercial Casualty invested in a real estate limited partnership of which Sierra is the general partner. California Indemnity agreed to adjust its partnership interest to approximate its occupancy. Together, the two insurance subsidiaries own limited partner interests totaling approximately 27% of the limited partnership. These transactions were done to enable both companies to qualify for certain premium tax credits in the state of Nevada and were approved by the California Department of Insurance. California Indemnity also had a rental agreement with the related partnership under which California Indemnity leased a portion of the transferred real estate. Rental expense under this agreement was approximately $1,267,000 and $1,168,000 for the years ended December 31, 2000 and 1999 , respectively. In December 2000, in conjunction with a sale-leaseback transaction of Sierra's Las Vegas real estate portfolio, the limited partnership sold the real estate to an unrelated third party and the rental agreement was canceled. Sierra entered into a 15-year master lease with the third party purchaser of this real estate. Effective January 1, 2001, Sierra and California Indemnity have entered into a one-year sublease for the space occupied by California Indemnity. The sublease is subject to the provisions of Sierra's master lease and automatically renews from year to year unless California Indemnity gives notice prior to December 1 of each year. Rental expense under this agreement was approximately $1,176,000 for the year ended December 31, 2001.
In March 2000, California Indemnity financed a $7,400,000 five-year mortgage note to Sierra. The note was secured by a first deed of trust and earned quarterly interest payments at 8.75% per annum beginning April 1, 2000 until April 1, 2005, when the unpaid principal balance was due and payable in full. The note was callable in April 2001. In December 2000, in conjunction with a sale-leaseback of Sierra's Las Vegas real estate portfolio, the mortgage note was assumed by the buyer. The loan to value based on the purchase price was 64%. The interest rate was increased to 30-day LIBOR plus a margin and the maturity date was set at December 31, 2001. The loan was scheduled to mature on December 31, 2001; however, the buyer exercised the option to extend the maturity date for six months and paid a fee of .5% of the outstanding balance. The buyer can extend the loan for an additional six months with proper notice to California Indemnity and payment of an additional fee.
In order to make the September 15, 2000 interest payment on the junior subordinated debentures, Sierra advanced $365,000 to CII Financial, Inc.
In connection with the exchange offer for the Subordinated Debentures, (see Note 7 of these consolidated financial statements), California Indemnity loaned Sierra $7.5 million. The loan bears interest at 8.5%, which is due semi-annually on March 31 and September 30 of each year, commencing September 30, 2001. All outstanding principal and accrued interest is due on September 30, 2004. The loan is secured by the common stock of Sierra Health and Life Insurance Company ("SHL"), a wholly owned subsidiary of Sierra, equal to 120% of the principal amount outstanding. At December 31, 2001, SHL had total equity, on a statutory accounting basis of approximately $16.4 million. As an additional part of the exchange offer transaction, Sierra lent CII Financial $15.0 million as well as an additional $2.0 million to enable CII Financial to pay the accrued interest on the Subordinated Debentures due March 15, 2001 and other operating expenses. Each of the loans are demand notes payable and bear interest at 9.5%, which is due on demand or semi-annually on March 15 and September 15 of each year, commencing September 15, 2001. The notes are subordinated to the 9 1/2% senior debentures and CII Financial's guaranty of Sierra's credit facility.
In May 2001, Sierra purchased $1.0 million of the 9 1/2% senior debentures from a non-affiliated debenture holder. These debentures are still outstanding and Sierra received $35,000 in interest payments in 2001.
In November 2001, California Indemnity acquired a newly constructed commercial building in the city of North Las Vegas and entered into a five-year lease agreement with Sierra. The monthly base rent is $13,500 and is subject to annual cost of living adjustments starting November 1, 2002 and a further market rental value adjustment on November 1, 2006. Sierra has the option to extend the terms of the lease for an additional five-year period.
California Indemnity has cost sharing agreements with two of its affiliates, SHL and Nevada Administrators, Inc. ("NVA"). In its agreement with SHL, the Company purchases the use of SHL's Health Care Organization ("HCO") and other managed care services. The services are provided at cost. During 2001, the Company paid $5.0 million to SHL under the terms of this agreement. In its agreement with NVA, the Company receives reimbursement for certain services provided by the Company at cost. During 2001, the Company received $57,000 from NVA under the terms of this agreement.
13. Unaudited Quarterly Information
The following table sets forth the unaudited data regarding operations for each quarter of the years ended December 31, 2001 and 2000. In the opinion of management, such unaudited data includes all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the information presented. The Company's operating results for any quarter are not necessarily indicative of the operating results for any future period.
March June September December 31 30 30 31 (In thousands) ----------- ------------- ----------- ---------- Year ended December 31, 2001: Net earned premiums.............................. $38,890 $ 42,484 $46,918 $44,923 Net investment income............................ 4,495 3,848 3,556 3,968 ------ ------- ------ ------ Total revenues................................... 43,385 46,332 50,474 48,891 Costs and expenses............................... 43,244 44,752 49,929 48,087 ------ ------- ------ ------ Income before income tax and extraordinary gain........................... 141 1,580 545 804 Federal income tax provision ................... 225 332 204 686 ------ ------- ------ ------ Income (loss) before extraordinary gain.......... (84) 1,248 341 118 Extraordinary gain, net of tax................... 0 463 (64) (37) ------ ------- ------ ------
Net (loss) income................................ $ (84) $ 1,711 $ 277 $ 81 ====== ======= ====== ======
Year ended December 31, 2000: Net earned premiums.............................. $25,344 $ 27,344 $38,263 $34,604 Net investment income............................ 3,369 3,571 3,817 3,697 ------ ------- ------ ------ Total revenues................................... 28,713 30,915 42,080 38,301 Costs and expenses............................... 25,926 48,957 40,832 36,346 ------ ------- ------ ------ Income (loss) before income tax and extraordinary gain........................... 2,787 (18,042) 1,248 1,955 Federal income tax provision (benefit)........... 1,153 (6,492) 437 1,233 ------ ------- ------ ------ Income (loss) before extraordinary gain.......... 1,634 (11,550) 811 722 Extraordinary gain, net of tax................... 76 485 93 0 ------ ------- ------ ------
Net income (loss) ............................... $ 1,710 $(11,065) $ 904 $ 722 ====== ======= ====== ======
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors and Executive Officers
The following table sets forth information concerning our directors and executive officers
Name Position Age ---- -------- ---
Paul H. Palmer..................... Director........................................................41 Frank E. Collins................... Director........................................................47 Kathleen M. Marlon................. President, Chief Executive Officer and Chairman of the Board of Directors..............................43 John F. Okita...................... Chief Financial Officer and Director............................53 Robert G. Riordan.................. Senior Vice President...........................................49 Louis R. Fabre..................... Vice President..................................................43 Kyle M. Fritzsinger................ Vice President..................................................53 Collette M. Mangold................ Treasurer and Controller........................................40 Robert L. Selli.................... Vice President..................................................60 David M. Sonenstein................ General Counsel and Secretary...................................53
Paul H. Palmer, Director. Mr. Palmer is the vice president of finance, chief financial officer and treasurer of Sierra. He was promoted to these offices in 1998. Prior to this, he was assistant vice president of Sierra from May 1996, corporate controller from November 1994 and director of finance when he joined Sierra in 1993. Prior to joining Sierra, Mr. Palmer was an audit manager at Deloitte & Touche LLP (formerly Touche Ross) in Las Vegas and California from 1988 to 1993. Mr. Palmer is a certified public accountant with an MBA and masters in accounting from Brigham Young University. He is a member of the American Institute of Certified Public Accountants, the Nevada State Society of Certified Public Accountants and the California State Society of Certified Public Accountants.
Frank E. Collins, Director. Mr. Collins joined Sierra in 1986 as general counsel and secretary. In 1997 he was appointed executive vice president. In 2001 he became senior vice president of legal and administration. From 1981 to 1986, Mr. Collins was employed by Blue Cross and Blue Shield of Kansas City, originally as staff legal counsel and in 1986 as associate general counsel. Mr. Collins also served as counsel for the Missouri Division of Insurance from 1979 to 1981, where he was responsible for providing legal advice on insurance- and HMO-related regulatory issues. Mr. Collins received his Juris Doctorate in 1979 from the University of Missouri at Kansas City school of law and is a member of the Missouri Bar Association.
Kathleen M. Marlon, President, Chief Executive Officer and Chairman of the Board of Directors. Ms. Marlon joined Sierra in March 1986. In 1990, she became president and chief operating officer of Sierra Healthcare Options, Inc., a start-up subsidiary of Sierra. In February 1996, Ms. Marlon became our president and chief executive officer. In December 2000, Ms. Marlon became our chairman. Prior to joining Sierra, Ms. Marlon held technical and management positions for six years with Delphi Systems and Quality Systems. Ms. Marlon received her Bachelor of Science in Accounting from the University of Southern California in 1980. Ms. Marlon has successfully completed the CPA exam and Property & Casualty and Health licensing exams and holds a F.L.M.I. designation. Ms. Marlon is married to Anthony M. Marlon's nephew. Anthony M. Marlon is the chairman and chief executive officer of Sierra.
John F. Okita, Chief Financial Officer and Director. Mr. Okita has served in this capacity since he started his employment with us in April 1992 until September 1999 and from June 2000 to present. In September 1999, Mr. Okita left us to become the corporate controller of Sierra, a position he still holds. In June 2000, he returned to us as our chief financial officer. Mr. Okita was elected to our board of directors in September 2001. Mr. Okita is a certified public accountant and a licensed attorney and has over twenty years of property-casualty insurance industry experience. Prior to joining us, Mr. Okita was in private tax and financial consulting practice. Mr. Okita served in several financial executive capacities at Fremont Insurance Group between 1980 and 1990. Prior to that, Mr. Okita was employed by Coopers & Lybrand from 1975 and audited both property-casualty and life insurance companies. Mr. Okita received his Bachelor of Science in Business Administration from California State University at Los Angeles and his Juris Doctorate from Loyola Law School.
Robert G. Riordan, Senior Vice President. Mr. Riordan was promoted to this position in May 1997 after having served as director of field operations since November 1993. He was vice president of Northern California operations for USA Casualty Company from November 1991 until joining Sierra in 1993. Prior to USA Casualty, Mr. Riordan had held various underwriting, marketing and financial reporting positions with Fireman's Fund Insurance Companies since 1976. Mr. Riordan attended Steubenville College where he received a Bachelor of Science degree in Business Administration.
Louis R. Fabre, Vice President. Mr. Fabre has served in this capacity since he started his employment with the Company in September 1998. Mr. Fabre has over 17 years in Information Technologies, primarily in business applications relating to workers' compensation, financial accounting and purchasing systems. Mr. Fabre has extensive experience in programming fourth generation languages and extensive data base administration experience in client server architecture. Prior to joining the company, Mr. Fabre worked with Zenith Insurance Company for 3 years as the Director of Software Development. During his tenure at Zenith, he was responsible for the oversight of over 30 developers and analysts. From 1986 to 1995, Mr. Fabre worked for Computer Sciences Corporation as a Consultant where he was a Project Manager, managing projects for various companies and organizations. Prior to that, Mr. Fabre served in the United States Air Force where he held various positions relating to computer technologies.
Kyle M. Fritzsinger, Vice President, Claims. Ms. Fritzsinger was promoted to this position in July 2000. She joined us in 1993 as the Claims Manager for the Burbank, California branch and was promoted to Assistant Vice President of Claims in Southern California in June 1995. Prior to joining us, Ms. Fritzsinger held Regional Claims Manager positions at California Compensation Insurance from 1991 to 1993 and Wausau Insurance Companies from 1985 to 1991. Ms. Fritzsinger graduated from the University of Wisconsin, Madison with a bachelor's degree in Education and she holds the Associate in Risk Management (ARM) designation.
Collette M. Mangold, Treasurer and Controller. Ms. Mangold was promoted to these positions in May 2000 after having served as our Accounting Manager from April 1997. Prior to joining us, Ms. Mangold served as a senior accountant for our parent, Sierra Health Services, from November 1994 until she transferred to us in October 1996. Ms. Mangold has a bachelor's degree in Accounting from Michigan State University and has over eighteen years of accounting experience. Prior to joining Sierra Health Services, Ms. Mangold was employed as an Assistant Controller at a manufacturing company.
Robert L. Selli, Vice President. Mr. Selli was promoted in November 1997 after serving as director of underwriting since December 1996. Mr. Selli has served as Northern California Underwriting Manager and key member of our California Open Rating Task Force since he joined us in January 1994. Prior to that time, Mr. Selli held various underwriting management and marketing positions with Fireman's Fund Insurance Company and Zurich American since entering the industry in 1967. Mr. Selli attended San Francisco State University where he received a Bachelor of Arts degree in economics.
David M. Sonenstein, General Counsel and Secretary. Mr. Sonenstein has served as general counsel since joining us in August 1997 and as secretary since early 1999. Mr. Sonenstein served as vice president and associate general counsel of Fireman's Fund Insurance Company, from 1991 to 1997. He started his employment with Fireman's Fund as Associate Counsel in 1979. Mr. Sonenstein was in private practice from 1972 to 1979. Mr. Sonenstein graduated from Claremont Men's College with a Bachelor of Arts degree and received his Juris Doctorate in 1972 from Hastings College of Law.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information with respect to the compensation paid by us for the year ended December 31, 2001 to our chief executive officer and to each of our four next most highly compensated executive officers:
SUMMARY COMPENSATION TABLE
Capacities in Cash All Other Name of Individual Which Served Compensation (1) Bonus Compensation --------------------- ------------ ---------------- ----- ------------
Kathleen M. Marlon President, Chief Executive Officer $245,508 $105,000 $ 20,935 (2)
John F. Okita Chief Financial Officer 164,106 (3) 100,200 (3) 7,357 (3)
Robert G. Riordan Senior Vice President 164,199 52,500 7,456
David M. Sonenstein General Counsel 146,886 38,000 7,102
Louis R. Fabre Vice President 139,190 32,000 0
(1) Amounts shown include cash compensation earned and received by the named executives as well as amounts earned but deferred at the election of the officers.
(2) Includes $13,493 of compensation resulting from split-dollar insurance policies purchased in 1997, calculated based on regulations of the SEC. The regulations require compensation to be calculated on the assumption that most of the premiums paid by us represent a long-term, no-interest loan to the executive. This assumption results in high compensation expense being shown in early years of the expected life of each policy and lower expense in later years, while in fact the cash surrender value of such a policy to the executive is very low in the early years and higher only in the late years.
(3) Mr. Okita's compensation was paid by Sierra to him in his capacity as assistant vice president, corporate controller. Mr. Okita's services to us as our chief financial officer was reimbursed to Sierra through the management fee, which includes accounting, human resources, systems and other administrative services. See "Certain Relationships and Related Transactions."
Compensation of Directors
The directors are our employees or employees of Sierra and receive no additional compensation for their service on our board.
Employment Agreements
Our subsidiary, California Indemnity Insurance Company, has entered into a three-year employment agreement with Kathleen M. Marlon, its chief executive officer. Under the agreement, Ms. Marlon may voluntarily terminate employment upon 60 days' notice. California Indemnity may terminate her employment, with or without cause, in accordance with California Indemnity's usual policies and procedures. The employment agreement provides that in the event of a termination by California Indemnity without cause, a severance payment will be paid in the amount of 12 months' salary to Ms. Marlon. The agreement also provides that, a disability must continue for at least six months before California Indemnity may terminate her employment. In the event of a change in control not approved by the board of directors of California Indemnity, or if a change in control is approved by the board but within two years thereafter Ms. Marlon is terminated without cause, demoted, provided reduced compensation or required to relocate, Ms. Marlon will be entitled to receive a payment equal to a multiple of two times her salary and target annual incentive. In addition, if "golden parachute" excise taxes apply to compensation paid by California Indemnity, California Indemnity will provide a gross-up payment sufficient to cause the after-tax value of the compensation and the gross-up payment to Ms. Marlon to be the same as if no such excise had applied. The employment agreement contemplates annual adjustments in compensation based on job duties, performance goals and objectives and other reasonable standards deemed appropriate by California Indemnity. The agreement restricts Ms. Marlon's use and disclosure of confidential information, interference with California Indemnity's business relationships, and competition with California Indemnity, including a prohibition, for a one-year period following any termination of employment, on her working for a competitor which operates in California, Nevada, or Texas.
Stock Options
Our executive officers participate in Sierra's stock option plan. The following table contains information concerning the grants by Sierra of stock options to acquire Sierra common stock to the named executives during fiscal year 2001:
OPTION/SAR GRANTS IN FISCAL YEAR 2001 Individual Grants (1) ----------------------------------------------------------- Number of Securities % of Total Potential Realizable Underlying Options/SARs Value at Assumed Options/SARs Granted to Exercise or Annual Rates of Stock Granted (#) Employees in Base Price Expiration Price Appreciation for (2), (3) 2001 ($/Share) Date Option Terms ------------ ------------ ----------- ---------- ------------------------ 5% ($) 10% ($) -------- -------- Kathleen M. Marlon 25,000 15% 8.93 12/10/11 $140,401 $355,803 50,000 31% 5.73 5/21/11 180,178 456,607 John F. Okita 7,500 5% 8.93 12/10/11 42,120 106,741 15,000 9% 5.73 5/21/11 54,053 136,982 Robert G. Riordan 4,000 2% 8.93 12/10/11 22,464 56,928 4,000 2% 5.73 5/21/11 14,414 36,529 David M. Sonenstein 2,500 2% 8.93 12/10/11 14,040 35,580 2,000 1% 5.73 5/21/11 7,207 18,264 Louis R. Fabre 3,000 2% 8.93 12/10/11 16,848 42,696 4,000 2% 5.73 5/21/11 14,414 36,529 -------------
(1) All options were granted at an exercise price equal to the fair market value of Sierra common stock on the option grant date. The exercise price may be paid by the optionee in cash or by check, except that Sierra's stock plan committee may, in its discretion, allow such payment to be by surrender of unrestricted shares of Sierra common stock (at their fair market value on the date of exercise), or by a combination of cash, check and unrestricted shares. (2) Options were granted on May 21, 2001 and December 10, 2001. The May 21, 2001 grant vests at 20% after 3 months and then 20% per year starting with the first anniversary date of the grant and will expire not later than ten years after grant. The December 10, 2001 grant vests at 20% per year starting with the first anniversary date of the grant and will expire not later than ten years after the grant. (3) All awards were non-qualified stock options granted pursuant to Sierra's 1995 long-term incentive plan. No stock appreciation rights were granted with the above awards. Upon a change of control of Sierra, as defined in the 1995 Plan, the vesting of the options will be automatically accelerated, provided, however, that Sierra's stock plan committee may exclude a change of control transaction from the foregoing provisions and permit the option to continue to vest in accordance with its original terms. In addition, the options shown above will terminate and may no longer be exercised if the respective optionee ceases to be an employee or director of Sierra or one of its affiliates, except certain post-termination exercise periods are permitted in the case of death, disability, or other involuntary termination except for a termination for "cause." The options together with certain gains realized upon exercise of the options during a specified period will be subject to forfeiture if the optionee engages in certain acts in competition with Sierra or one of its affiliates, misuses proprietary information of Sierra or one of its affiliates, or fails to assist Sierra or one of its affiliates in litigation. Cashless withholding to satisfy tax obligations may be permitted by Sierra's stock plan committee.
Option Exercises and Holdings
The following table provides information with respect to the named executives concerning the exercise of Sierra stock options during the fiscal year ended December 31, 2001 and unexercised Sierra stock options held as of December 31, 2001:
Aggregated Option/SAR Exercises in Fiscal 2001 and Year-End Option Values
Number of Securities Underlying Value of Unexercised Unexercised In-the-Money Options/SARs at Options/SARs at Shares FY-End (#) FY-End ($) Acquired on Value Exercisable/ Exercisable/ Exercise (#) Realized ($) Unexercisable Unexercisable (1) ------------ ------------ -------------- ------------------ Kathleen M. Marlon 30,000 108,750 30,500 / 167,500 $31,125 / 354,375 John F. Okita -0- -0- 31,590 / 39,500 35,722 / 89,940 Robert G. Riordan -0- -0- 16,336 / 22,119 10,502 / 31,416 David M. Sonenstein -0- -0- 8,000 / 13,750 9,535 / 27,548 Louis R. Fabre -0- -0- 5,400 / 15,100 10,483 / 31,340 --------------
(1) Based on the closing price of Sierra common stock on December 31, 2001, which was $8.10, minus the exercise price of the option.
CII Financial's Supplemental Executive Retirement Plans
Certain of our executive officers were participants in the CII Financial, Inc. Supplemental Executive Retirement Plan, or the SERP Plan, and the CII Financial, Inc. Supplemental Senior Executive Retirement Plan, or the Senior SERP Plan. These plans were effective as of January 1, 1990 and the SERP Plan was amended and restated April 24, 1993. When we were acquired by Sierra in October 1995, both plans were frozen as to any new contributions, participants, and accrued benefits. The Senior SERP Plan had only one participant, Mr. Joseph G. Havlick, who at that time was our chief executive officer. Of the eight participants in the SERP Plan, only Mr. Okita remains an officer of CII Financial.
Our Board of Directors appoints a committee to administer both plans. Participation in both plans was limited to the executives, officers and employees selected by our chief executive officer and approved by our board of directors. The criteria used to determine participation in either plan was the participant's position, past contributions and anticipated contributions to our future success.
The committee determined the benefit amount that would be paid at the participant's normal retirement age. The initial benefit amount was discretionary and was adjusted based on the participant's employment service years from the date of participation. Participants were given credit for employment prior to the plans' effective date of January 1, 1990. Under the SERP Plan, the benefit amount was also adjusted based on whether a participant retired at, prior to, or after, normal retirement age. Benefit amounts under both plans are paid in equal monthly installments over a 10-year period. Both plans also provide for a benefit payable over a 10-year period if a participant dies while still employed by us. Mr. Okita's annual benefits under the SERP Plan are $300.
Sierra's Supplemental Executive Retirement Plan
Ms. Kathleen Marlon participates in Sierra's Supplemental Executive Retirement Plan II (the "Supplemental Plan II"), which provides retirement benefits for selected executive officers. Under the Supplemental Plan II, each executive selected for participation generally will be entitled to receive annual payments, following retirement, disability, and certain other terminations of employment, for a 15-year period, equal to 2.5% of their "final average compensation" (as defined) for each year of service credited to the executive up to 20 years, reduced by an amount equal to the annualized payout over a 15-year period that would be payable to the executive as a result of Company contributions under the 401(k) Plan and the Deferred Compensation Plan (but not reduced for social security payments or other offsets). An executive's right to benefits under the Supplemental Plan II vests when five years of service have been credited or earlier upon the executive's death or disability or upon occurrence of a change in control (defined in the same way as under other compensatory plans). Upon the death of the executive, benefits will be payable for the 15-year period to the executive's beneficiary. Benefits will begin after retirement at or after age 65, a termination at or after age 55 and ten years of credited service, or a termination due to disability, and benefits will begin, in the case of other terminations (except a termination for "cause," as defined) prior to a change in control, at the later of termination or the date the executive would have completed ten years of service but for the termination.
The following table shows the approximate amounts of annual retirement income that would be payable under the Supplemental Plan II to executives covered by it based on various assumptions as to final average compensation and years of service, assuming benefits are paid out over 15 years:
Estimated Annual Benefits Based on Credited Years of Service ------------------------------------------------------------ Final Average Compensation 5 Years 10 Years 15 Years 20 Years 30 Years ------------ ------- -------- --------- -------- -------- $200,000 $23,366 $ 46,732 $ 70,099 $ 92,465 $ 93,465 400,000 45,225 90,450 135,675 180,900 180,900 600,000 67,837 135,675 203,512 271,350 271,350
Final average compensation generally means the average of the three highest years of compensation out of the last five years, with compensation being generally the amounts reported as salary and bonus in the Summary Compensation Table.
Ms. Marlon has 15 years of credited service under the Supplemental Plan II. An additional year of service will be credited in the event of a termination within six years after a change in control, and the year of service for the year of the change in control will be deemed completed at the time of the change in control. An executive's or beneficiary's benefits are payable in a lump sum in certain circumstances, including following a change in control.
No other executives of CII Financial participate in Sierra's Supplemental Executive Retirement Plan II.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
All of our common stock is owned by Sierra Health Services, Inc.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We entered into an investment services agreement with Sierra. Under this agreement, Sierra manages our investments. Sierra is, however, subject to our investment guidelines and the ultimate control of each insurer's board of directors. The management fee is a percentage of the total amount under management. The annual investment fees paid by us in 2001, 2000 and 1999 were approximately $265,000, $400,000 and $335,000, respectively.
Effective January 1, 1999, Sierra and California Indemnity entered into a management agreement where Sierra would furnish services, including accounting, human resources, systems and other administrative services. The fee for the services is based on the actual direct and allocable cost. The services are subject to the ultimate control of California Indemnity Insurance Company's board of directors. The annual fees for these services were approximately $1,335,000, $1,201,000 and $1,003,000 in 2001, 2000 and 1999, respectively. We did not have a management agreement with Sierra prior to January 1, 1999.
We purchase employee health insurance from our affiliates, Health Plan of Nevada, Inc., Sierra Health and Life Insurance Company, Inc. and Texas Health Choice, L.C. We paid $885,000, $672,000 and $642,000 to the aforementioned affiliates for years ended December 31, 2001, 2000 and 1999, respectively. The premiums paid to our affiliates were determined on an arms-length basis.
At January 1, 1999, California Indemnity and Commercial Casualty invested in a real estate limited partnership of which Sierra is the general partner. California Indemnity agreed to adjust its partnership interest to approximate its occupancy. Together, the two insurance subsidiaries own limited partner interests totaling approximately 27% of the limited partnership. These transactions were done to enable both companies to qualify for certain premium tax credits in the state of Nevada and were approved by the California Department of Insurance. California Indemnity also had a rental agreement with the related partnership under which California Indemnity leased a portion of the transferred real estate. Rental expense under this agreement was approximately $1,267,000 and $1,168,000 for the years ended December 31, 2000 and 1999 , respectively. In December 2000, in conjunction with a sale-leaseback transaction of Sierra's Las Vegas real estate portfolio, the limited partnership sold the real estate to an unrelated third party and the rental agreement was canceled. Sierra entered into a 15-year master lease with the third party purchaser of this real estate. Effective January 1, 2001, Sierra and California Indemnity have entered into a one-year sublease for the space occupied by California Indemnity. The sublease is subject to the provisions of Sierra's master lease and automatically renews from year to year unless California Indemnity gives notice prior to December 1 of each year. Rental expense under this agreement was approximately $1,176,000 for the year ended December 31, 2001.
In March 2000, California Indemnity financed a $7,400,000 five-year mortgage note to Sierra. The note was secured by a first deed of trust and earned quarterly interest payments at 8.75% per annum beginning April 1, 2000 until April 1, 2005, when the unpaid principal balance was due and payable in full. The note was callable in April 2001. In December 2000, in conjunction with a sale-leaseback of Sierra's Las Vegas real estate portfolio, the mortgage note was assumed by the buyer. The loan to value based on the purchase price was 64%. The interest rate was increased to 30-day LIBOR plus a margin and the maturity date was set at December 31, 2001. The loan was scheduled to mature on December 31, 2001; however, the buyer exercised the option to extend the maturity date for six months and paid a fee of .5% of the outstanding balance. The buyer can extend the loan for an additional six months with proper notice to California Indemnity and payment of an additional fee.
In order to make the September 15, 2000 interest payment on the junior subordinated debentures, Sierra advanced $365,000 to CII Financial, Inc.
In connection with the exchange offer for the Subordinated Debentures, (see Note 7 of Notes to Consolidated Financial Statements), California Indemnity loaned Sierra $7.5 million. The loan bears interest at 8.5%, which is due semi-annually on March 31 and September 30 of each year, commencing September 30, 2001. All outstanding principal and accrued interest is due on September 30, 2004. The loan is secured by the common stock of Sierra Health and Life insurance Company, or SHL, a wholly owned subsidiary of Sierra, equal to 120% of the principal amount outstanding. At December 31, 2001, SHL had total equity, on a statutory accounting basis of approximately $16.4 million. As an additional part of the exchange offer transaction, Sierra lent CII Financial $15.0 million as well as an additional $2.0 million to enable CII Financial to pay the accrued interest on the Subordinated Debentures due March 15, 2001 and other operating expenses. Each of the loans are demand notes payable and bear interest at 9.5%, which is due on demand or semi-annually on March 15 and September 15 of each year, commencing September 15, 2001. The notes are subordinated to the 9 1/2% senior debentures and CII Financial's guaranty of Sierra's credit facility.
In May 2001, Sierra purchased $1.0 million of the 9 1/2% senior debentures from a non-affiliated debenture holder. These debentures are still outstanding and Sierra received $35,000 in interest payments in 2001.
In November 2001, California Indemnity acquired a newly constructed commercial building in the city of North Las Vegas and entered into a five-year lease agreement with Sierra. The monthly base rent is $13,500 and is subject to annual cost of living adjustments starting November 1, 2002 and a further market rental value adjustment on November 1, 2006. Sierra has the option to extend the terms of the lease for an additional five-year period.
California Indemnity has cost sharing agreements with two of its affiliates, SHL and Nevada Administrators, Inc., or NVA. In its agreement with SHL, we purchase the use of SHL's Health Care Organization, or HCO, and other managed care services. The services are provided at cost. During 2001, we paid $5.0 million to SHL under the terms of this agreement. In its agreement with NVA, the Company receives reimbursement for certain services provided by the Company at cost. During 2001, we received $57,000 from NVA under the terms of this agreement.
We have, in the normal course of business, entered into various agreements and arrangements with Sierra and its wholly-owned subsidiaries. These agreements and arrangements have been entered into on either a cost or arms' length basis.
Effective January 1, 1996, federal income taxes are calculated pursuant to a tax allocation agreement between Sierra and CII Financial. Income taxes are allocated on a separate return basis for each company and tax benefits are recorded only to the extent that an entity could recoup taxes paid in prior years.
All of our directors are also officers of Sierra.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following consolidated financial statements are included in Part II, Item 8 of this Report:
Page ----
Independent Auditors' Report............................................................. 34 Consolidated Balance Sheets at December 31, 2001 and 2000................................ 35 Consolidated Statements of Operations for the Years Ended December 31, 2001, 2000 and 1999...................................................... 36 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2001, 2000 and 1999.................................. 37 Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999...................................................... 38 Notes to Consolidated Financial Statements............................................... 39
(a)(2) Financial Statement Schedules:
Schedule I - Condensed Financial Information of Registrant................... S-1
All other schedules are omitted because they are not applicable, not required, or because the required information is in the consolidated financial statements or notes thereto.
(a)(3) The following exhibits are filed as part of, or incorporated by reference into, this Report as required by Item 601 of Regulation S-K:
Exhibit Number Description ------ -----------
3.1 --Articles of Incorporation of the Company, incorporate by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
3.2 --Bylaws of the Company, incorporate by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
4.1 --Form of Indenture for 9 1/2% senior debentures due September 15, 2004 from the Company to Wells Fargo Bank Minnesota, N.A., as Trustee, incorporate by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
4.2 --Specimen 9 1/2% senior debenture due September 15, 2004 of the Company (included in Exhibit 4.1 hereto).
10.1 --Credit Agreement dated as of October 30, 1998, among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank, First Union National Bank as Syndication Agent, and the other financial institutions party thereto, dated as of October 30, 1998, incorporated by reference to Exhibit 10.4 to Sierra's 1998 Form 10-K filed for the fiscal year ended December 31, 1998.
10.2 --First Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and Issuing Bank and the other financial institutions party thereto, dated as of November 23, 1998, incorporated by reference to Exhibit 10.5 to Sierra's 1998 Form 10-K filed for the fiscal year ended December 31, 1998.
10.3 --Second Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of January 15, 1999, incorporated by reference to Exhibit 10.6 to Sierra's 1998 Form 10-K filed for the fiscal year ended December 31, 1998.
10.4 --Third Amendment to Credit Agreement among Sierra as borrower, Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, dated as of September 30, 1999, incorporated by reference to Exhibit 10.7 to Sierra's 1999 Form 10-K filed for the fiscal year ended December 31, 1999.
10.5 --Amended and Restated Credit Agreement among Sierra as borrower, Bank of America, N.A. as Administrative Agent and Issuing Bank, First Union National Bank, as Syndication Agent and the other financial institutions party thereto, dated as of December 15, 2000, incorporated by reference to Sierra's Current Report on Form 8-K dated December 15, 2000.
10.6 --Intercompany Services Agreement dated January 1, 1999, by and between Sierra and California Indemnity Insurance Company, incorporate by reference to Exhibit 10.6 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.7 --Tax Allocation Agreement dated May 30, 1997, among Sierra, Health Plan of Nevada, the Company, Sierra Health and Life Insurance Company, California Indemnity Insurance Company, Commercial Casualty Insurance Company and CII Insurance Company, incorporate by reference to Exhibit 10.7 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.8 --HCO Contract with Claims Administrator and Supplement dated January 19, 2001 among California Indemnity Insurance Company, and each of its insurer subsidiaries, and Sierra Health and Life Insurance Company, incorporate by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.9 --Agreement and Plan of Merger dated as of June 12, 1995 among Sierra, Health Acquisition Corp., and the Company, incorporated by reference to the Report on Form 8-K dated June 13, 1995, as amended.
10.10--Guaranty, dated as of August 23, 2000, among the Company, among others, as guarantors, in favor of Bank of America National Trust and Savings Association as Administrative Agent and the other financial institutions party thereto, incorporated by reference to Sierra's Quarterly Report on Form 10-Q filed for the quarter ended September 30, 2000.
10.11--First and Second Underlying Excess Loss Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.11 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.12--Casualty Quota Share Reinsurance Agreement dated July 1, 1998, by and between Traveler's Indemnity Insurance Company of Illinois, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.13--Statutory Workers' Compensation Excess of Loss Reinsurance Agreement dated January 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.13 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.14--Workers' Compensation Excess of Loss Reinsurance Agreement dated July 1, 2000, by and between National Union Fire Insurance Company of Pittsburgh, Pennsylvania, California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.14 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.15--Limited Partnership Agreement of the 2716 N. Tenaya Way Limited Partnership dated December 3, 1998, among California Indemnity Insurance Company, Commercial Casualty Insurance Company and Sierra, incorporate by reference to Exhibit 10.15 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.16--Sublease of 2716 North Tenaya Way, Las Vegas, Nevada, dated January 25, 2001, among Sierra and California Indemnity Insurance Company, incorporate by reference to Exhibit 10.16 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.17--Intercompany Pooling Agreement dated January 1, 1999, among California Indemnity Insurance Company, Commercial Casualty Insurance Company, CII Insurance Company and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.17 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.18--Investment Services Agreement dated January 1, 1999, between Sierra and California Indemnity Insurance Company, incorporate by reference to Exhibit 10.18 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.19--Investment Services Agreement dated January 1, 1999, between Sierra and Commercial Casualty Insurance Company, incorporate by reference to Exhibit 10.19 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.20--Investment Services Agreement dated January 1, 1999, between Sierra and CII Insurance Company, incorporate by reference to Exhibit 10.20 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.21--Investment Services Agreement dated January 1, 1999, between Sierra and Sierra Insurance Company of Texas, incorporate by reference to Exhibit 10.21 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.22--Form of Promissory Notes from the Company to Sierra, incorporate by reference to Exhibit 10.22 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
10.23--Lease of Print Shop to Sierra Health Services, Inc.
21 --Subsidiaries of the Company, incorporate by reference to Exhibit 21 to the Company's Registration Statement on Form S-4 (File No. 333-52726).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereto duly authorized.
CII FINANCIAL, INC.
By /s/ Kathleen M. Marlon --------------------------------------- Kathleen M. Marlon President, Chief Executive Officer and Chairman of the Board
Date: April 1, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
/s/ Kathleen M. Marlon President, Chief Executive Officer April 1, 2002 ------------------------------------ Kathleen M. Marlon and Chairman of the Board (Chief Executive Officer)
/s/ John F. Okita Chief Financial Officer and Director April 1, 2002 ------------------------------------ John F. Okita (Principal Financial and Accounting Officer)
/s/ Paul H. Palmer Director April 1, 2002 ------------------------------------ Paul H. Palmer
/s/ Frank E. Collins Director April 1, 2002 ------------------------------------ Frank E. Collins
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS - Parent Company Only (In thousands except share data)
December 31, ------------ 2001 2000 ---- ---- ASSETS Cash and cash equivalents.............................................. $ 555 $ 499 Preferred stock, at fair value......................................... 1,092 Equity in net assets of subsidiaries................................... 104,940 111,142 Property and equipment, net............................................ 613 1,094 Other assets........................................................... 458 99 ------- -------
TOTAL ASSETS...................................................... $106,566 $113,926 ======= =======
LIABILITIES AND STOCKHOLDER'S EQUITY Senior debentures...................................................... $ 19,187 Convertible subordinated debentures.................................... $ 47,059 Net payable to affiliates.............................................. 2,276 418 Note payable to Sierra................................................. 17,000 Accrued interest payable............................................... 1,082 1,029 Accounts payable and accrued expenses.................................. 1,585 2,068 ------- ------- TOTAL LIABILITIES................................................. 41,130 50,574 ------- -------
STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; shares issued and outstanding - 100................................ 3,604 3,604 Additional paid-in capital............................................. 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments of subsidiaries..................................... (4,436) (4,535) Retained earnings (accumulated deficit)................................ 1,818 (167) ------- ------- TOTAL STOCKHOLDER'S EQUITY........................................ 65,436 63,352 ------- ------- TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY................................. $106,566 $113,926 ======= =======
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENT OF OPERATIONS - Parent Company Only (In thousands)
Years Ended December 31, 2001 2000 1999 ---- ---- ----
REVENUES Net investment income..................................... $ 40 $ 51 $ 1 Other..................................................... 857 932 1,084 ----- ------ -----
Total revenues.............................................. 897 983 1,085 ----- ------ -----
EXPENSES Interest expense.......................................... 2,308 3,607 3,707 General and administrative................................ 579 1,461 765 ----- ------ -----
Total expenses.............................................. 2,887 5,068 4,472 ----- ------ -----
Equity in undistributed earnings (loss) of subsidiaries....... 3,275 (4,651) 7,141 ----- ------ -----
INCOME (LOSS) BEFORE FEDERAL INCOME TAX (BENEFIT) EXPENSE AND EXTRAORDINARY GAIN.................................. 1,285 (8,736) 3,754
Federal income tax (benefit) expense.......................... (338) (353) 261 ----- ------ -----
INCOME (LOSS) BEFORE EXTRAORDINARY GAIN....................... 1,623 (8,383) 3,493
Extraordinary gain from debt extinguishment (net of income taxes of $195, $353 and $59)............... 362 654 111 ----- ------ -----
NET INCOME (LOSS)............................................. $1,985 $(7,729) $3,604 ===== ====== =====
CII FINANCIAL, INC. AND SUBSIDIARIES SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENT OF CASH FLOWS - Parent Company Only (In thousands)
Years Ended December 31, 2001 2000 1999 ---- ---- ---- CASH FLOW OPERATING ACTIVITIES: Net income (loss)............................................ $ 1,985 $(7,729) $ 3,604 Adjustments to reconcile net income (loss) to net............ cash used in operating activities: Equity in undistributed (earnings) loss of subsidiaries...... (3,275) 4,651 (7,141) Extraordinary gain........................................... (557) (1,007) (170) Depreciation and amortization................................ 470 673 721 Changes in assets and liabilities............................ 459 2,415 (2,057) ------- ------ ------
Net cash used in operating activities............................. (918) (997) (5,043) ------- ------ ------
CASH FLOWS FROM INVESTING ACTIVITIES: Property and equipment dispositions.......................... 44 Sales (purchases) of available-for-sale investments.......... 1,092 (1,092) 2 ------- ------- ------
Net cash provided by (used in) investing activities............... 1,136 (1,092) 2 ------- ------- ------
CASH FLOW FROM FINANCING ACTIVITIES: Repurchase of convertible subordinated debentures............ (27,162) (2,432) (583) Dividend to Sierra........................................... (2,637) Dividends from subsidiary.................................... 10,000 6,800 6,000 Note Payable to Sierra....................................... 17,000 ------- ------ ------
Net cash (used in) provided by financing activities............... (162) 1,731 5,417 ------- ------ ------
NET CHANGE IN CASH AND CASH EQUIVALENTS.................................................. 56 (358) 376 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............................................ 499 857 481 ------- ------ ------
CASH AND CASH EQUIVALENTS AT END OF YEAR.......................... $ 555 $ 499 $ 857 ======= ====== ======