ITEM 1 - BUSINESS
Universal American Financial Corp. ("Company" or "Universal American") is a specialty health and life insurance holding company, with an emphasis on providing a broad array of health insurance and managed care products and services to the growing senior population. Our principal health insurance products for the senior market are Medicare Supplement and Medicare Advantage. In addition, we sell specialty health insurance to self-employed individuals in the United States and Canada, as well as life insurance and fixed annuities. We distribute these products through a career agency system and an independent general agency system. We also provide administrative services for senior market insurance and non-insurance programs to both affiliated and unaffiliated insurance companies.
Collectively, our insurance subsidiaries are licensed to sell health insurance, life insurance and annuities in all 50 states, the District of Columbia, Puerto Rico and all the provinces of Canada. Our managed care subsidiary operates Medicare Advantage health plans in Texas, New York and Pennsylvania.
We were incorporated under the laws of the State of New York on August 31, 1981. Our corporate headquarters are located at 6 International Drive, Rye Brook, New York 10573 and our telephone number is (914) 934-5200. We make available free of charge on our Internet website (http://www.uafc.com) our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Copies of any materials we file with the SEC can be read or copied at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You can obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Copies of any materials we have filed electronically with the SEC may be accessed at the SEC's website: http://www.sec.gov.
SENIOR MARKET OPPORTUNITY
We believe that attractive growth opportunities exist in providing an array of products, particularly individual health insurance, to the growing senior market. At present, more than 41 million Americans are eligible for Medicare. According to the U.S. Census Bureau, more than 2 million Americans turn 65 in the United States each year, and this number is expected to grow faster as the so-called baby boomers continue to turn 65. In addition, many large employers, who traditionally have provided retiree medical coverage, have begun to curtail their offerings. Finally, the Federal government has embarked on a program to encourage and incent private insurers to broaden their health insurance offerings to the senior market. Taken together, these conditions present significant opportunities for us to increase the sale of our core products.
In the past ten years, we have become a leading provider of Medicare Supplement coverage as well as other products designed for the senior market. The primary elements of our success have been broad and deep distribution, active risk management and opportunistic acquisitions. We believe that the market for Medicare Supplement products will continue to be vibrant, especially since many seniors may lose similar coverage that had previously been offered to them as retiree benefits by their former employers.
The passage of the Medicare Modernization Act of 2003 (the "MMA"), has created new opportunities for us to use our core skills to expand our business. The MMA expanded the healthcare options available to Medicare beneficiaries by, among other things, increasing the reimbursement rates to Medicare managed care plans ("Medicare Advantage") and making available a subsidized prescription drug insurance benefit ("Part D"). Beginning in 2006, every Medicare recipient will be able to buy a prescription drug plan from a private insurer, largely funded by the federal government. This new prescription drug benefit will be available to Medicare managed care enrollees as well as Medicare fee-for-service enrollees. Further, as a result of the increased reimbursement rates to Medicare managed care plans which generally allows Medicare managed care plans to offer more attractive benefits and the additional Part D drug benefit offering, we believe that enrollment in Medicare's managed care programs is likely to increase in the coming years.
OUR STRATEGY
The principal components of our business strategy are to:
- Build our senior health insurance business by offering a broad array of products, including:
o Medicare Supplement and Medicare Select
o Medicare Advantage
o Medicare Part D Drug Benefit;
- Build distribution with an emphasis on expanding our Senior Solutions(R) brand;
- Sell complementary senior market and specialty health products through our distribution networks;
- Build our senior market administrative services business;
- Continue to complement our internal growth through acquisitions;
- Continue to improve our operating efficiency; and
- Continue to employ conservative risk management techniques, including maintaining a high quality investment portfolio, disciplined pricing and prudent use of reinsurance.
OUR OPERATING SEGMENTS
Beginning with this Form 10-K, we have changed the way we report our business to more accurately reflect the way we manage our business. Previously, we looked at our business primarily in terms of the type of distribution channel. Now, we have reorganized our business segments to reflect the products that we sell and the markets that we serve.
Our business now consists of five principal business segments: Senior Market Health Insurance, Senior Managed Care - Medicare Advantage, Specialty Health Insurance - Self-Employed, Life Insurance/Annuities and Senior Administrative Services. We also report the corporate activities of our holding company in a separate segment. Information regarding each segment's revenue, income or loss before taxes and total assets for each of the last three fiscal years is included in Note 22 - Business Segment Information in our consolidated financial statements included in this Form 10-K. Information regarding our foreign operations in Canada (that are included in our Speciality Health Insurance segment) is included in Note 23 - Foreign Operations in our consolidated financial statements included in this Form 10-K.
SENIOR MARKET HEALTH INSURANCE
Our Senior Market Health Insurance segment focuses on selling health insurance products designed for the senior market through our Senior Solutions(R) career agency force and through our network of independent general agencies. Our primary products are Medicare Supplement and Medicare Select. As of December 31, 2004, we had $575 million of gross premiums in force in this segment.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE
This segment includes the operations of Heritage Health Systems, Inc. ("Heritage"), which we acquired in May 2004, and our other initiatives in managed care for seniors. Heritage operates Medicare Advantage plans in Southeastern Texas and Medicare Advantage private fee-for-service plans in New York and Pennsylvania. As of the end of 2004, this segment had $172 million of premium in force.
SPECIALTY HEALTH INSURANCE - SELF-EMPLOYED
Traditionally, our career agency segment concentrated on selling specialty health insurance products, primarily fixed benefit accident and sickness disability insurance, to the middle-income, self-employed market in the United States and Canada. Even though the primary focus of this field force in the United States has shifted to the senior market, a significant number of our United States career agents and all of the Canadian career agents continue to actively market these products. This segment also includes certain products that we no longer sell, such as long term care. As of December 31, 2004, we had $167 million of gross premiums in force in this segment.
LIFE INSURANCE/ANNUITIES
The focus of this segment is the sale of life insurance and annuity products, principally to the senior market. This segment also includes other traditional life and interest-sensitive life insurance products which are no longer actively being sold. As of December 31, 2004, we had $67 million of gross premiums in force for this segment and policy holder account balances for our annuities and interest-sensitive life insurance products of $478 million.
SENIOR ADMINISTRATIVE SERVICES
Our administrative services subsidiary, CHCS Services, Inc. ("CHCS Services"), has emerged as a leading, full-service administrator of senior insurance products and an innovator in geriatric care management. We utilize state of the art technology and a national network of highly trained health care professionals to provide the administrative platform for insurance and insurance-related products and services. Currently, we provide services to over 50 companies as well as to our own insurance company subsidiaries. Our Senior Administrative Services segment generated revenues of $57 million for the year ended December 31, 2004.
CORPORATE
Our corporate segment reflects the activities of our holding company including debt service, certain senior executive compensation and compliance with regulatory requirements resulting from our status as a public company.
SIGNIFICANT TRANSACTIONS - ACQUISITIONS
ACQUISITION OF HERITAGE HEALTH SYSTEMS, INC.
On May 28, 2004, we acquired Heritage, a privately owned managed care company that operates Medicare Advantage plans in Houston and Beaumont Texas, for $98 million in cash plus transaction costs of $1.6 million. The acquisition was financed with $66.5 million of net proceeds derived from the amendment of our credit facility and $33.1 million of cash on hand. As of the date of acquisition, Heritage had approximately 16,000 Medicare members and annualized revenues of approximately $140 million. Operating results generated by Heritage prior to the date of acquisition are not included in our consolidated financial statements.
ACQUISITION OF PYRAMID LIFE
On March 31, 2003, we acquired all of the outstanding common stock of Pyramid Life Insurance Company ("Pyramid Life"). Pyramid Life specializes in selling health and life insurance products to the senior market, including Medicare Supplement and Select, long term care, life insurance, and annuities. With this acquisition, we acquired a $120 million block of in-force business, as well as a career sales force that is skilled in selling senior market insurance products. Pyramid Life currently markets its products in 30 states through a career agency sales force of over 1,000 agents operating out of 39 Senior Solutions(R) Sales Centers. Following a transition period that took approximately ten months, the Pyramid Life business was fully transitioned into our existing operations. Operating results generated by Pyramid Life prior to the date of acquisition are not included in our consolidated financial statements.
RECAPTURE OF REINSURANCE CEDED
Effective April 1, 2003, we entered into agreements to recapture approximately $48 million of Medicare Supplement business that had previously been reinsured to Transamerica Occidental Life Insurance Company, Reinsurance Division under two quota share contracts. No ceding allowance was paid in the recapture and we currently retain 100% of the risks on the $48 million of Medicare Supplement business. There was no gain or loss reported on these recapture agreements.
ACQUISITION OF NATIONWIDE BLOCK OF BUSINESS
In November 2002, we entered into an agreement with Nationwide Life Insurance Company to acquire, through a 100% quota share reinsurance agreement, Nationwide's individual Medicare Supplement policies. Approximately $22 million of annualized premium was in force at the date of acquisition.
ACQUISITION OF AMERIPLUS
On August 1, 2003, we acquired 100% of the outstanding common stock of Ameriplus Preferred Care, Inc. ("Ameriplus"). Ameriplus is engaged in the business of creating and maintaining a network of hospitals for the purpose of providing discounts to our Medicare Select policyholders. Ameriplus' network is utilized in connection with Medicare Select policies written by our subsidiaries and can be offered to non-affiliated parties as well. Ameriplus receives network fees when premiums for these Medicare Select policies are collected.
ACQUISITION OF GUARANTEE RESERVE MARKETING ORGANIZATION
Effective July 1, 2003, we entered into an agreement with Swiss Re and its newly acquired subsidiary, Guarantee Reserve Life Insurance Company ("Guarantee Reserve"), to acquire Guarantee Reserve's marketing organization, including all rights to do business with its field force. The primary product sold by this marketing organization is low face amount whole life insurance, primarily for seniors. Beginning July 1, 2003, the Guarantee Reserve field force continued to write this business in Guarantee Reserve, with us administering all new business and assuming 50% of the risk through a quota share reinsurance arrangement. New business has been written by our subsidiaries with 50% of the risk ceded to Swiss Re beginning in the second quarter of 2004 as the products were approved for sale in each state.
SIGNIFICANT TRANSACTIONS - FINANCING
SHELF REGISTRATION
On November 3, 2004, we filed a universal shelf registration statement on Form S-3 with the SEC, pursuant to which we may issue common stock, warrants and debt securities from time to time, up to an aggregate offering of $140 million. The registration statement also covers five million shares of common stock that may be offered for sale by Capital Z Financial Services Fund II, L.P ("Capital Z"), our largest shareholder. In the event that Capital Z sells all of the five million shares, Capital Z would still own 20.3 million shares or approximately 37% of our outstanding common stock, before giving effect to any issuance of shares by us pursuant to the shelf registration. The shelf registration statement was declared effective in December 2004.
The shelf registration statement enables us to raise funds from the offering of any individual security covered by the shelf registration statement, as well as any combination thereof, through one or more methods of distribution, subject to market conditions and our capital needs. The terms of any offering pursuant to this shelf will be established at the time of the offering. We plan to use the proceeds from any future offering under the registration statement for general corporate purposes, including, but not limited to, working capital, capital expenditures, investments in subsidiaries, acquisitions and refinancing of debt. A more detailed description of the use of proceeds will be included in any specific offering of securities in the prospectus supplement relating to the offering. A copy of the shelf registration statement as filed with the SEC on Form S-3 may be obtained at the SEC's website at www.sec.gov, or through the Investor Relations section of the Universal American website at www.uafc.com.
2003 CREDIT AGREEMENT AND 2004 AMENDMENT
In connection with the acquisition of Pyramid Life on March 31, 2003, we entered into a new $80 million credit facility consisting of a $65 million term loan and a $15 million revolving loan facility. We used the proceeds from the new term loan to repay the $38 million balance outstanding on our then existing term loan and the balance to fund the purchase of Pyramid Life.
In connection with the acquisition of Heritage on May 28, 2004, we amended the March 2003 credit facility to increase the term loan to $105 million from $36.4 million, the balance then outstanding. We used the additional proceeds to fund the purchase of Heritage. Under the amended credit agreement, the interest rate was reduced to 225 basis points over the three month London Inter Bank Offering Rate, the term was extended to March 2009, and the amortization was reduced in the early years. As of December 31, 2004, the outstanding balance on our term loan was $101 million. Information regarding our term loan is included in Note 14 - Loan Payable in our consolidated financial statements included in this Form 10-K.
TRUST PREFERRED ISSUANCES
During 2003, we issued $60 million of fixed and floating rate trust preferred securities through subsidiary trusts which, combined with the $15 million issued in December 2002, results in a total of $75 million of such securities outstanding. A portion of the proceeds of the 2003 issuances was used to pay down our existing debt, and the balance was retained at the parent company for general corporate purposes. Information regarding our trust preferred securities is included in Note 15 - Other Long Term Debt in our consolidated financial statements included in this Form 10-K.
OUR BUSINESS
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement and Medicare Select. Our core senior market health insurance products are Medicare Supplement and Medicare Select plans. Under Federal and National Association of Insurance Commissioners ("NAIC") model regulations adopted in nearly all states, there are currently 12 standard Medicare Supplement plans (Plans A through J and High Deductible Plans F and J). These policies provide supplemental coverage for many of the medical expenses that the basic Medicare program does not cover, such as deductibles, coinsurance and specified losses that exceed the Federal program's maximum benefits. Plan A provides the least extensive coverage, while Plan J provides the most extensive coverage. Under NAIC regulations, Medicare Supplement insurers must offer Plan A, but may offer any of the other plans at their option. Our insurance company subsidiaries offer Medicare Supplement policies primarily on plans A, B, C, D, F, G and High Deductible F. In some areas, we also sell Medicare Select policies in conjunction with hospitals that contract with us to waive the Medicare Part A deductible.
These products are guaranteed renewable for the lifetime of the policyholder, which means that we cannot cancel the policy but we can seek to increase premium rates on existing and future policies issued based upon our actual claims experience. We monitor the claims experience and, when necessary, apply for rate increases in the states in which we sell the products. These rate increases are subject to state regulatory approval and Federal and state loss-ratio requirements.
Other Senior Health Products. Our other senior health products include acute recovery care ("Acute Care"), senior dental and hospital indemnity products marketed to seniors. Acute Care and senior dental are new products which we added to our portfolio in 2004. Our Acute Care product provides benefits for confined care and home health care for short term periods for individuals recovering from accident or serious illness. Senior dental is a scheduled benefit indemnity product for seniors that allows policyholders to use their own dentists.
Medicare Part D. Beginning in 2006, private insurers will be permitted to offer an insured stand-alone prescription drug benefit ("Part D") pursuant to the MMA. A portion of the premium for this insurance will be paid by the federal government, and the balance, if any, will be paid by the individuals who enroll. The federal government will also provide additional subsidies in the form of premium support and coverage of the cost-sharing elements of the plan to certain low income Medicare beneficiaries. We plan to file with appropriate governmental authorities to offer these programs in several of the regions that have been established for this program. There is no assurance that our applications will be accepted or that the program will provide meaningful revenues.
New Business Production. The following tables show our total new sales (issued annualized premiums) of our senior market health insurance products produced by our independent agency and career agency systems on a gross basis (before reinsurance) and a net basis (after reinsurance):
Annualized Premium In Force. Total senior market insurance product annualized premium in force on a gross basis and the net amount we retained after reinsurance, is as follows:
SENIOR MANAGED CARE -- MEDICARE ADVANTAGE
With the acquisition of Heritage and internally generated initiatives, we now offer a line of Medicare Advantage products to complement our Medicare Supplement business.
Medicare Advantage: HMO Plan. SelectCare of Texas, the health plan operated by Heritage, offers an HMO product in several counties in Houston and southeastern Texas. The plan provides all basic Medicare covered benefits with reduced member cost-sharing as well as additional supplemental benefits, including a defined prescription drug benefit. This HMO product is built around contracted networks of providers who, in connection with the health plan, coordinate an active medical management program. In addition to a monthly payment per member from CMS, for certain products, the plan may collect a monthly premium from its members.
This Plan is distributed by Heritage's direct sales force, and our career agents through Senior Solutions(R) Centers in the coverage areas. As of December 31, 2004, SelectCare had approximately 18,800 members enrolled.
Medicare Advantage: Private Fee for Service. In June 2004, we began enrolling members in Medicare Advantage private fee for service ("PFFS") plans in certain counties of New York and Pennsylvania. These plans provide enhanced health care benefits compared to traditional Medicare, including a prescription drug benefit, subject to cost sharing and other limitations. There are no provider network restrictions, which allow the members to have more flexibility in the delivery of their health care services than other Medicare Advantage plans. In addition to a fixed monthly payment per member from CMS, individuals in these plans pay a monthly premium. The PFFS products are distributed by our independent agents in the coverage areas. As of December 31, 2004, 1,405 members were enrolled in the program generating approximately $9.6 million of annualized revenue. In early 2005, we filed for expansion of this program into several additional states.
Membership and Annualized Premium In Force. Membership for our health plan and private fee for service plans and the related annualized premium in force, is as follows:
(1) The health plan was included in the acquisition of Heritage on May 28, 2004. (2) We began enrolling members in our private fee for service plan in June, 2004.
SPECIALTY HEALTH INSURANCE - SELF-EMPLOYED
Products in our Specialty Health Insurance segment include fixed benefit accident and sickness disability and other health insurance products sold to the self-employed market in the United States and Canada, as well as certain lines of business no longer being sold, including long term care and major medical. This segment's products are distributed primarily by our career agents.
Fixed Benefit Accident and Sickness. Fixed benefit accident and health products provide three principal types of benefits: disability (fixed periodic payments to an insured who becomes disabled and unable to work due to an accident or sickness), hospital (fixed periodic payments to an insured who becomes hospitalized), and surgical (fixed single payments that vary in amount for specified surgical or diagnostic procedures). Because the benefits we provide are fixed in amount at the time of policy issuance and are not intended to provide full reimbursement for medical and hospital expenses, payment amounts are not generally affected by inflation or the rising cost of health care services.
Long Term Care. As of the end of 2004, we no longer distribute new long term care products. Previously, we had offered several long term care plans consisting of fully integrated plans and nursing home, and home health care plans, which remain in force. These products typically are guaranteed renewable for the lifetime of the policyholder, which means that we cannot cancel the policy but can seek to increase premium rates on existing policies based upon our actual claims experience, subject to state regulatory approval and loss-ratio requirements.
New Business Production. The following tables show our total new sales (issued annualized premiums) of specialty health insurance products produced by primarily by our career agency systems on a gross basis (before reinsurance) and a net basis (after reinsurance):
Annualized Premium In Force. Total specialty health insurance product annualized premium in force on a gross basis and the net amount we retained after reinsurance, is as follows:
LIFE INSURANCE/ANNUITIES
This segment includes all of the life insurance and annuity business that we sell in the United States. The life insurance products that we currently sell are designed primarily for the senior market. These include "final expense" life insurance and asset accumulation life insurance. In addition, we sell single and flexible premium fixed annuities. These products are distributed through both independent general agents and our career agency distribution systems. This segment also includes previously produced or acquired term, universal life, and whole life insurance products that are no longer sold.
Senior Life. We offer a line of low-face amount, simplified issue whole life products that are sold by our senior market independent agency and our career agency systems.
Asset Enhancer Life Insurance. We market a line of interest sensitive whole life products that are designed for efficient asset transfer to beneficiaries. These products also offer acceleration of benefit features that cover certain long term care expenses.
New Business Production. The following tables show our total new sales (issued annualized premiums) of our life insurance products produced by our independent agency and career agency systems on a gross basis (before reinsurance) and a net basis (after reinsurance):
Annuities. We market single and flexible premium deferred annuities primarily focusing on the senior and retirement markets. The base rates on the annuity products currently marketed by us range from 3% to 3.6%. We offer sales inducements in the form of first year only bonus interest rates, which range from 1% to 4%, on certain of our annuity products. Including the bonus interest rates, our current credited rates on our annuity products range from 3% to 7.3%. Our currently marketed annuity products have minimum guaranteed interest rates ranging from 1.5% to 3%. We have the right to change the crediting rates at any time, subject to the minimums, and generally adjust them quarterly.
Annuity deposits are not reported as revenue in accordance with generally accepted accounting principles. The following table shows our annuity deposits by distribution channel:
The decline in annuity deposits is as a result of a reduction in the current interest rates that we credit and the minimum interest rates that we guarantee on our annuity products.
SENIOR ADMINISTRATIVE SERVICES
We have built our administrative services capabilities through internal development and acquisition. Through our wholly owned subsidiary, CHCS Services, we provide outsourcing services that support insurance and non-insurance products, primarily for the senior market.
We perform a full range of administrative services for senior market insurance products, primarily Medicare Supplement and Select, senior life and long term care, for both affiliated and unaffiliated companies. The services include policy underwriting and issuance, policy billing and collection, telephone verification, policyholder services, claims adjudication and payment, clinical case management, care assessment and referral to health care facilities.
We also perform similar services, particularly in the long term care area, for non-insurance products offered both by insurance and non-insurance companies, including our Nurse Navigator(SM) product, a non-insurance elder care service product that includes health related information and referrals and access to nationwide networks of geriatric care nurses and long term care providers available on a discounted basis.
We utilize state of the art technology and a national network of highly trained health care professionals to provide the administrative platform for these insurance and insurance-related products and services. The information technology includes electronic claims processing, imaging and workflow processes to ensure maximum efficiency in policy issue, policy administration and claims processing. Our proprietary network of registered nurses and social workers provides personalized support and care for our senior programs nationwide. In addition, our proprietary network of discount providers is an integral part of our geriatric care management services. We have a customer contact center that provides around the clock access to our nurses on staff and can handle calls in several different languages.
The following table shows the sources of our service fee revenue by type of product:
Included in unaffiliated revenue are fees received to administer certain business of our insurance subsidiaries that is 100% reinsured to an unaffiliated reinsurer which amounted to $5.3 million for the year ended December 31, 2004, $7.4 million for 2003 and $6.9 million for 2002. These fees, together with the affiliated revenue, were eliminated in consolidation.
MARKETING AND DISTRIBUTION
We distribute our insurance and managed care products through both our career agency system and a traditional independent general agency system. We measure new sales of our products based on issued annualized premiums, representing the total annual premium expected to be received by us on policies that were issued during the year. The following tables show our new sales, excluding annuity deposits, (issued annualized premiums) by distribution channel and by major product line on a gross basis (before reinsurance) and a net basis (after reinsurance):
We have continued to expand geographically, and we have increased our recruiting efforts to augment our production. Additionally, based on the increased financial strength of our Company, we have increased our retention on new Medicare Supplement business, in order to continue growing our net premium.
One marketing organization produced 8.5% in 2004 and 7.6% in 2003 of our total annualized new sales, primarily senior life business. In 2002, two marketing organizations produced 6.4% and 5.8%, respectively, of our total annualized new sales, primarily Medicare Supplement business. No other marketing organization or single agent produced more than 5.0% of our total annualized new sales in 2004, 2003 or 2002.
CAREER AGENCY
In order to maximize production from our career agency sales force, we focus on the sale of senior market insured and non-insured products through our Senior Solutions(R) program. Senior Solutions(R) is our trademarked brand for our portfolio of supplemental health and life insurance, asset protection and senior care service products we offer the senior market, exclusively through our career companies of Pennsylvania Life and Pyramid Life. In 2004, our career agents also began distributing our Medicare Advantage products. As of December 31, 2004, our career field force had 84 Senior Solutions(R) branch offices throughout the United States with approximately 1,800 agents. In contrast to independent agents, career agents have an exclusive arrangement with us, and only sell products that we provide or authorize.
Immediately after we acquired Heritage, our Senior Solutions(R) offices in Southeastern Texas began to sell our SelectCare health plan product. By the end of 2004, our Senior Solutions(R) agents represented approximately 35% of the new sales of this product.
In addition, our career agency sales force distributes specialty health insurance products, primarily fixed benefit accident and sickness disability insurance, to the self-employed market in the United States and Canada. We have 13 branch offices in Canada, with approximately 300 agents that focus primarily on this market.
The following tables show our new sales, excluding annuity deposits, (issued annualized premiums) by our career agency systems by major product line on a gross basis (before reinsurance) and a net basis (after reinsurance):
SENIOR MARKET INDEPENDENT AGENTS
This field force focuses on the sale of senior market products, including Medicare Supplement and Medicare Select, senior life insurance, Acute Care and senior dental products and annuities. These marketing organizations and general agencies typically recruit and train their own agents, bearing all of the costs incurred in connection with developing their organization. We now sell our products through approximately 28,000 independent licensed agents in 35 states and have plans to recruit more agents and expand into additional states.
In 2004, we began offering our Medicare Advantage private fee for service products in New York and Pennsylvania through our senior market independent agents.
The following tables show our new sales, excluding annuity deposits, (issued annualized premiums) by our independent general agency system by major product line on a gross basis (before reinsurance) and a net basis (after reinsurance):
DIRECT DISTRIBUTION
The Medicare Advantage HMO products offered by Heritage in the Texas market are also distributed directly to consumers through a full-time employee sales force. If we expand the geographical areas in which we market Medicare Advantage HMO plans, we intend to build this aspect of our distribution.
GEOGRAPHICAL DISTRIBUTION OF PREMIUM
Through our insurance subsidiaries, we are licensed to market our products in all fifty states, the District of Columbia, Puerto Rico and in all the provinces of Canada. Our managed care subsidiary operates Medicare Advantage health plans in Texas, New York and Pennsylvania. The following table shows the geographical distribution of the direct cash premium and annuity deposits collected (in thousands), as reported on a statutory basis to the regulatory authorities for the full year of 2004:
TOTAL BUSINESS IN FORCE
Our direct, acquired and assumed annualized premium in force (including only the portion of premiums on interest-sensitive products that is applied to the cost of insurance) and related policy counts are shown in the following tables:
ACCOUNT VALUES ON INTEREST-SENSITIVE PRODUCTS
The following table shows the account values and policy counts for our interest-sensitive products before reinsurance. For these products, we earn income on the difference between investment income that we earn on our invested assets and interest credited to these account balances.
INVESTMENTS
Our investment policy is to balance the portfolio duration to achieve investment returns consistent with the preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. We invest in assets permitted under the insurance laws of the various states in which we operate. Such laws generally prescribe the nature, quality of and limitations on various types of investments that may be made. However, we do not currently have investments in partnerships, special purpose entities, real estate, commodity contracts, or other derivative securities. We currently engage the services of three investment advisors under the direction of the management of our insurance company subsidiaries and in accordance with guidelines adopted by the Investment Committees of their respective boards of directors. Conning Asset Management Company manages the portfolio of all of our United States subsidiaries, except for the portfolio of Pyramid Life and certain floating rate portfolios, which are managed by Hyperion Capital. MFC Global Investment Management manages our Canadian portfolio. We invest primarily in fixed maturity securities of the U.S. Government and its agencies and in corporate fixed maturity securities with investment grade ratings of "BBB-" (Standard & Poor's Corporation), "Baa3" (Moody's Investor Service), or higher. Our current policy is not to invest in derivative programs
or other hybrid securities, except for GNMA's, FNMA's and investment grade corporate collateralized mortgage obligations.
The following table summarizes the composition of our investment portfolio by carrying value (which represents fair value):
(1) U.S. Government and government agencies include GNMA and FMNA mortgage-backed securities.
(2) Primarily Canadian dollar denominated bonds supporting our Canadian insurance reserves.
The following table shows the distribution of the contractual maturities of our portfolio of fixed maturity securities by carrying value as of December 31, 2004. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties:
The following table shows the distribution of the ratings assigned by Standard & Poor's Corporation to the securities in our portfolio of fixed maturity securities:
At December 31, 2004, 99.4% of our fixed maturity investments were rated "investment grade" compared to 99.3% as of December 31, 2003. "Investment grade" securities are those rated "BBB-" or higher by Standard & Poor's Corporation or "Baa3" or higher by Moody's Investors Service. We owned approximately $332.8 million of collateralized mortgage obligations secured by residential mortgages and asset-backed securities, as of December 31, 2004 compared to $253.1 million, as of December 31, 2003, representing approximately 28.4% of our fixed maturity portfolio as of December 31, 2004 and 22.2% of our fixed maturity portfolio as of December 31, 2003. Some classes of mortgage backed securities are subject to significant prepayment risk, because in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled, as individuals refinance higher rate mortgages to take advantage of the lower rates. As a result, holders of mortgage backed securities may receive higher prepayments on their investments, which they may not be able to reinvest at an interest rate comparable to the rate paid on such mortgage backed securities.
Fixed maturity securities with less than investment grade ratings had aggregate carrying values of $7.0 million as of December 31, 2004 and $8.4 million as of December 31, 2003, amounting to 0.6% of total investments as of December 31, 2004 and 0.7% of total investments as of December 31, 2003. These securities represented less than 0.4% of total assets as of December 31, 2004 and 0.5% of total assets as of December 31, 2003. Our holdings of less than investment grade fixed maturity securities are diversified and the largest investment in any one such security as of December 31, 2004 was $3.0 million, which was less than 0.2% of total assets. During the year ended December 31, 2004, we did not write down the value of any fixed maturity securities. We wrote down the value of certain of our fixed maturity portfolio's securities considered to have been subject to an other-than-temporary decline in value by $1.3 million in 2003 and $10.6 million in 2002 (primarily as a result of the impairment of our WorldCom bonds, which were disposed of in the third quarter of 2002 at a price approximating their carrying value after the other-than-temporary decline was recognized). The other-than-temporary impairments were included in net realized gains (losses) on investments in our consolidated statements of operations.
INVESTMENT INCOME
Investment income is an important part of our total revenues and profitability. We cannot predict the impact that changes in future interest rates will have on our financial statements. The following table presents the investment results of our total invested asset portfolio:
The decrease in our yield is a result of a decline in overall economic interest rates and our decision to maintain higher cash balances in anticipation of an increase in the economic interest rates.
REINSURANCE
In the normal course of business, we reinsure portions of certain policies that we underwrite. We enter into reinsurance arrangements with unaffiliated reinsurance companies to limit our exposure on individual claims and to limit or eliminate risk on our non-core or under-performing blocks of business. Accordingly, we are party to several reinsurance agreements on our life and accident & health insurance risks. Our senior market accident & health insurance products are generally reinsured under quota share coinsurance treaties, while our life insurance risks are generally reinsured under either quota share coinsurance or yearly-renewable term treaties. Under quota share coinsurance treaties, we pay the reinsurer an agreed upon percentage of all premiums and the reinsurer reimburses us that same percentage of any losses. In addition, the reinsurer pays us allowances to cover commissions, cost of administering the policies and premium taxes. Under yearly-renewable term treaties, the reinsurer receives premiums at an agreed upon rate for its share of the risk on a yearly-renewable term basis. We also use excess of loss reinsurance agreements for certain policies whereby we limit our loss in excess of specified thresholds.
The table below details our gross annualized premium in force, the portion that we ceded to reinsurers and the net amount that we retained:
We have several quota share coinsurance agreements (as described above) in place with General Re Life Corporation ("General Re") and Hannover Life Re of America ("Hannover"). General Re is rated "A+" and Hannover is rated "A" by A.M. Best. These agreements cover various accident & health insurance products, primarily Medicare Supplement and long term care policies, written or acquired by us and contain ceding percentages ranging from 25% to 100%. Effective January 1, 2004, we increased our retention on all new Medicare Supplement sales to 100%. During 2004, we ceded premiums of $109.0 million to General Re and $105.3 million to Hannover, each representing approximately 12% of our total direct and assumed premiums. During 2003, we ceded premiums of $123.5 million to General Re and $116.3 million to Hannover, representing 17% and 16%, respectively, of our total direct and assumed premiums.
Our quota share coinsurance agreements are generally subject to cancellation on 90 days notice as to future business, but policies reinsured prior to such cancellation remain reinsured as long as they remain in force. There is no assurance that if any of our reinsurance agreements were canceled we would be able to obtain other reinsurance arrangements on satisfactory terms.
We evaluate the financial condition of our reinsurers and monitor concentrations of credit risk to minimize our exposure to significant losses from reinsurer insolvencies. We are obligated to pay claims in the event that a reinsurer to whom we have ceded an insured claim fails to meet its obligations under the reinsurance agreement. As of December 31, 2004, all of our primary reinsurers were rated "A" or better by A.M. Best. We do not know of any instances where any of our reinsurers have been unable to pay any policy claims on any reinsured business.
ADMINISTRATION OF REINSURED BLOCKS OF BUSINESS
We retain the administration for reinsured blocks of business, including underwriting, issue, policy maintenance, rate management and claims adjudication and payment. In addition to reimbursement for commissions and premium taxes on the reinsured business, we also receive allowances from the reinsurers as compensation for our administration.
SENIOR MARKET HEALTH INSURANCE
Historically, we reinsured much of our Senior Market Health Insurance business to unaffiliated reinsurers under quota share coinsurance agreements. Beginning in 2001, we gradually reduced the amount of premium that we ceded to reinsurers on new business, and all new Medicare Supplement business written after January 1, 2004 has been 100% retained by the Company. Under the existing coinsurance agreements, which remain in effect for the life of each policy reinsured, we reinsure a portion of the premiums, claims and commissions on a pro rata basis and receive additional expense allowances for policy issue and administration and premium taxes. The amounts reinsured under these agreements range from 25% to 100%. As older, reinsured business lapses and new business that has no reinsurance is written, the overall percentage of business we retain will increase. As of December 31, 2004, the percentage of Medicare Supplement business we retained increased to 64%, as compared to 57% at the end of 2003.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE
We reinsure our Medicare Advantage and private fee for service products on an excess of loss basis, which limits our risk to amounts ranging from $100,000 to $200,000.
SPECIALTY HEALTH INSURANCE
We retain 100% of the fixed benefit accident & sickness disability and hospital business issued in our Specialty Health Insurance segment. Long term care business is reinsured on a 50% quota share basis, except for the acquired long term care business written in Pennsylvania Life and Union Bankers which is 100% retained. We have excess of loss reinsurance agreements to reduce our liability on individual risks for home health care policies to $250,000. For other long term care policies issued in the U.S. we have reinsurance agreements which cover 90% of the benefits on claims after two years and 100% of the benefits on claims after the third or fourth years depending upon the plan. We also have excess of loss reinsurance agreements with unaffiliated reinsurance companies on most of our medical insurance policies to reduce the liability on individual risks to $325,000 per year.
LIFE INSURANCE/ANNUITIES
Senior life insurance products currently being issued are reinsured under 50% quota share coinsurance agreements, except for certain states where our retention is 100%. Our whole life products currently being issued are reinsured on a yearly renewable term basis for amounts in excess of $100,000.
UNDERWRITING PROCEDURES
Premiums charged on insurance products are based, in part, on assumptions about expected mortality and morbidity experience. We have adopted and follow detailed uniform underwriting procedures designed to assess and quantify various insurance risks before issuing individual life insurance, health insurance policies and annuity policies to individuals. These procedures are generally based on industry practices, reinsurer underwriting manuals and our prior underwriting experience. To implement these procedures, our insurance company subsidiaries employ an experienced professional underwriting staff.
Applications for insurance are reviewed on the basis of the answers that the customer provides to the application questions. Where appropriate to the type and amount of insurance applied for and the applicant's age and medical history, additional information is required, such as medical examinations, statements from doctors who have treated the applicant in the past and, where indicated, special medical tests. If deemed necessary, we use investigative services to supplement and substantiate information. For certain coverages, we may verify information with the applicant by telephone. After reviewing the information collected, we either issue the policy as applied for on a standard basis, issue the policy with an extra premium charge due to unfavorable factors, issue the policy excluding benefits for certain conditions, either permanently or for a period of time, or reject the application. For some of our coverages, we have adopted simplified policy issue procedures in which the applicant submits an application for coverage typically containing only a few health-related questions instead of a complete medical history. Under regulations promulgated by the National Association of Insurance Commissioners ("NAIC") and adopted as a result of the Omnibus Budget Reconciliation Act of 1990, we are prohibited from using medical underwriting criteria for our Medicare Supplement policies for certain first-time purchasers and for dis-enrollees from health maintenance organizations (HMOs). If a person applies for insurance within six months after becoming eligible by reason of age, or disability in some circumstances, the application may not be rejected due to medical conditions. For other prospective Medicare Supplement policyholders, such as senior citizens who are purchasing our products, the underwriting procedures are limited based upon standard industry practices.
In New York and some other states, some of our products, including Medicare Supplement, are subject to guaranteed issue "Community Rating" laws that severely limit or prevent underwriting of individual applications. See the "Regulation" section of this document. Additionally, we are not permitted to underwrite for new members for our Medicare Advantage HMO Plan or our private fee for service plans.
RESERVES
In accordance with applicable insurance regulations, we have established, and carry as liabilities in our statutory financial statements, actuarially determined reserves that are calculated to satisfy our policy and contract obligations. Reserves, together with premiums to be received on outstanding policies and contracts and interest at assumed rates on such amounts, are calculated to be sufficient to satisfy policy and contract obligations. The actuarial factors used in determining reserves for life insurance policies are based on statutorily prescribed mortality tables and interest rates. In addition, reserves for accident and health insurance policies use prescribed or permitted morbidity tables. Reserves are also maintained for unearned premiums, for premium deposits, for claims that have been reported and are in the process of being paid or contested and for our estimate for claims that have been incurred but have not yet been reported.
The reserves reflected in our consolidated financial statements are calculated in accordance with generally accepted accounting principles ("GAAP"). These reserves are determined based on our best estimates of mortality and morbidity, persistency, expenses and investment income. We use the net level premium method for all non-interest-sensitive products and the retrospective deposit method for interest-sensitive products. GAAP reserves differ from statutory reserves due to the use of different assumptions regarding mortality and morbidity, interest rates and the introduction of lapse assumptions into the GAAP reserve calculation.
When we acquire blocks of insurance policies or insurers owning blocks of policies, our assessment of the adequacy of the transferred policy liabilities is subject to risks and uncertainties. With acquired and existing businesses, we may from time to time need to increase our claims reserves significantly in excess of those estimated. An inadequate estimate in reserves could have a material adverse impact on our results of operations or financial condition.
COMPETITION
The life and accident and health insurance industry in North America is highly competitive. There are approximately 2,000 life and accident and health insurance companies operating in the United States. We compete with numerous other insurance companies on a national basis plus other regional insurance companies and financial services companies, including health maintenance organizations, preferred provider organizations, and other health care-related institutions which provide medical benefits based on contractual agreements. We may be at a disadvantage because many of these organizations have been in business for a longer period of time and have substantially greater capital, larger and more diversified portfolios of life and health insurance policies, larger agency sales operations and higher ratings than we do. In addition, it has become increasingly difficult for smaller and mid-size companies to compete effectively with their larger competitors for insurance product sales in part as a result of heightened consumer and agent awareness of the ratings and financial size of companies.
We believe we can meet these competitive pressures by offering a high level of service and accessibility to our field force and by developing specialized products and marketing approaches. We also believe that our policies and premium rates, as well as the commissions paid to our sales agents, are generally competitive with those offered by other companies selling similar types of products in the same jurisdictions. In addition, our insurance subsidiaries operate at lower policy acquisition and administrative expense levels than some other insurance companies, allowing us to offer competitive rates while maintaining underwriting margins. In the case of our Medicare Supplement business, low expense levels are necessary in order to meet state mandated loss ratios and achieve the desired underwriting margins. Also, we believe our disciplined underwriting procedures, pricing practices, effective rate management and related staff, our quality customer service, our significant market position in certain
geographic areas, the quality of our distribution network and our appropriate financial strength, provide additional strength to compete effectively.
In addition, we compete with other managed care organizations for government healthcare program contracts, renewals of those government contracts, members and providers. Many of our competitors are large companies that have greater financial, technological and marketing resources than we do. In the Medicare managed care market, our primary competitors for contracts, members and providers are national and regional commercial managed care organizations that serve Medicare recipients and provider-sponsored organizations. The MMA may cause a number of commercial managed care organizations already in our service areas to decide to enter the Medicare market. In addition, beginning in 2006, a new regional Medicare Preferred Provider Organization, or Medicare PPO, program will be implemented pursuant to the MMA. Medicare PPOs would allow their members more flexibility to select physicians than the current Medicare Advantage plans, such as HMOs, which often require members to coordinate with a primary care physician. Regional Medicare PPO plans will compete with local Medicare Advantage HMO plans, including the plans we offer.
RATINGS
Increased public and regulatory concerns regarding the financial stability of insurance companies have resulted in policyholders placing greater emphasis upon company ratings and have created some measure of competitive advantage for insurance carriers with higher ratings. A.M. Best is considered to be a leading insurance company rating agency. In evaluating a company's financial and operating performance, A.M. Best reviews profitability, leverage and liquidity as well as the quality of the book of business, the adequacy and soundness of reinsurance programs, the quality and estimated market value of assets, reserve adequacy and the experience and competence of management. A.M. Best's ratings are based upon factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors. Currently, A.M. Best maintains ratings of "B++" on American Pioneer, American Progressive, Constitution Life, Penncorp Life (Canada), Pennsylvania Life, and Pyramid Life and B+ on Union Bankers. These B++ and B+ ratings mean that, in A.M. Best's opinion, these companies have demonstrated "very good" overall performance when compared to standards it has established and have a "good" ability to meet their obligations to policyholders and are in the "Secure" category of all companies rated by A.M. Best. A.M. Best does not rate our other insurance company subsidiaries.
Standard & Poor's currently assigns its "BBB+ (stable outlook)" counterparty credit and financial strength ratings to our American Pioneer, American Progressive, Pennsylvania Life and Penncorp Life (Canada) subsidiaries. This rating means that in Standard & Poor's opinion, these companies have good financial security characteristics, but are more likely to be affected by adverse business conditions than are insurers that are rated higher by Standard & Poor's. A plus (+) or minus (-) shows Standard & Poor's opinion of the relative standing of the insurer within a rating category. In connection with our acquisition of Heritage Health Systems, Inc., Standard & Poor's placed its "BBB- (stable outlook)" credit rating on our Amended Credit Facility. This investment grade rating means the obligation exhibits adequate protection parameters.
Our insurance company subsidiaries are not currently rated by Moody's Investors Service or Fitch Ratings. Although a higher rating by A.M. Best, Standard & Poor's or another insurance rating organization could have a favorable effect on our business, we believe that our competitive pricing, effective rate management, quality customer service and effective marketing has enabled, and will continue to enable, our insurance company subsidiaries to compete effectively.
REGULATION
General
Our insurance company subsidiaries, like other insurance companies, are subject to the laws, regulations and supervision of the jurisdictions in which they are domiciled. The purpose of those laws and regulations is primarily to provide safeguards for policyholders rather than to protect the interest of shareholders. The following table sets forth the domiciles of our insurance company subsidiaries.
Florida: American Pioneer Life Insurance Company ("American Pioneer") Peninsular Life Insurance Company ("Peninsular")
New York: American Progressive Life & Health Insurance Company of New York ("American Progressive")
Kansas: The Pyramid Life Insurance Company ("Pyramid Life")
Oklahoma: Eagle Life Insurance Company ("Eagle")
Pennsylvania: Pennsylvania Life Insurance Company ("Pennsylvania Life")
Texas: American Exchange Life Insurance Company ("American Exchange") Constitution Life Insurance Company ("Constitution") Marquette National Life Insurance Company ("Marquette") SelectCare of Texas ("SelectCare") Union Bankers Insurance Company ("Union Bankers")
Canada: Penncorp Life Insurance Company ("Penncorp Life (Canada)")
Pennsylvania Life, Constitution Life, Union Bankers, American Pioneer and American Progressive are subsidiaries of American Exchange. Pyramid Life is a subsidiary of Pennsylvania Life. Marquette is a subsidiary of Constitution. Peninsular Life is a subsidiary of American Pioneer. SelectCare is a subsidiary of Heritage.
Each of our insurance company subsidiaries is also subject to the regulations and supervision by the insurance department of each of the jurisdictions in which they are admitted and authorized to transact business. Such regulations cover, among other things, the declaration and payment of dividends by our insurance company subsidiaries, the setting of rates to be charged for some types of insurance, the granting and revocation of licenses to transact business, the licensing of agents, the regulation and monitoring of market conduct and claims practices, the approval of forms, the establishment of reserve requirements, investment restrictions, the regulation of maximum allowable commission rates, the mandating of some insurance benefits, minimum capital and surplus levels, and the form and accounting practices used to prepare financial statements required by statute. A failure to comply with legal or regulatory restrictions may subject the insurance company subsidiary to a
loss of a right to engage in some businesses or an obligation to pay fines or make restitution, which may affect our profitability.
Most jurisdictions mandate minimum benefit standards and loss ratios for accident and health insurance policies. Generally we are required to maintain, with respect to our individual long term care policies, minimum anticipated loss ratios over the entire period of coverage. With respect to our Medicare Supplement policies, we are generally required to attain and maintain an actual loss ratio, after three years, of not less than 65 percent of earned premium. We provide, to the insurance departments of all states in which we conduct business, annual calculations that demonstrate compliance with required loss ratio standards for both long term care and Medicare Supplement insurance. We prepare these calculations utilizing statutory lapse and interest rate assumptions. In the event we fail to maintain minimum mandated loss ratios, our insurance company subsidiaries could be required to provide retrospective premium refunds or prospective premium rate reductions. We believe that our insurance company subsidiaries currently comply with all applicable mandated minimum loss ratios. In addition, we actively review the loss ratio experience of our products and request approval for rate increases from the respective insurance departments when we determine they are needed. We cannot guarantee that we will receive the rate increases we request.
Under Federal and NAIC model regulations, adopted in substantially all states, there are currently 12 standard Medicare Supplement plans (Plans A through J and High Deductible Plans F and J). Plan A provides the least extensive coverage, while Plan J provides the most extensive coverage. Under NAIC regulations, Medicare Supplement insurers must offer Plan A, but may offer any of the other plans at their option. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("MMA") prohibits the sale of the former H, I and J plans and authorizes two additional plans after December 2005 (Plans K and L).
Every insurance company that is a member of an "insurance holding company system" generally is required to register with the insurance regulatory authorities in its domicile state and file periodic reports concerning its relationships with its insurance holding company and with its affiliates. Material transactions between registered insurance companies and members of the holding company system are required to be "fair and reasonable" and in some cases are subject to administrative approval. The books, accounts and records of each party are required to be maintained so as to clearly and accurately disclose the precise nature and details of any such transactions.
Each of our U.S. insurance company subsidiaries is required to file detailed reports with the insurance department of each jurisdiction in which it is licensed to conduct business and its books and records are subject to examination by each such insurance department. In accordance with the insurance codes of their domiciliary states and the rules and practices of the NAIC, our insurance company subsidiaries are examined periodically by examiners of each company's domiciliary state with elective participation by representatives of the other states in which they are licensed to do business. Regularly scheduled regulatory financial examinations are near completion for American Progressive, Pyramid, and Marquette as of and for the period ended December 31, 2003. We have not been informed of any significant findings or adjustments to statutory surplus from these examinations, except for a finding for American Progressive regarding annuity sales practices. During the fourth quarter of 2004, we recorded approximately $0.3 million in additional benefits on certain replacement annuity policies that we determined contained inappropriate disclosure information to the insured. There is no additional liability to these policyholders. There were no other regulatory financial examinations of our insurance subsidiaries during 2004.
Many states require deposits of assets by insurance companies for the protection of policyholders either in those states or for all policyholders. These deposited assets remain part of the total assets of the
company. As of December 31, 2004, securities totaling $41.8 million, representing approximately 3.8% of the carrying value of our total investments, were on deposit with various state treasurers or custodians. As of December 31, 2003, securities totaling $44.1 million, representing approximately 3.8% of total investments, were on deposit. These deposits must consist of securities that comply with the standards established by the particular state.
Penncorp Life (Canada), our Canadian domiciled subsidiary, is subject to provincial regulation and supervision in each of the provinces of Canada in which it conducts business. Provincial insurance regulation is concerned primarily with the form of insurance contracts and the sale and marketing of insurance and annuity products, including the licensing and supervision of insurance marketing personnel.
Other Insurance Regulatory Changes
The NAIC and state insurance regulators in the United States are involved in a process of re-examining existing laws and regulations and their application to insurance companies. This re-examination has focused on insurance company investment and solvency issues, risk-based capital guidelines, assumption reinsurance, interpretations of existing laws, the development of new laws, the interpretation of non-statutory guidelines, and the circumstances under which dividends may be paid. The NAIC has encouraged states to adopt model laws on specific topics as follows: investment reserve requirements; risk-based capital standards; additional investment restrictions; restrictions on an insurance company's ability to pay dividends; product illustrations; suitability of annuity sales to seniors; and producer compensation disclosures.
The NAIC is currently developing new model laws or regulations, including product design standards and reserve requirements. While the Federal government currently does not regulate the insurance business directly, Federal legislation and administrative policies in a number of areas, such as Medicare, employee benefits regulation, age, sex and disability-based discrimination, financial services regulation and Federal taxation, can significantly affect the insurance business. It is not possible to predict the future impact of changing regulation on our operations or the operations of our insurance company subsidiaries.
Since 1993, New York State has required that all health insurance sold to individuals and groups with less than 50 employees be offered on an open enrollment and community rated basis. The community rating aspect of the law prohibits the use of age, sex, health or occupational factors in rating and requires that the same average rate be used for all persons with the same policy residing in the same location. Such insurance may continue to be sold to groups with more than 50 employees on an underwritten basis, with premium set to reflect expected or actual results. The Medicare Supplement policies actively marketed by American Progressive in New York State and some of its in force business are subject to the community rating rules. Similar legislation is in effect for certain products in other states. The extension of such legislation to other states where we offer significant medically underwritten health insurance might cause us to reconsider our health care coverage offerings in any such state.
Producer Compensation Disclosure
State regulators and attorney generals have initiated investigations into producer compensation and product pricing. While the initial investigations have focused on commercial lines insurers and brokers, it remains to be seen whether the investigations will broaden and potentially change how our products are sold. We have responded to inquiries regarding our sales practices, and we do not anticipate that our responses will require any change in our compensation practices or any other adverse result. The NAIC appointed a task force to consider appropriate regulatory action. In late December 2004, the NAIC adopted an amendment to the Producer Licensing Model Act. The amendment, while not a state law, is expected to be considered by state legislators during 2005. The amendment to the model law would require our producers to disclose to prospective purchasers of our products the fact that the producer will
receive compensation from the insurance company that issues an insurance product to the consumer. It is possible that some states will adopt laws that are broader than the NAIC model amendment.
Long Term Care Rate Stabilization
In 2000, the NAIC adopted a model law intended to address the issue of the rising cost of long term care insurance and other matters. The model law includes provisions intended to assure that rates on long term care insurance policies, under which the insurer reserves the right to increase premiums, are initially set high enough to make such increases unlikely. These rate stabilization laws have been adopted in a number of states. Although we no longer market long term care insurance, we are complying with the laws as they are adopted by filing new policy forms and rates. Insurers are now required to certify that rates will not be increased in moderately adverse circumstances.
Annuity Suitability
In September 2003, the National Association of Insurance Commissioners adopted the Senior Protection in Annuity Transaction Model Regulation. It is expected that most states will adopt the regulation swiftly. The model regulation imposes additional obligations on insurance producers and their supervisors relating to annuity sales to customers age 65 and over. The burden of demonstrating suitability of the recommended annuity is that of the producer with oversight responsibilities imposed on the producer's supervisor and the insurer. We are developing guidelines to distribute to our sales forces to assist in complying with the regulations.
Recent Medicare Reform Legislation
Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital and medical insurance benefits. Medicare beneficiaries have the option to enroll in a Medicare Advantage plan as an HMO benefit in areas where such a plan is offered. Under Medicare Advantage, managed care plans contract with CMS to provide comparable Medicare benefits as a traditional fee-for-service Medicare in exchange for a fixed monthly payment per member that varies based on the county in which a member resides.
On December 8, 2003, President Bush signed MMA, which made numerous changes to the Medicare program, including expanding the Medicare program to include a prescription drug benefit beginning in 2006, a transitional drug discount card that as of June 2004 enables Medicare beneficiaries to obtain discounts on drugs prior to receiving drug coverage in 2006, and expanding the Medicare+Choice program and renaming it "Medicare Advantage." Medicare Advantage plans are eligible to sponsor the drug discount card and transitional assistance program as well as the new prescription drug plan. CMS, however, may limit the number of prescription drug plan sponsors and endorsed drug card sponsors that are selected in a particular area. We offer an approved drug discount card in certain markets.
MMA creates the drug discount card and transitional assistance program as an interim program until the new drug benefit goes into effect January 1, 2006. The voluntary drug discount card program will enable Medicare beneficiaries to pay a fixed fee to access discounts on drugs. Certain low income beneficiaries may enroll in the transitional assistance program and receive a subsidy of up to $600 per year for certain covered drugs that are purchased using the drug discount card. A Medicare Advantage plan may apply to be an endorsed sponsor of the drug card as a stand alone product or may apply to offer the drug discount card exclusively to its enrollees. The drug discount card program went into effect in June 2004 and sponsors may continue to enroll eligible individuals through December 31, 2005. In 2006, endorsed card sponsors must honor the drug card until the end of a transition period which runs until the date of the individual's enrollment in a new drug benefit or the end of the drug benefit enrollment period.
Under MMA, commencing in 2006, a new voluntary prescription drug benefit will be available under Medicare. Medicare beneficiaries will pay a monthly premium for the covered outpatient drug benefit offered through a private drug plan. The drug benefit is subject to certain cost sharing. Under the standard drug coverage, for 2006, the cost sharing is a $250 deductible, 25% coinsurance for annual drug costs reimbursed by Medicare, up to $2,250, and no reimbursement for drug costs above $2,250, until the beneficiary has paid $3,600. After that, MMA provides catastrophic stop loss coverage for annual incurred drug costs in excess of $3,600, subject to nominal cost-sharing. Plans are not required to mirror these limits; instead, drug plans are required to provide coverage that is at least actuarially equivalent to the standard drug coverage delineated in the MMA. These numbers will be adjusted on an annual basis. MMA provides subsidies and the reduction or elimination of cost sharing for certain low-income beneficiaries, including dual-eligible individuals who receive benefits under both Medicare and Medicaid. This new drug benefit will be offered by new regional prescription drug plans. Medicare Advantage organizations must offer a plan with the drug benefit. In addition, Medicare Advantage plans may bid to offer a stand-alone prescription drug plan that beneficiaries who have fee for service Medicare may elect.
MMA also revises payment methodologies for Medicare Advantage organizations beginning in 2004, and in 2006 MMA expands the Medicare Advantage program to include, in addition to the traditional HMO and fee-for-service plans established by county, new regional plans which will provide out-of-network benefits in addition to in-network benefits. The Secretary of Health and Human Services, or HHS, created 26 regions, each of which may include more than one state or portions of a particular state. MMA creates a new competitive bidding process beginning in 2006 for both the local HMO plan and the new regional plan for setting the payment to the Medicare Advantage plan and the beneficiary premium and benefits. The bidding process does not limit the number of plans that may participate in the Medicare Advantage program.
MMA shifts coverage responsibility for the drug benefit for dual-eligible individuals. Starting January 1, 2006, dual-eligibles will receive their drug coverage from the Medicare program and not the Medicaid program.
Dividend Restrictions
American Progressive is a New York insurance company. New York State insurance law provides that the declaration or payment of a dividend by American Progressive requires the approval of the New York Superintendent of Insurance. Management expects that no dividend would be approved until American Progressive had generated sufficient statutory profits to offset its negative unassigned surplus.
Pennsylvania Life is a Pennsylvania insurance company, Pyramid Life is a Kansas insurance company and American Exchange, Constitution, Marquette and Union Bankers are Texas insurance companies. SelectCare is licensed in Texas as a Provider Sponsored Organization ("PSO"). Pennsylvania, Kansas and Texas insurance laws provide that a life insurer may pay dividends or make distributions from accumulated earnings without the prior approval of the Insurance Department, provided they do not exceed the greater of (i) 10% of the insurer's surplus as to policyholders as of the preceding December 31; or (ii) the insurer's net gain from operations for the immediately preceding calendar year with 30 days advance notification to the insurance department. Accordingly, Pennsylvania Life would be able to pay ordinary dividends of up to $6.3 million to American Exchange (its direct parent) without the prior approval from the Pennsylvania Insurance Department in 2005. Pyramid Life would be able to pay ordinary dividends of up to $2.5 million to Pennsylvania Life (its direct parent) without the prior approval from the Kansas Insurance Department and Marquette would be able to pay ordinary dividends of up to $0.3 million to Constitution (its direct parent) without the prior approval from the Texas Insurance Department in 2005. American Exchange, Constitution and Union Bankers had negative earned surplus at December 31, 2004 and would not be able to pay dividends in 2005 without
special approval. Texas insurance companies are also required to have positive "earned surplus", as defined by Texas regulations, which differs from statutory unassigned surplus. SelectCare would not be able to pay dividends in 2005 with out special approval.
American Pioneer and Peninsular are Florida insurance companies. Florida insurance law provides that a life insurer may pay a dividend or make a distribution without the prior written approval of the department when certain conditions are met. American Pioneer had negative unassigned surplus at December 31, 2004 and would not be able to pay dividends in 2005 without special approval.
Penncorp Life (Canada) is a Canadian insurance company. Canadian law provides that a life insurer may pay a dividend after such dividend declaration has been approved by its board of directors and upon at least 10 days prior notification to the Superintendent of Financial Institutions. Such a dividend is limited to retained net income (based on Canadian GAAP) for the preceding two years, plus net income earned for the current year. In considering approval of a dividend, the board of directors must consider whether the payment of such dividend would be in contravention of the Insurance Companies Act of Canada. During 2004, Penncorp Life (Canada) paid dividends of C$33.9 million (approximately US$25.5 million) to Universal American in 2004. We anticipate that Penncorp (Canada) will be able to pay dividends equal to its net income earned during 2005, less $2.5 million.
Risk-Based Capital and Minimum Capital Requirements
The NAIC's risk-based capital requirements for insurance companies adopted by state regulators take into account asset risks, interest rate risks, mortality and morbidity risks and other relevant risks with respect to the insurer's business and specify varying degrees of regulatory action to occur to the extent that an insurer does not meet the specified risk-based capital thresholds, with increasing degrees of regulatory scrutiny or intervention provided for companies in categories of lesser risk-based capital compliance. Penncorp Life (Canada), is subject to minimum continuing capital and surplus requirements, which Canadian regulators use to assess financial strength and to determine when regulatory intervention is needed. As of December 31, 2004 all of our U.S. insurance company subsidiaries maintained ratios of total adjusted capital to risk-based capital in excess of the authorized control level and Penncorp Life (Canada) maintained minimum continuing capital and surplus requirement ratios in excess of minimum requirements. However, should our insurance company subsidiaries' risk-based capital position decline in the future, their ability to pay dividends, required capital contributions from Universal American and the degree of regulatory supervision or control to which they are subjected might be affected.
Guaranty Association Assessments
Our insurance company subsidiaries can be required, under solvency or guaranty laws of most jurisdictions in which they do business, to pay assessments to fund policyholder losses or liabilities of unaffiliated insurance companies that become insolvent. These assessments may be deferred or forgiven under most solvency or guaranty laws if they would threaten an insurer's financial strength and, in most instances, may be offset against future premium taxes. The insurance company subsidiaries provide for known and expected insolvency assessments based on information provided by the National Organization of Life & Health Guaranty Associations. Our insurance company subsidiaries have not incurred any significant costs of this nature. The likelihood and amount of any future assessments is unknown and is beyond our control.
The Health Insurance Portability and Accountability Act of 1996
The Health Insurance Portability and Accountability Act of 1996 ("HIPAA") mandates guaranteed availability and renewability of health insurance for certain employees and individuals; limits on termination options and on the use of preexisting condition exclusions; prohibitions against discriminating on the basis of health status; and requirements which make it easier to continue coverage in cases where an employee is terminated or changes employers. HIPAA also calls for the adoption of standards for the exchange of electronic health information and privacy requirements that govern the handling, use and disclosure of protected customer health information. We anticipate that we will meet the HIPAA Security Rule changes that will become effective on April 21, 2005, many of which have been implemented with the privacy portion of HIPAA. However, HIPAA is far-reaching and complex and proper interpretation and practice under the law continue to evolve. Consequently, our efforts to measure, monitor and adjust our business practices to comply with HIPAA are ongoing. We do not believe that compliance with those aspects of HIPAA currently in effect and those in the process of regulatory completion, if adopted as currently proposed, will have a material adverse effect on our financial condition or results of operations.
"Do Not Call" Regulations
Effective October 1, 2003, the Federal government removed the exemption for insurance companies as it relates to "Do Not Call" regulations. Insurance companies are now required to develop their own "Do Not Call" lists and reference state and Federal Do Not Call Registries, before making calls to market insurance products. Approximately two thirds of the country's residential telephone numbers are on the Federal registry, which could limit the marketing calls made and potentially negatively impact sales.
Patriot Act
The portion of the USA PATRIOT Act that applies to insurance companies became effective in mid 2004. Insurance companies will have to impose tighter processes and procedures to more thoroughly verify its applicants, insureds, claimants and premium payers in an effort to prevent money laundering. Our insurance companies have implemented measures to comply with the Office of Federal Asset Control requirements, whereby the names of customers and potential customers must be reviewed against a listing of known terrorists and money launderers.
OUTSOURCING ARRANGEMENTS
Mainframe Processing - Data Center Outsourcing. We outsource our mainframe processing to Alicomp ("Alicomp"), a division of Alicare, Inc. The data center is located in Leonia, New Jersey. Our core application software programs are run in Alicomp's data center facility to obtain the necessary mainframe computer capacity and other computer support services without making the substantial capital and infrastructure investments that would be necessary for us to provide these services internally.
Our current agreement with Alicomp obligates Alicomp to provide us with comprehensive data processing services and obligates us to utilize Alicomp's services for substantially all of our mainframe data processing requirements. We are billed monthly for these services on an as-used basis in accordance with a predetermined pricing schedule for specific services. Our agreement with Alicomp, as amended, expires on December 31, 2008, and is terminable by us with or without cause. Our current agreement with Alicomp is renewable automatically for consecutive one year terms unless and until either party has provided the other with six months prior written notice of nonrenewal. In the event we elect to terminate the contract, we would be subject to termination fees equal to six months of current fees should we terminate the contract in 2005, four months of current fees should we terminate the contract in 2006, two
months of current fees should we terminate the contract in 2007 and one month of current fees should we terminate the contract in 2008. Alicomp also provides us with mainframe disaster recovery services. During 2004, we paid an average of $0.4 million per month.
Medicare Advantage Administration. Heritage outsources certain administrative services, including member services and billing and enrollment to an unaffiliated heath care services company. Under this agreement, which expires in January 2010, Heritage pays a percentage of monthly revenues for the contracted services. During 2004, we paid an average of $0.4 million per month.
EMPLOYEES
As of February 25, 2005, we employed approximately 1,200 employees, none of whom is represented by a labor union in such employment. We consider our relations with our employees to be good.
RISK FACTORS
The following risks may have a material impact on our results of operations or financial condition:
RISKS RELATED TO OUR BUSINESS
Our net income may decline if our premium rates are not adequate.
We set the premium rates on our insurance policies based on facts and circumstances known at the time we issue the policies and on assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the severity and duration of the claim, the mortality rate of our policyholder base, the persistency or renewal rate of our policies in force, our commission and policy administration expenses, and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics and other factors. If our actual claims experience proves to be less favorable than we assumed and we are unable to raise our premium rates, our net income may decrease. We generally cannot raise our premiums in any state unless we first obtain the approval of the insurance regulator in that state. We review the adequacy of our accident & health premium rates regularly and file rate increases on our products when we believe permitted premium rates are too low. When determining whether to approve or disapprove our rate increase filings, the various state insurance departments take into consideration our actual claim experience compared to expected claim experience, policy persistency (which means the percentage of policies that are in-force at certain intervals from the issue date compared to the total amount originally issued), investment income and medical cost inflation. If the regulators do not believe these factors warrant a rate increase, it is possible that we will not be able to obtain approval for premium rate increases from currently pending requests or requests filed in the future. If we are unable to raise our premium rates because we fail to obtain approval for rate increases in one or more states, our net income may decrease. If we are successful in obtaining regulatory approval to raise premium rates, the increased premium rates may reduce the volume of our new sales and cause existing policyholders to let their policies lapse. This would reduce our premium income in future periods. Increased lapse rates also could require us to expense all or a portion of the deferred policy costs relating to lapsed policies in the period in which those policies lapse, reducing our net income in that period.
Our reserves for future policy benefits and claims may prove to be inadequate, requiring us to increase liabilities and resulting in reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders using the same actuarial assumptions that we use to set our premiums. For our accident and health insurance business, we establish active life reserves for expected future policy benefits (including for certain of our policies, provisions for return of premiums ("ROP")), plus a liability for due and unpaid claims, claims in the course of settlement, and incurred but not reported claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, taxability of ROP benefits, inflation, hospital and medical costs, changes in doctrines of legal liability and extra-contractual damage awards. Therefore, the reserves and liabilities we establish are necessarily based on extensive estimates, assumptions and prior years' statistics. When we acquire other insurance companies or blocks of insurance, our assessment of the adequacy of acquired policy liabilities is subject to similar estimates and assumptions. Establishing reserves involves inherent uncertainties, and it is possible that actual claims could materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our net income depends significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves and pricing our policies. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities resulting in reduced net income, statutory surplus and shareholders' equity.
We incurred additional debt obligations in connection with our acquisition of Heritage that could restrict our operations.
We have a significant amount of outstanding indebtedness. As of December 31, 2004, we had $101 million in borrowings outstanding under our amended credit agreement and $75 million in trust preferred securities. We have available borrowing capacity under our new senior secured revolving credit facility of approximately $15 million. We may also incur additional indebtedness in the future. Our substantial indebtedness could have adverse consequences, including:
- increasing our vulnerability to adverse economic, regulatory and industry conditions, and placing us at a disadvantage compared to our competitors that are less leveraged;
- limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
- limiting our ability to borrow additional funds for working capital, capital expenditures, acquisitions and general corporate or other purposes; and
- exposing us to greater interest rate risk since the interest rate on borrowings under our senior credit facilities is variable.
Our debt service obligations will require us to use a portion of our operating cash flow to pay interest and principal on indebtedness instead of for other corporate purposes, including funding future expansion of our business and ongoing capital expenditures. If our operating cash flow and capital resources are insufficient to service our debt obligations, we may be forced to sell assets, seek additional equity or debt capital or restructure our debt. However, these measures might be unsuccessful or inadequate in permitting us to meet scheduled debt service obligations.
We may be unable to service and repay our debt obligations if our subsidiaries cannot pay sufficient dividends or make other cash payments to us.
We are an insurance holding company whose assets principally consist of the capital stock of our operating subsidiaries, substantially all of which is pledged to our bank lenders. Because our principal outstanding indebtedness has been incurred by our parent company, our ability to make interest and principal payments on our outstanding debt is dependent upon the ability of our subsidiaries to pay cash dividends or make other cash payments to our parent company. Our subsidiaries will be able to pay dividends to our parent company only if they earn sufficient profits and, in the case of our insurance company subsidiaries, they satisfy the requirements of the state insurance laws relating to dividend payments and the maintenance of required surplus, to which they are subject.
Capital constraints could restrict our ability to support our premium growth
Our continued growth is dependent upon our ability to support premium growth through the expansion of our markets and our network of agents while at the same time maintaining sufficient levels of capital and surplus to support that growth. Our new business growth typically results in reduced income, or net losses, on some products during the early years of a policy (statutory surplus strain), due primarily to differences in accounting practices between statutory accounting principles and generally accepted accounting principles in the United States and Canada. The resulting statutory surplus strain can limit our ability to generate new business due to statutory restrictions on premium to surplus ratios and other required statutory surplus parameters. In addition, some states, such as Florida and Texas, limit an insurer's ability to write certain lines of business if gross and/or net premiums written would exceed a specified percentage of surplus. In addition, we are required to maintain adequate risk based capital ratios as prescribed by the National Association of Insurance Commissioners ("NAIC"). Moreover, substantially more capital than the statutory minimums are needed to support our level of premium growth and to finance acquisitions. If we cannot generate sufficient capital and statutory surplus to maintain minimum statutory requirements and support our growth, we could be restricted in our ability to generate new premium revenue.
The availability of reinsurance on acceptable terms and the financial stability of our reinsurers could impact our ability to manage risk and increase the volume of insurance that we sell.
We utilize reinsurance agreements with larger, financially sound reinsurers to mitigate insurance risks that we underwrite. We enter into reinsurance arrangements with unaffiliated reinsurance companies to limit our exposure on individual claims and to limit or eliminate risk on our non-core or under-performing blocks of business. As of December 31, 2004, we ceded to reinsurers approximately 25% of our gross annualized insurance premium in force. Reinsurance arrangements leave us exposed to two risks: credit risk and replacement risk. Credit risk exists because reinsurance does not relieve us of our liability to our insureds for the portion of the risks ceded to reinsurers. We are exposed to the risk of a reinsurer's failure to pay in full and in a timely manner the claims we make against them in accordance with the terms of our reinsurance agreements, which could expose our insurance company subsidiaries to liabilities in excess of their reserves and surplus and could expose them to insolvency proceedings. The failure of a reinsurer to make claims payments to us could materially and adversely affect our results of operations and financial condition and our ability to make payments to our policyholders. Replacement risk exists because a reinsurer may cancel its participation on new business issued on advance notice. As a result, we would need to find reinsurance from another source to support our level of new business. The amount and cost of reinsurance available to us is subject, in large part, to prevailing market conditions beyond our control. Because our current reinsurance agreements are non-cancelable for business in force, non-renewal or cancellation of a reinsurance arrangement affects only new business and the reinsurer remains liable on business reinsured prior to non-renewal or cancellation. In the event that current reinsurers cancel their
participation on new business, we would seek to replace them, possibly at higher rates. If we are not able to reinsure our life insurance products on acceptable terms, we would consider limiting the amount of such new business issued. A failure to obtain reinsurance on acceptable terms would allow us to underwrite new business only to the extent that we are willing and able to bear the exposure to the new business on our own.
Our financial strength rating is lower than several distributors' minimum acceptable rating and could affect our competitiveness and results of operations.
Increased public and regulatory concerns regarding the financial stability of insurance companies have resulted in policyholders placing greater emphasis upon financial strength ratings and have created some measure of competitive advantage for insurance companies with higher ratings. Our ability to expand and to attract new business is affected by the financial strength ratings assigned to our insurance company subsidiaries by independent insurance industry rating agencies, such as A.M. Best Company, Inc. Some distributors such as financial institutions, unions, associations and affinity groups may not sell our products to these groups unless the rating of our insurance company subsidiary writing the business improves to at least an "A-" from their current "B++." The lack of higher A.M. Best ratings for our insurance company subsidiaries could adversely affect sales of our products. In addition, any future downgrade in our ratings may cause our policyholders to allow their existing policies to lapse. Increased lapse rates would reduce our premium income and would also cause us to expense fully the deferred policy costs relating to lapsed policies in the period in which those policies lapsed, reducing net income in that period. Any future downgrade in our ratings could also cause some of our agents to sell less of our products or to cease selling our policies altogether.
Failure to maintain our information systems could adversely affect our business.
Our business depends significantly on efficient, effective and well controlled information systems. We have various information systems which support our operating segments. Our information systems require an ongoing commitment of significant resources to maintain and enhance existing systems and develop new systems in order to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. We have outsourced the operation of our data center to an independent third party and may from time to time obtain additional services or facilities from other independent third parties. Dependence on third parties for these services and facilities may make our operations vulnerable to their failure to perform as agreed.
There is no assurance that we will continue to be successful in managing our growing operations or in integrating acquired companies into our operations.
As part of our strategy, we have experienced, and expect to continue to experience, considerable growth through acquisitions and our internal efforts. The rapid growth in the size and complexity of our operations has placed, and will continue to place, significant demands on our management, operations systems, accounting systems, internal controls systems and financial resources. Acquisitions involve numerous additional risks, some of which we have experienced in the past, including: (i) difficulties in integrating operations, technologies, products, systems and personnel of the acquired company; (ii) diversion of financial and management resources from existing operations; (iii) potential increases in policy lapses; (iv) potential losses from unanticipated litigation or levels of claims; and (v) inability to generate sufficient revenue to offset acquisition costs. Our ability to manage our growth and compete effectively will depend, in part, on our success in addressing these demands and risks. Any failure by us to effectively manage our growth could have a material adverse effect on our business, financial condition or results of operations.
We may not be able to find suitable acquisition candidates.
Part of our business strategy is to make acquisitions that will be accretive to income and will advance our strategic mission. Since 1990, we have acquired ten insurance companies, three administrative companies and four blocks of insurance business. Additionally, in May 2004, we acquired Heritage Health Systems, Inc., a privately owned managed care company that operates Medicare Advantage plans in Southeastern Texas. We continue to evaluate possible acquisition transactions on an ongoing basis, and at any given time, we may be engaged in discussions with respect to possible acquisitions. We cannot be sure that we will be able to find suitable acquisition candidates and close the transactions. Factors that might preclude closing transactions include the inability to reach a definitive agreement with the seller, the inability to obtain financing on acceptable terms, and the discovery of material issues with the acquisition candidate as a result of our due diligence investigation. If we cannot find suitable acquisition candidates or are not successful in completing acquisitions, we may not be able to sustain our recent historical growth rates.
Changes in the exchange rate between the U.S. dollar and the Canadian dollar may impact our results.
We publish our consolidated financial statements in U.S. dollars. However, portions of our operations are transacted using the Canadian dollar as the functional currency. As of and for the year ended December 31, 2004, approximately 12% of our assets, 9% of our revenues, excluding realized gains, and 16% of our income before realized gains and taxes were derived from our Canadian operations. Accordingly, our earnings and shareholders' equity are affected by fluctuations in the value of the U.S. dollar as compared to the Canadian dollar. Although this risk is somewhat mitigated by the fact that both the assets and liabilities for our Canadian operations are denominated in Canadian dollars, we are still subject to losses resulting from currency translation that will impact our reported consolidated financial condition, results of operations and cash flows from year to year.
A significant amount of our assets is invested in fixed income securities and is subject to market fluctuations.
Our investment portfolio consists almost entirely of fixed income securities. The fair market value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions. The fair market value of our investments in fixed income securities generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk (such as mortgage-backed and other asset-backed securities) may differ from those anticipated at the time of investment as a result of interest rate fluctuations. Because substantially all of our fixed income securities are classified as available for sale, changes in the market value of our securities are reflected in our balance sheet. Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our results of operations and financial condition.
Compliance with recently enacted laws and regulations is complex and expensive
Several laws and regulations adopted by the Federal government including Sarbanes-Oxley, HIPPA, the Patriot Act, and "Do Not Call" regulations, have created additional administrative and compliance requirements on the Company. The requirements of these laws and regulations are still evolving and the cost of compliance may have an adverse effect on our profitability. In addition, if we do not comply adequately, we may be faced with administrative penalties.
Future changes in legislation may adversely affect our business
Since insurance and managed care are regulated businesses with high public profiles, it is always possible that future legislation may be enacted which would have an adverse effect on our business.
Proposals for further federal reforms have included, among other things, restricting coverage of deductible and co-payments on Medicare Supplement policies, coverage to persons under age 65 and employer-based insurance systems, subsidizing premiums for lower income people and programs, regulating policy availability, affordability of public and private programs standardization of major medical or long term care coverages, imposing mandated or target loss ratios or rate regulation, and requiring the use of community rating or other means that further limit the ability of insurers to differentiate among risks, or mandating utilization review or other managed care concepts to determine what benefits would be paid by insurers.
In addition to federal regulation, many states have enacted, or are considering, various health care reform statutes. These proposed reforms relate to, among other things, managed care practices, such as waiting period restrictions on pre-existing conditions, credit for certain prior coverage, and limitations on rate increases and guaranteed renewability for small business plans and policies for individuals. Most states have also enacted patient confidentiality laws that prohibit the disclosure of confidential medical information, some of which, as permitted by HIPAA, are more restrictive than HIPAA's rules protecting health information privacy. These or other reform proposals could necessitate revisions in our Medicare Supplement products could increase or decrease the level of competition among health care insurers and could significantly affect our health insurance business, although it is not possible to predict which proposals will be adopted and what their effect will be.
A portion of our insurance business is the sale of deferred annuities and life insurance products, which are attractive to purchasers in part because policyholders generally are not subject to Federal income tax on increases in the value of an annuity or life and health insurance contract until some form of distribution is made from the contract. From time to time, Congress has considered proposals to reduce or eliminate the tax advantages of annuities and life insurance, which, if enacted, might have an adverse effect on our ability to sell the affected products in the future.
We may be responsible for the actions of our independent and career agents
In litigation against our subsidiaries, claims are sometimes made that agents failed to comply with applicable laws, regulations and rules, or acted improperly in other ways, and that we are responsible for such failure. Although we require our agents to comply with applicable laws, regulations, and our rules and standards, and maintain monitoring and supervisory procedures to enforce this requirement, we may be held liable for contractual or extra-contractual damages on such claims. While no such claim has resulted in material liability to any of our insurance subsidiaries in the past, no assurance can be given that no material liability will result in the future.
RISKS RELATED TO OUR MEDICARE ADVANTAGE BUSINESS
If our government contracts are not renewed or are terminated, our business could be substantially impaired.
We provide our Medicare and other services through a limited number of contracts with federal government agencies. These contracts generally have terms of one or two years and are subject to nonrenewal by the applicable agency. All of our government contracts are terminable for cause if we breach a material provision of the contract or violate relevant laws or regulations. In addition, our right to add new members may be suspended by a government agency if it finds deficiencies in our provider network or operations. If we are unable to renew, or to successfully rebid or compete for any of our government contracts, or if any of our contracts are terminated, our business could be substantially impaired. If any of those circumstances were to occur, we would likely pursue one or more alternatives, including seeking to enter into contracts in other geographic markets, seeking to enter into contracts for other services in our existing markets, or seeking to acquire other businesses with existing government contracts. If we were unable to do so, we could be forced to cease conducting business. In any such event, our revenues and profits would decrease materially.
If we are unable to manage medical benefits expense effectively, our profitability will likely be reduced or we could cease to be profitable.
The profitability of our Medicare Advantage business depends, to a significant degree, on our ability to predict and effectively manage our costs related to the provision of healthcare services. Relatively small changes in the ratio of our expenses related to healthcare services to the premiums we receive, or medical loss ratio, can create significant changes in our financial results. Factors that may cause medical benefits expense to exceed our estimates include:
- an increase in the cost of healthcare services and supplies, including pharmaceuticals, whether as a result of inflation or otherwise;
- higher than expected utilization of healthcare services;
- periodic renegotiation of hospital, physician and other provider contracts;
- the occurrence of catastrophes, major epidemics, terrorism or bio-terrorism;
- changes in the demographics of our members and medical trends affecting them; and
- new mandated benefits or other changes in healthcare laws, regulations and/or practices.
Because of the relatively high average age of the Medicare population, medical benefits expense for our Medicare plans may be particularly difficult to control. Although we have been able to manage our medical benefits expense through a variety of techniques, we may not be able to continue to manage these expenses effectively in the future. If our medical benefits expense increases, our profits could be reduced or we may not remain profitable. We maintain reinsurance to protect us against severe or catastrophic medical claims, but we cannot assure you that such reinsurance coverage currently is or will be adequate or available to us in the future or that the cost of such reinsurance will not limit our ability to obtain it.
Because our Medicare Advantage premiums, which generate most of our Medicare Advantage revenues, are fixed by contract, we are unable to increase our Medicare Advantage premiums during the contract term if our corresponding medical benefits expense exceeds our estimates.
Most of our Medicare Advantage revenues are generated by premiums consisting of fixed monthly payments per member. These payments are fixed on an annual basis by contract, and we are obligated during the contract period, which is generally one or two years, to provide or arrange for the provision of healthcare services as established by state and federal governments. We have less control over costs related to the provision of healthcare services than we do over our selling, general and administrative expense. Medical benefits expense as a percentage of premium revenue tends to fluctuate. If our medical benefits expense exceeds our estimates, we will be unable to adjust the premiums we receive under our current contracts, and our profits may decline.
Reductions in funding for government healthcare programs could substantially reduce our profitability.
All of our Medicare Advantage programs we offer are through government-sponsored programs, such as Medicare. As a result, our profitability is dependent, in large part, on continued funding for government healthcare programs at or above current levels. For example, the premium rates paid to health plans like ours by the Federal government differ depending on a combination of factors such as upper payment limits established by the Federal government, a member's health status, age, gender, county or region, and member eligibility categories. In addition, CMS has adopted a payment program, whereby in 2004, 30% of the premium rates paid to health plans related to specific disease classification of members. This will increase to 50% in 2005, to 75% in 2006 and to 100% in 2007. Reductions in payments under Medicare or the other programs under which we offer health plans could likewise reduce our profitability. Federal budgetary constraints also may limit premiums payable under our Medicare plans.
We are subject to extensive government regulation, and any violation of the laws and regulations applicable to us could reduce our revenues and profitability and otherwise adversely affect our operating results.
Our Medicare Advantage business is extensively regulated by the federal government and the states in which we operate. The laws and regulations governing our Medicare Advantage operations are generally intended to benefit and protect health plan members and providers rather than stockholders. The government agencies administering these laws and regulations have broad latitude to enforce them. These laws and regulations, along with the terms of our government contracts, regulate how we do business, what services we offer, and how we interact with our members, providers and the public. We are subject, on an ongoing basis, to various governmental reviews, audits and investigations to verify our compliance with our contracts and applicable laws and regulations. Any adverse review, audit or investigation could result in:
- forfeiture of amounts we have been paid pursuant to our government contracts;
- imposition of civil or criminal penalties, fines or other sanctions on us;
- loss of our right to participate in government-sponsored programs, including Medicare;
- damage to our reputation in various markets;
- increased difficulty in marketing our products and services; and
- loss of one or more of our licenses to act as an insurer or health maintenance organization or to otherwise provide a service.
Any of these events could reduce our revenues and profitability and otherwise adversely affect our operating results.
We derive a substantial portion of our Medicare Advantage revenues and profits from Medicare Advantage operations in Texas, and legislative actions, economic conditions or other factors that adversely affect those operations could materially reduce our revenues and profits.
If we are unable to continue to operate in Texas, or if our current operations in any portion of Texas are significantly curtailed, our revenues will decrease materially. Our reliance on our operations in Texas could cause our revenues and profitability to change suddenly and unexpectedly, depending on legislative actions, economic conditions and similar factors. In addition, our market share in Texas may make it more difficult for us to expand our membership in existing markets in Texas. Our inability to continue to operate in Texas, or a decrease in the revenues of our Texas operations, would harm our overall operating results.
We may be unable to expand into some geographic areas without incurring significant additional costs.
We are likely to incur additional costs if we enter states or counties where we do not currently operate. Our rate of expansion into other geographic areas may also be inhibited by:
- the time and costs associated with obtaining a health maintenance organization license to operate in the new area or the expansion of our licensed service area, if necessary;
- our inability to develop a network of physicians, hospitals and other healthcare providers that meets our requirements and those of government regulators;
- competition, which increases the costs of recruiting members;
- the cost of providing healthcare services in those areas; and
- demographics and population density.
Accordingly, we may be unsuccessful in entering other metropolitan areas, counties or states.
A failure to estimate incurred but not reported medical benefits expense accurately will affect our profitability.
Our medical benefits expense includes estimates of medical claims incurred but not reported, or IBNR. We, together with our internal and consulting actuaries, estimate our medical cost liabilities using actuarial methods based on historical data adjusted for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. Actual conditions, however, could differ from those assumed in the estimation process. Due to the uncertainties associated with the factors used in these assumptions, materially different amounts could be reported in our financial statements for a particular period under different conditions or using different assumptions. Adjustments, if necessary, are made to medical benefits expense when the criteria used to determine IBNR change and when actual claim costs are ultimately determined. Although our estimates of IBNR have historically been adequate, they may be inadequate in the future, which would adversely affect our results of
operations. Further, our inability to estimate IBNR accurately may also affect our ability to take timely corrective actions, further exacerbating the extent of any adverse effect on our results.
The new Medicare legislation makes changes to the Medicare program that could reduce our profitability and increase competition for our existing and prospective members.
On December 8, 2003, President Bush signed the Medicare Modernization Act of 2003 (the "MMA"). The new rate methodologies, expanded benefits and shifts in certain coverage responsibilities pursuant to the Act may increase competition and create uncertainties, including the following:
- The Act increases reimbursement for Medicare Advantage plans. Higher reimbursement rates may increase the number of plans that participate in the program, creating new competition that could adversely affect our profitability.
- Beginning in 2006, a new regional Medicare Preferred Provider Organization, or Medicare PPO, program will be implemented pursuant to the Act. Medicare PPOs would allow their members more flexibility to select physicians than the current plans, which are HMOs that require members to coordinate with a primary care physician. The regional Medicare PPO program will compete with local Medicare Advantage HMO programs and may affect our Medicare Advantage HMO business. We do not know how the creation of the regional Medicare PPO program, which is intended to provide further choice to beneficiaries, will affect our Medicare Advantage HMO business.
- Beginning in 2006, the payments for the local Medicare Advantage HMO and regional Medicare Advantage PPO programs will be based on a competitive bidding process that may decrease the amount of premiums paid to us or cause us to increase the benefits we offer.
- Beginning in 2006, organizations that offer Medicare Advantage plans of the type we currently offer will be required to offer a prescription drug benefit, as defined by Medicare, and Medicare Advantage enrollees will be required to obtain their drug benefit from their Medicare Advantage plan. It is not known at this time whether the governmental payments will be adequate to cover the actual costs for this benefit. Current enrollees may prefer a stand-alone drug plan and may dis-enroll from the Medicare Advantage plan altogether in order to participate in another drug plan. Accordingly, the new prescription drug benefit could reduce our profitability and membership enrollment following its implementation in 2006.
- Some enrollees may have chosen our Medicare Advantage plan in the past rather than a Medicare fee-for-service program because of the added drug benefit that we offer with our Medicare Advantage plan. Following the implementation of the new prescription drug benefit, Medicare beneficiaries will have the opportunity to obtain a drug benefit without joining a managed care plan. As a result, our membership enrollment may decline.
Future changes in healthcare law may reduce our profitability or liquidity.
Healthcare laws and regulations, and their interpretations, are subject to frequent change. Changes in existing laws or regulations, or their interpretations, or the enactment of new laws or regulations could reduce our profitability by:
- imposing additional capital requirements;
- increasing our administrative and other costs;
- increasing mandated benefits;
- forcing us to restructure our relationships with providers; or
- requiring us to implement additional or different programs and systems.
Changes in state law also may adversely affect our profitability. Laws relating to managed care consumer protection standards, including increased plan information disclosure, limits to premium increases, expedited appeals and grievance procedures, third party review of certain medical decisions, health plan liability, access to specialists, clean claim payment timing, physician collective bargaining rights and confidentiality of medical records either have been enacted or continue to be under discussion. New healthcare reform legislation may require us to change the way we operate our business, which may be costly. Further, although we have exercised care in structuring our operations to attempt to comply in all material respects with the laws and regulations applicable to us, government officials charged with responsibility for enforcing such laws may assert that we or certain transactions in which we are involved are in violation of these laws, or courts may ultimately interpret such laws in a manner inconsistent with our interpretation. Therefore, it is possible that future legislation and regulation and the interpretation of laws and regulations could have a material adverse effect on our ability to operate under the Medicare program and to continue to serve our members and attract new members.
Restrictions on our ability to market would adversely affect our revenue.
We rely on our marketing and sales efforts for a significant portion of our membership growth. The federal and state governments in which we currently operate permit marketing but impose strict requirements and limitations as to the types of marketing activities that are permitted. If our marketing efforts were to be prohibited or curtailed, our ability to increase or sustain membership would be significantly harmed, which would adversely affect our revenue.
If we are unable to maintain satisfactory relationships with our providers, our profitability could decline and we may be precluded from operating in some markets.
Our profitability depends, in large part, upon our ability to enter into cost-effective contracts with hospitals, physicians and other healthcare providers in appropriate numbers in our geographic markets and at convenient locations for our members. In any particular market, however, providers could refuse to contract, demand higher payments or take other actions that could result in higher medical benefits expense. In some markets, certain providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions or near monopolies. If such a provider or any of our other providers refuse to contract with us, use their market position to negotiate contracts that might not be cost-effective or otherwise place us at a competitive disadvantage, those activities could adversely affect our operating results in that market area. In the long term, our ability to contract successfully with a sufficiently large number of providers in a particular geographic market will
affect the relative attractiveness of our managed care products in that market and could preclude us from renewing our Medicare contracts in those markets or from entering into new markets. Our provider contracts with network primary care physicians and specialists generally have terms of one year, with automatic renewal for successive one-year terms. We may terminate these contracts for cause, based on provider conduct or other appropriate reasons, subject to laws giving providers due process rights. The contracts generally may be cancelled by either party without cause upon 60 or 90 days prior written notice. Our contracts with hospitals generally have terms of one to two years, with automatic renewal for successive one-year terms. We may terminate these contracts for cause, based on provider misconduct or other appropriate reasons. Our hospital contracts generally may be cancelled by either party without cause upon 120 days prior written notice. We may be unable to continue to renew such contracts or enter into new contracts enabling us to serve our members profitably. We will be required to establish acceptable provider networks prior to entering new markets. Although we have established long-term relationships with many of our network providers, we may be unable to maintain those relationships or enter into agreements with providers in new markets on a timely basis or under favorable terms. If we are unable to retain our current provider contracts or enter into new provider contracts timely or on favorable terms, our profitability could decline.
We may not have adequate intellectual property rights in our brand names for our health plans, and we may be unable to adequately enforce such rights.
Our success depends, in part, upon our ability to market our health plans under our brand names, including our "Texan Plus" family of products. While we hold federal trademark registrations for the "Texan Plus" trademark, we have not taken enforcement action to prevent infringement of our federal trademark and have not secured registrations of our other marks. Other businesses may have prior rights in the brand names that we market under or in similar names, which could limit or prevent our ability to use these marks, or to prevent others from using similar marks. If we are unable to prevent others from using our brand names, or if others prohibit us from using them, our revenues could be adversely affected. Even if we are able to protect our intellectual property rights in such brands, we could incur significant costs in doing so.
Ineffective management of our growth may adversely affect our results of operations, financial condition and business.
Depending on acquisition and other opportunities, we expect to continue to increase our membership and to expand into other markets. Continued rapid growth could place a significant strain on our management and on other resources. Our ability to manage our growth may depend on our ability to strengthen our management team and attract, train and retain skilled associates, and our ability to implement and improve operational, financial and management information systems on a timely basis. If we are unable to manage our growth effectively, our financial condition and results of operations could be materially and adversely affected.
We are subject to competition that may limit our ability to increase or maintain membership in the markets we serve.
We operate in a highly competitive environment and in an industry that is currently subject to significant changes due to business consolidations, new strategic alliances and aggressive marketing practices by other managed care organizations. We compete for members principally on the basis of size, location and quality of provider network, benefits provided, quality of service and reputation. A number of these competitive elements are partially dependent upon and can be positively affected by financial resources available to a health plan. Many other organizations with which we compete have substantially greater financial and other resources than we do. In addition, changes resulting from the new Medicare
legislation may bring additional competitors into our market area. As a result, we may be unable to increase or maintain our membership.
Claims relating to medical malpractice and other litigation could cause us to incur significant expenses.
The providers with whom we contract who are involved in medical care decisions may be exposed to the risk of medical malpractice claims. A small percentage of these providers do not have malpractice insurance. Although our network providers are independent contractors, claimants sometimes allege that a managed care organization such as us should be held responsible for alleged provider malpractice, and some courts have permitted that theory of liability. In addition, managed care organizations may be sued directly for alleged negligence, such as in connection with the credentialing of network providers or for improper denials or delay of care. In addition, Congress and several states are considering legislation that would expressly permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. From time to time, we are party to various other litigation matters, some of which seek monetary damages. We cannot predict with certainty the eventual outcome of any pending litigation or potential future litigation, and we might incur substantial expense in defending these or future lawsuits or indemnifying third parties with respect to the results of such litigation. We maintain errors and omissions insurance with a policy limit of $10 million and other insurance coverage and, in some cases, indemnification rights that we believe are adequate based on industry standards. However, potential liabilities may not be covered by insurance or indemnity, our insurers or indemnifying parties may dispute coverage or may be unable to meet their obligations or the amount of our insurance or indemnification coverage may be inadequate. We cannot assure you that we will be able to obtain insurance coverage in the future, or that insurance will continue to be available on a cost-effective basis, if at all. Moreover, even if claims brought against us are unsuccessful or without merit, we would have to defend ourselves against such claims. The defense of any such actions may be time-consuming and costly, and may distract our management's attention. As a result, we may incur significant expenses and may be unable to effectively operate our business.
Negative publicity regarding the managed care industry may harm our business and operating results.
In the past, the managed care industry has received negative publicity. This publicity has led to increased legislation, regulation, review of industry practices and private litigation in the commercial sector. These factors may adversely affect our ability to market our services, require us to change our services and increase the regulatory burdens under which we operate, further increasing the costs of doing business and adversely affecting our operating results.
RISKS RELATED TO THE INSURANCE BUSINESS
We may not be able to compete successfully with competitors that have greater resources than we do.
We sell our products in highly competitive markets. We compete with large national insurers, smaller regional insurers and specialty insurers. Many insurers are larger and have greater resources and higher financial strength ratings than we do. In addition, we are subject to competition from insurers with broader product lines. We also may be subject, from time to time, to new competition resulting from changes in Medicare benefits, as well as from additional private insurance carriers introducing products similar to those offered by us. Our future success will depend, in part, on our ability to effectively enhance our current products and claims processing capabilities and to develop new products in the changing health care environment on a timely and cost-effective basis.
We may not be able to compete successfully if we cannot recruit and retain insurance agents.
We distribute our products principally through career agents and independent agents who we recruit and train to market and sell our products. We also engage managing general agents from time to time to recruit agents and develop networks of agents in various states. We compete with other insurance companies for productive agents, primarily on the basis of our financial position, support services, compensation and product features. It can be difficult to successfully compete with larger insurance companies that have higher financial strength ratings than we do for productive agents. Our business and ability to compete will suffer if we are unable to recruit and retain insurance agents or if we lose the services provided by our managing general agents.
Governmental regulation could affect our profitability.
Our insurance company subsidiaries are subject to regulation and supervision by the insurance departments of their domiciliary jurisdictions. Each is also subject to regulation and supervision by the insurance department of each of the other states in which they are admitted to do business. Such supervision and regulation are largely for the benefit and protection of policyholders and not shareholders. Such regulation and supervision by the insurance departments extend, among other things, to the declaration and payment of dividends by our insurance company subsidiaries, the setting of rates to be charged for some types of insurance, the granting and revocation of licenses to transact business, the licensing of agents, monitoring market conduct, approval of forms, establishment of reserve requirements, regulation of maximum commissions payable, mandating some insurance benefits, claims practices, maintenance of minimum surplus requirements, and the form and content of financial statements required by statute. Our failure to comply with legal or regulatory restrictions could result in our inability to engage in some businesses or an obligation to pay fines or make restitution, which could affect our profitability. State insurance regulators and the National Association of Insurance Commissioners (NAIC) continually reexamine existing laws and regulations, and may impose changes in the future that materially adversely affect our business, results of operations and financial condition. In particular, rate rollback legislation and legislation to control premiums, policy terminations and other policy terms may affect the amount we may charge for insurance premiums. Some states currently limit rate increases on long term care insurance products and other states have considered doing so. Because insurance premiums are our primary source of income, our net income may be reduced by any of these changes.
We may be required to refund or reduce premiums if our premium rates are determined to be too high.
Insurance regulators require that we maintain minimum statutory loss ratios on some of the insurance products that we sell. We must therefore pay out, on average, a specified minimum percentage of premiums as benefits to policyholders. State regulations also mandate the manner in which insurance companies may compute loss ratios and the manner in which compliance is measured and enforced. If our insurance products are not in compliance with state mandated minimum loss ratios, state regulators may require us to refund or reduce premiums.
Recently enacted and pending or future legislation could affect our income.
During recent years, the health insurance industry has experienced substantial changes, primarily caused by healthcare legislation. Recent Federal and state legislation and legislative proposals relating to healthcare reform contain features that could severely limit or eliminate our ability to vary our pricing terms or apply medical underwriting standards with respect to individuals, which could increase our loss ratios and decrease our profitability. In 2003, Congress passed the Medicare Modernization Act of 2003. Although there are several components to this Medicare reform bill that may have an impact on our
Medicare Supplement business, two fundamental components will be most relevant. First, the bill establishes a prescription drug benefit under Medicare and a mechanism for private insurers to offer this program. Second, the bill contains significant incentives designed to improve current Medicare + Choice (now known as Medicare Advantage) plans, and to encourage new Medicare Advantage plans to enter the market on a favorable basis. The legislation may create some downward pressure on our Medicare Supplement sales, largely because the increased government reimbursements for managed care plans will encourage HMOs to add benefits to existing plans or add new plans, in more jurisdictions. In addition, an increase in the market acceptance of Medicare Advantage plans may adversely affect our persistency. If the legislation leads to a significant increase in the number of Medicare beneficiaries enrolled in health maintenance organizations, sales of our Medicare Supplement products may decrease since the product provides benefits that supplement the coverage provided by traditional Medicare. This could have a material adverse effect on our business, financial condition and results of operations.
We have stopped selling new long term care insurance and the premiums that we charge for the policies that remain in force may not be adequate to cover the claims expenses that we incur.
We have concluded that the sale of long term care insurance does not fit within our strategic or financial goals. We began to curtail the sale of new business in 2003, and stopped all new sales at the end of 2004. Approximately, $42 million of premium remains in force, of which we retain approximately $27 million. Although the entire block of business was slightly profitable in 2004, we have incurred substantial losses from a block of home health care business that we stopped selling in 1999. There can be no assurance that current premiums we charge will be adequate to cover the claims expenses that we will incur in the future. There is also no assurance that rate increases that we may seek will be approved by the applicable state regulators or, if approved, will be adequate to fully mitigate adverse loss experience.
Tax law changes could adversely affect our sales and profitability.
We sell deferred annuities and some forms of life insurance products, which are attractive to purchasers in part because policyholders generally are not subject to Federal income tax on increases in policy values until some form of distribution is made. From time to time, Congress has considered proposals to reduce or eliminate the tax advantages of annuities and life insurance which, if enacted, could make these products less attractive to consumers. We do not believe that Congress is now actively considering any legislation that would reduce or eliminate the tax advantages of annuities or life insurance. However, it is possible that the tax treatment of annuities or life insurance could change as a result of legislation, Internal Revenue Service regulations, or judicial decisions. The reduction or loss of these tax advantages could reduce our sales of life and annuity products and their profitability.
Insurance companies are frequently the targets of litigation, including class action litigation that could result in substantial judgments.
A number of civil jury verdicts have been returned against insurers in the jurisdictions in which we do business involving insurers' sales practices, alleged agent misconduct, discrimination and other matters. Increasingly these lawsuits have resulted in the award of substantial judgments against the insurer that are disproportionate to the actual damages, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive and non-economic compensatory damages which creates the potential for unpredictable material adverse judgments in any given lawsuit. In addition, in some class action and other lawsuits involving insurers' sales practices, insurers have made material settlement payments. We may also face lawsuits from insureds who dispute our refusal to pay claims made by them. From time to time we are involved in such litigation or, alternatively, in arbitration. We cannot predict the outcome of any such litigation or arbitration. Because litigation and jury trials are
inherently unpredictable and some amounts sought by plaintiffs are large, there can be no assurance that any litigation involving us will not have a material adverse effect on our business, financial condition or results of operations.
ITEM 2 - PROPERTIES
Our executive offices are located in Rye Brook, New York. Marketing and professional staff for our U.S. insurance subsidiaries occupy space in Lake Mary, Florida. Our Canadian operations are located in Mississauga, Ontario, Canada. Our Administrative Services operations occupy office space in Pensacola and Weston, Florida. Our Medicare Advantage operations occupy office space in Houston and Beaumont, Texas and Nashville, Tennessee. We lease all of the approximately 285,000 square feet of office space that we occupy. Management considers its office facilities suitable and adequate for the current level of operations. In addition to the above, Pennsylvania Life or Penncorp Life (Canada) is the named lessee on approximately 71 properties occupied by career agents for use as field offices. Rent for these field offices is reimbursed by the agents. Additional information regarding our lease obligations is included in Note 17 - Commitments and Contingencies in our consolidated financial statements included in this Form 10-K.
ITEM 3 - LEGAL PROCEEDINGS
We have litigation in the ordinary course of our business, including claims for medical, disability and life insurance benefits, and in some cases, seeking punitive damages. Management and counsel believe that after reserves and liability insurance recoveries, none of these will have a material adverse effect on us.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted by us to a vote of stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of 2004.
PART II
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF COMMON SECURITIES
MARKET INFORMATION
Our common stock is traded in the over-the-counter market and quoted on the Nasdaq National Market tier of The Nasdaq Stock Market ("Nasdaq") under the symbol "UHCO". The following table sets forth the high and low sales prices for our common stock on the Nasdaq National Market, as reported by Nasdaq for the periods indicated.
On March 1, 2005, the closing sale price of our common stock as reported by Nasdaq was $16.10 per share.
STOCKHOLDERS
As of the close of business on March 1, 2005, there were approximately 1,300 holders of record of our common stock. We estimate that there are approximately 15,000 beneficial owners of our common stock.
DIVIDENDS
We have never declared cash dividends on our common stock, and have no present intention to declare any cash dividends in the foreseeable future.
ISSUER PURCHASES OF EQUITY SECURITIES
(1) All shares were purchased in private transactions.
During 2000, our Board of Directors approved a plan for us to repurchase up to 0.5 million shares of our common stock in the open market. The primary purpose of the plan is to fund employee stock bonuses. Our Board approved an amendment to the plan to increase the total shares authorized for repurchase to 1.0 million in March 2002 and during December 2003 approved a second amendment to increase the shares authorized for repurchase to 1.5 million. Additional repurchases may be made from time to time at prevailing prices, subject to restrictions on volume and timing.
RECENT SALES OF UNREGISTERED SECURITIES
During the Company's fiscal quarter ended September 30, 2004 in connection with the acquisition of Heritage Health Systems, Inc., an employee acquired 14,500 shares of the Company's Common Stock pursuant to the Company's 1998 Incentive Compensation Plan. These shares were reissued from the Company's treasury stock on September 10, 2004. The Company received proceeds of $10.35 per share, or $150,000, equal to the market value for the ten days trailing the date the award was approved, in connection with the issuance of such shares. The issuance was exempt from registration under the Securities Act pursuant to Section 4(2) thereof. The issuance did not involve any public offering and the employee received shares which contained a legend to indicate that such shares are not registered under the Securities Act and cannot be transferred in the absence of such a registration or an exemption from registration. The employee who acquired such shares is a member of the Company's management.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The information regarding securities authorized for issuance under our equity compensation plans is disclosed in Item 12 "Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."
ITEM 6 - SELECTED FINANCIAL DATA
The table below provides selected financial data and other operating information as of and for the five fiscal years ended December 31, 2004. We derived the selected financial data presented below for the five fiscal years ended December 31, 2004 from our audited financial statements, which were audited by Ernst & Young LLP, our independent auditors. We have prepared the following data, other than statutory data, in conformity with generally accepted accounting principles. You should read this selected financial data together with our financial statements and the notes to those financial statements as well as the discussion under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations."
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(1) Includes the results of American Insurance Administration Group, Inc. since its acquisition on January 6, 2000, and Capitated Health Care Services, Inc. since its acquisition on August 10, 2000.
(2) Includes the results of Pyramid Life since its acquisition on March 31, 2003.
(3) Includes the results of Heritage Health Systems, Inc. since its acquisition on May 28, 2004.
(4) Includes capital and surplus of Penncorp Life (Canada) of C$82,907 as of December 31, 2003 and C$57,398 as of December 31, 2004, as reported to the Office of the Superintendent of Financial Institutions Canada, converted at the related exchange rates of C$0.7654 per U.S. $1.00 as of December 31, 2003 and C$0.8320 per U.S. $1.00 as of December 31, 2004.
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following analysis of our consolidated results of operations and financial condition should be read in conjunction with the consolidated financial statements and related consolidated footnotes included in this Annual Report on Form 10-K.
The following discussion and analysis presents a review of the Company as of December 31, 2004 and its results of operations for the fiscal years ended December 31, 2004, 2003 and 2002.
OVERVIEW
Our principal business segments are based on product and include: Senior Market Health Insurance, Senior Managed Care - Medicare Advantage, Specialty Health Insurance, Life Insurance/Annuities and Senior Administrative Services. We also report the activities of our holding company in a separate segment. Previously, we reported our segments based on distribution channel. Our former Senior Market Brokerage and Career Agency segments have been replaced with the three new segments: Senior Market Health Insurance, Life Insurance/Annuity and Specialty Health Insurance. Our Senior Managed Care - Medicare Advantage and Senior Administrative Services segments will be unchanged. We believe that this new segmentation will provide even greater clarity to our results. Reclassifications have been made to conform prior year amounts to the current year presentation. A description of these segments follows:
SENIOR MARKET HEALTH INSURANCE - This segment consists primarily of our Medicare Supplement business and other senior market health products distributed through our career agency sales force and through our network of independent general agencies.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE - Our Senior Managed Care - Medicare Advantage segment includes the operations of Heritage and our other initiatives in managed care for Seniors. Heritage operates Medicare Advantage plans in Houston and Beaumont Texas, and our Medicare Advantage private fee-for-service plan in the New York and Pennsylvania.
SPECIALTY HEALTH INSURANCE - Our Specialty Health Insurance segment includes specialty health insurance products, primarily fixed benefit accident and sickness disability insurance, sold to the middle-income self-employed market in the United States and Canada. This segment also includes certain products that we no longer sell, such as long term care and major medical. This segment's products are distributed primarily by our career agents.
LIFE INSURANCE/ANNUITIES - This segment includes all of the life insurance and annuity business sold in the United States. This segment's products include senior, traditional and universal life insurance and fixed annuities and are distributed through both independent general agents and our career agency distribution systems.
SENIOR ADMINISTRATIVE SERVICES - Our administrative services subsidiary, CHCS Services, acts as a third party administrator and service provider of senior market insurance products and geriatric care management for both affiliated and unaffiliated insurance companies. The services provided include policy underwriting and issuance, telephone and face-to-face verification, policyholder services, claims adjudication, case management, care assessment and referral to health care facilities.
CORPORATE - Our Corporate segment reflects the activities of our holding company, including debt service, certain senior executive compensation, and compliance with regulatory requirements resulting from our status as a public company.
Intersegment revenues and expenses are reported on a gross basis in each of the operating segments but eliminated in the consolidated results. These intersegment revenues and expenses affect the amounts reported on the individual financial statement line items, but are eliminated in consolidation and do not change income before taxes. The significant items eliminated include intersegment revenue and expense relating to services performed by the Senior Administrative Services segment for our other segments and interest on notes payable or receivable between the Corporate segment and the other operating segments.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of our financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts of assets and liabilities and disclosures of assets and liabilities reported by us at the date of the financial statements and the revenues and expenses reported during the reporting period. As additional information becomes available or actual amounts become determinable, the recorded estimates may be revised and reflected in operating results. Actual results could differ from those estimates. Accounts that, in our judgment, are most critical to the preparation of our financial statements include policy liabilities and accruals, deferred policy acquisition costs, intangible assets, valuation of certain investments and deferred income taxes. There have been no changes in our critical accounting policies during the current quarter.
POLICY RELATED LIABILITIES
We calculate and maintain reserves for the estimated future payment of claims to our policyholders using the same actuarial assumptions that we use in the pricing of our products. For our accident and health insurance business, we establish an active life reserve for expected future policy benefits, plus a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra contractual damage awards. Therefore, the reserves and liabilities we establish are based on extensive estimates, assumptions and prior years' statistics. When we acquire other insurance companies or blocks of insurance, our assessment of the adequacy of acquired policy liabilities is subject to similar estimates and assumptions. Establishing reserves involves inherent uncertainties, and it is possible that actual claims could materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our net income depends significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves and pricing our policies. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities resulting in reduced net income and shareholders' equity.
DEFERRED POLICY ACQUISITION COSTS
The cost of acquiring new business, principally non-level commissions and agency production, underwriting, policy issuance, and associated costs, all of which vary with, and are primarily related to the production of new and renewal business, are deferred. For interest-sensitive life and annuity products, these costs are amortized in relation to the present value of expected gross profits on the policies arising principally from investment, mortality and expense margins in accordance with SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". For other life and health products, these costs are amortized in proportion to premium revenue using the same assumptions used in estimating the
liabilities for future policy benefits in accordance with SFAS No. 60, "Accounting and Reporting by Insurance Enterprises."
The determination of expected gross profits for interest-sensitive products is an inherently uncertain process that relies on assumptions including projected interest rates, the persistency of the policies issued as well as anticipated benefits, commissions and expenses. It is possible that the actual profits from the business may vary materially from the assumptions used in the determination and amortization of deferred acquisition costs. Deferred policy acquisition costs are written off to the extent that it is determined that future policy premiums and investment income or gross profits would not be adequate to cover related losses and expenses.
PRESENT VALUE OF FUTURE PROFITS AND OTHER INTANGIBLES
Business combinations accounted for as a purchase result in the allocation of the purchase consideration to the fair values of the assets and liabilities acquired, including the present value of future profits, establishing such fair values as the new accounting basis. The present value of future profits is based on an estimate of the cash flows of the in force business acquired, discounted to reflect the present value of those cash flows. The discount rate selected depends upon the general market conditions at the time of the acquisition and the inherent risk in the transaction. Purchase consideration in excess of the fair value of net assets acquired, including the present value of future profits and other identified intangibles, for a specific acquisition, is allocated to goodwill. Allocation of purchase price is performed in the period in which the purchase is consummated. Adjustments, if any, in subsequent periods relate to resolution of pre-acquisition contingencies and refinements made to estimates of fair value in connection with the preliminary allocation.
Amortization of present value of future profits is based upon the pattern of the projected cash flows of the in-force business acquired, over weighted average lives ranging from six to forty years. Other identified intangibles are amortized over their estimated lives.
On a periodic basis, management reviews the unamortized balances of present value of future profits, goodwill and other identified intangibles to determine whether events or circumstances indicate the carrying value of such assets is not recoverable, in which case an impairment charge would be recognized. Management believes that no impairments of present value of future profits, goodwill or other identified intangibles existed as of December 31, 2004.
INVESTMENT VALUATION
Fair value of investments is based upon quoted market prices, where available, or on values obtained from independent pricing services. For certain mortgage and asset-backed securities, the determination of fair value is based primarily upon the amount and timing of expected future cash flows of the security. Estimates of these cash flows are based upon current economic conditions, past credit loss experience and other circumstances.
We regularly evaluate the amortized cost of our investments compared to the fair value of those investments. Impairments of securities generally are recognized when a decline in fair value below the amortized cost basis is considered to be other-than-temporary. Generally, we consider a decline in fair value to be other-than-temporary when the fair value of an individual security is below amortized cost for an extended period and we do not believe that recovery in fair value is probable. Impairment losses for certain mortgage and asset-backed securities are recognized when an adverse change in the amount or timing of estimated cash flows occurs, unless the adverse change is solely a result of changes in estimated market interest rates and we intend to hold the security until maturity. The cost basis for securities
determined to be impaired are reduced to their fair value, with the excess of the cost basis over the fair value recognized as a realized investment loss.
INCOME TAXES
We use the liability method to account for deferred income taxes. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date of a change in tax rates.
We establish valuation allowances on our deferred tax assets for amounts that we determine will not be recoverable based upon our analysis of projected taxable income and our ability to implement prudent and feasible tax planning strategies. Increases in these valuation allowances are recognized as deferred tax expense. Subsequent determinations that portions of the valuation allowances are no longer necessary are reflected as deferred tax benefits. To the extent that valuation allowances were established in conjunction with acquisitions, changes in those allowances are first applied to increasing or decreasing the goodwill (but not below zero) or other intangibles related to the acquisition and then applied as an increase or decrease in income tax expense.
SIGNIFICANT TRANSACTIONS - ACQUISITIONS
Acquisition of Heritage Health Systems, Inc.
On May 28, 2004, we acquired Heritage, a privately owned managed care company that operates Medicare Advantage plans in Houston and Beaumont Texas, for $98 million in cash plus transaction costs of $1.6 million. The acquisition was financed with $66.5 million of net proceeds derived from the amendment of our credit facility and $33.1 million of cash on hand. As of the date of acquisition, Heritage had approximately 16,000 Medicare members and annualized revenues of approximately $140 million. Operating results generated by Heritage prior to the date of acquisition are not included in our consolidated financial statements.
ACQUISITION OF PYRAMID LIFE
On March 31, 2003, we acquired all of the outstanding common stock of Pyramid Life Insurance Company ("Pyramid Life"). Pyramid Life specializes in selling health and life insurance products to the senior market, including Medicare Supplement and Select, long term care, life insurance, and annuities. With this acquisition, we acquired a $120 million block of in-force business, as well as a career sales force that is skilled in selling senior market insurance products. Pyramid Life markets its products in 30 states through a career agency sales force of over 1,000 agents operating out of 39 Senior Solutions(R) Sales Centers. Following a transition period that took approximately ten months, the Pyramid Life business was fully transitioned into our existing operations. Operating results generated by Pyramid Life prior to the date of acquisition are not included in our consolidated financial statements.
RECAPTURE OF REINSURANCE CEDED
Effective April 1, 2003, we entered into agreements to recapture approximately $48 million of Medicare Supplement business that had previously been reinsured to Transamerica Occidental Life Insurance Company, Reinsurance Division ("Transamerica") under two quota share contracts. No ceding allowance was paid in the recapture and we currently retain 100% of the risks on the $48 million of Medicare Supplement business. There was no gain or loss reported on these recapture agreements.
ACQUISITION OF NATIONWIDE BLOCK OF BUSINESS
In November 2002 we entered into an agreement with Nationwide Life Insurance Company ("Nationwide") to acquire, through a 100% quota share reinsurance agreement, Nationwide's individual Medicare Supplement policies. Approximately $22 million of annualized premium was in force at the date of acquisition.
ACQUISITION OF AMERIPLUS
On August 1, 2003, we acquired 100% of the outstanding common stock of Ameriplus Preferred Care, Inc. ("Ameriplus"). Ameriplus is engaged in the business of creating and maintaining a network of hospitals for the purpose of providing discounts to our Medicare Select policyholders. Ameriplus' network is utilized in connection with Medicare Select policies written by our subsidiaries and can be offered to non-affiliated parties as well. Ameriplus receives network fees when premiums for these Medicare Select policies are collected.
ACQUISITION OF GUARANTEE RESERVE MARKETING ORGANIZATION
Effective July 1, 2003, we entered into an agreement with Swiss Re and its newly acquired subsidiary, Guarantee Reserve Life Insurance Company ("Guarantee Reserve"), to acquire Guarantee Reserve's marketing organization, including all rights to do business with its field force. The primary product sold by this marketing organization is low face amount whole life insurance, primarily for seniors. Beginning July 1, 2003, the Guarantee Reserve field force continued to write this business in Guarantee Reserve, with us administering all new business and assuming 50% of the risk through a quota share reinsurance arrangement. New business has been written by our subsidiaries with 50% of the risk ceded to Swiss Re beginning in the second quarter of 2004 as the products were approved for sale in each state.
RESULTS OF OPERATIONS -- CONSOLIDATED OVERVIEW
The following table reflects income from each of our segments (1) and contains a reconciliation to reported net income:
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(1) We evaluate the results of operations of our segments based on income before realized gains and income taxes. Management believes that realized gains and losses are not indicative of overall operating trends. This differs from generally accepted accounting principles, which includes the effect of realized gains in the determination of net income. The schedule above reconciles our segment income to net income in accordance with generally accepted accounting principles.
Years ended December 31, 2004 and 2003
Net income for 2004 increased 48% to $63.9 million, or $1.13 per share, compared to $43.1 million, or $0.78 per share in 2003. During 2004, we recognized realized gains, net of tax, of $6.9 million, or $0.12 per share, compared to realized gains, net of tax, of $1.3 million, or $0.02 per share in 2003. The realized gains in 2004 were generated at Penncorp Life (Canada) as a result of the sale of investments to fund the dividend of approximately $19.6 million paid to the parent company during the first quarter of 2004 and the tax payments made during the first quarter of 2004 relating to 2003 taxable income. See "Liquidity and Capital Resources -- Obligations of the Parent Company to Affiliates" for additional information regarding the dividend. Additionally, during the third quarter of 2004, we took the opportunity to realize investment gains as interest rates dropped during the year to make efficient use of our tax capital loss carryforwards. We believe that further opportunity for generating realized investment gains is limited. Our overall effective tax rate was 33.8% for 2004 and 35.2% for 2003.
Our Senior Market Health Insurance segment results improved by $7.7 million, or 28%, to $35.4 million in 2004 compared to 2003, primarily as a result of the Pyramid Life business being included for a full year in 2004 compared to nine months in 2003 and increased retention of the Medicare Supplement business. We have increased our retention to 100% for all Medicare Supplement business sold beginning January 1, 2004.
Our Senior Managed Care - Medicare Advantage segment includes the results of Heritage and our other initiatives in Medicare managed care, including our Medicare Advantage private fee for service plans, for the seven months since acquisition or inception.
Our Specialty Health Insurance segment results improved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of improvement in loss ratios, as well as the strengthening of the Canadian dollar, relative to the U.S. dollar.
Results for our Life Insurance/Annuities segment improved by $1.4 million, or 12%, to $13.4 million in 2004 compared to 2003, primarily as a result of an increase in business and more favorable morbidity.
Our Senior Administrative Services segment income improved by $2.1 million, or 19%, compared to 2003. This improvement was primarily a result of the growth in premiums managed.
The loss from our Corporate segment increased by $1.8 million, or 16%, compared to the 2003. The increase was due to higher interest cost as a result of an increase in the amount of the debt outstanding during the year, relating to the amendment of our credit facility in connection with our acquisition of Heritage, offset in part, by a reduction in the weighted average interest rates, as compared to the same period of 2003.
Years Ended December 31, 2003 and 2002
Net income for 2003 increased 43%, to $43.1 million, or $0.78 per share, compared to $30.1 million, or $0.56 per share in 2002. During 2003, we recognized realized gains, net of tax of $1.3 million, or $0.02 per share, compared to realized losses, net of tax of $3.3 million, or $0.06 per share in 2002. The losses in 2002 were primarily a result of the recognition of an impairment of our WorldCom holdings. In connection with the acquisition of Pyramid Life on March 31, 2003, we refinanced our credit facility. As a result of the repayment of our existing debt, we were required to write off the unamortized portion of the fees we incurred for that debt. This resulted in a pre-tax, non-cash charge of $1.8 million (the "financing charge"), which is included in the operating loss of the Corporate segment. Our overall effective tax rate was 35.2% for 2003 as compared to 31.6% for 2002. Our 2002 results benefited from the release of a portion of a tax valuation reserve that added $0.03 per share. Excluding the release of the tax valuation allowance, the effective tax rate was 35.2% in 2002.
Our Senior Market Health Insurance segment results increased by $19.2 million, or 224%, to $27.7 million in 2003 compared to 2002, primarily due to the addition of the Pyramid Life business since its acquisition on March 31, 2003 and growth and increased retention of the Medicare Supplement business. We had increased our retention, on average, to 75% for all Medicare Supplement business sold beginning January 1, 2003, from 50% in 2002.
Our Specialty Health Insurance segment results decreased by $1.2 million, or 5%, to $24.4 million in 2003 compared to 2002, primarily as a result of an increase in loss ratios, offset by strengthening of the Canadian dollar.
Results for our Life Insurance/Annuities segment declined by $2.2 million, or 16%, to $12.0 million in 2003 compared to 2002, primarily as a result of less favorable mortality.
Our Senior Administrative Services segment income improved by $3.4 million, or 44%, compared to 2002. This improvement was primarily a result of the growth in premiums managed and the scheduled reduction in the amortization of intangible assets.
The loss from our Corporate segment increased by $3.9 million, or 56%, compared to 2002, due primarily to the charge associated with the refinancing of our debt and the increase in financing costs and other parent company expenses. In connection with the acquisition of Pyramid Life, we refinanced our debt. The early extinguishment of the existing debt resulted in the immediate amortization of the related capitalized loan origination fees, resulting in a pre-tax expense of approximately $1.8 million. The increase in financing cost was due to an increase in the amount of the debt outstanding during the year, offset in part, by a reduction in the weighted average interest rates for the year, compared to 2002.
SEGMENT RESULTS -- SENIOR MARKET HEALTH INSURANCE
Years ended December 31, 2004 and 2003
Our Senior Market Health Insurance segment results improved by $7.7 million, or 28%, to $35.4 million in 2004 compared to 2003, primarily as a result of the inclusion of the results of operations of the Pyramid Life business for a full year in 2004 compared to only nine months in 2003 and increased retention of the Medicare Supplement business. We have increased our retention to 100% for all Medicare Supplement business sold beginning January 1, 2004.
REVENUES. Net premiums for the Senior Market Health Insurance segment increased by $87.3 million, or 33%, compared to 2003. Approximately $28.2 million, or 11%, relates to additional premiums from the Pyramid Life business as a result of the inclusion of the results of operations of the Pyramid Life business for a full year in 2004 compared to only nine months in 2003. $59.1 million, or 22%, is due to growth and increased retention of the Medicare Supplement business
Net investment income increased by approximately $0.8 million, or 25%, compared to 2003. The increase is due primarily to growth in invested assets due to growth in business.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, increased by $61.5 million, or 33%, during 2004 compared to 2003, primarily as a result of the increased retention of the Medicare Supplement business noted above, the effect of a full year of the Pyramid Life operations and a modest increase in loss ratios. Overall loss ratios for the segment increased to 69.2% in 2004 compared to 68.8% in 2003, which accounted for $1.3 million of the increase in benefits. The additional quarter of the Pyramid Life business contributed $19.6 million and the growth and increased retention rate added the balance of $40.6 million to the increase.
The change in deferred acquisition costs was $11.0 million more in 2004, compared to the amount in 2003. $3.7 million of this change is due to the Pyramid Life business being included for a full year in 2004 compared to nine months in 2003. The balance of $7.3 million is a result of growth and the increased retention of the Medicare Supplement business.
The amortization of intangibles relates primarily to intangibles relating to the acquisition of Pyramid Life.
Commissions and general expenses increased by $30.3 million, or 38%, in 2004 compared to 2003. $7.8 million of this increase is due to the inclusion of an additional quarter of the results of operations of the Pyramid Life business and the balance of $22.5 million is due to higher net commission expense due to the growth and increased retention of the Medicare Supplement business. The following table details the components of commission and other operating expenses:
The ratio of commissions to gross premiums decreased to 14.7% during 2004, from 15.3% in 2003, as a result of the growth in the in force renewal premium from better persistency and rate increases. Other operating costs as a percentage of gross premiums increased to 12.5% during 2004 from 12.0% in 2003. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded also decreased to 21.5% during 2004 from 24.6% in 2003, primarily due to the reduction in new business ceded and the affects of normal lower commission allowances on an aging base of renewal ceded business.
Years ended December 31, 2003 and 2002
Our Senior Market Health Insurance segment results increased by $19.2 million, or 224%, to $27.7 million in 2003 compared to 2002, primarily due to the inclusion of the results of operations of the Pyramid Life business since its acquisition on March 31, 2003 and growth and increased retention of the Medicare Supplement business. We had increased our retention, on average, to 75% for all Medicare Supplement business sold beginning January 1, 2003, from 50% in 2002.
REVENUES. Net premiums for the Senior Market Health Insurance segment increased by $163.1 million, or 156%, compared to 2002. Approximately $77.1 million, or 47% of the increase, related to additional premiums from the Pyramid Life business since its acquisition. $86.0 million, or 53% of the increase, is due to growth and increased retention of the Medicare Supplement business
Net investment income increased by approximately $1.5 million, or 80%, compared to 2003. The increase is due primarily to growth in invested assets due to growth in business.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, increased by $111.0 million, or 151%, during 2003 compared to 2002, primarily as a result of increased retention of the Medicare Supplement business noted above and the inclusion of the results of operations of the Pyramid Life business, since its acquisition. This was partially offset by a decrease in loss ratios. Overall loss ratios for the segment decreased to 68.8% in 2003 compared to 70.0% in 2002, which decreased benefits by $1.1 million. The additional Pyramid Life business contributed $51.8 million of additional benefits expense and growth in business and the increased retention rate added the balance of $60.3 million to the increase.
The change in deferred acquisition costs was $11.7 million more in 2003, compared to the amount in 2002. $7.5 million of this change was due to the addition of Pyramid Life business, since its acquisition. The balance of $4.2 million was a result of growth and the increased retention of the Medicare Supplement business.
The amortization of intangibles relates primarily to intangibles relating to the acquisition of Pyramid Life.
Commissions and general expenses increased by $44.5 million, or 127%, in 2003 compared to 2002. $24.2 million of this increase is due to the additional Pyramid business, since its acquisition on March 31, 2003 and the balance of $20.3 million is due to higher net commission expense due to the growth and increased retention of the Medicare Supplement business. The following table details the components of commission and other operating expenses:
The ratio of commissions to gross premiums decreased to 15.3% during 2003, from 16.9% in 2002, as a result of the growth in the in force renewal premium from better persistency and rate increases. Other operating costs as a percentage of gross premiums decreased to 12.0% during 2003 from 12.6% in 2002. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded also decreased to 24.6% during 2003 from 28.1% in 2002, primarily due to the reduction in new business ceded, the recapture of the Transamerica treaties, and the affects of normal lower commission allowances on an aging base of renewal ceded business.
SEGMENT RESULTS -- SENIOR MANAGED CARE - MEDICARE ADVANTAGE
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(1) In addition to segment income, we also evaluate the results of our Medicare Advantage segment based on earnings before interest, taxes, depreciation and amortization ("EBITDA"). EBITDA is a common alternative measure of performance used by investors, financial analysts and rating agencies. It is also a measure that is included in the fixed charge ratio required by the covenants for our outstanding bank debt. Accordingly, these groups use EBITDA, along with other measures, to estimate the value of a company and evaluate the Company's ability to meet its debt service requirements. While we consider EBITDA to be an important measure of comparative operating performance, it should not be construed as an alternative to segment income or cash flows from operating activities (as determined in accordance with generally accepted accounting principles).
(2) Includes results for the seven months since acquisition or inception.
Our Senior Managed Care - Medicare Advantage segment includes the operations of Heritage and our other initiatives in Medicare managed care, including our Medicare Advantage private fee-for-service plans. Heritage generates its revenues and profits from three sources. First, Heritage owns an interest in SelectCare, a health plan that offers coverage to Medicare beneficiaries under a contract with CMS. Next, Heritage operates three separate Management Service Organizations ("MSO's") that manage the business of SelectCare and two affiliated Independent Physician Associations ("IPA's"). Lastly, Heritage participates in the profits derived from these IPA's. The components of the revenues and results within the segment are as follows:
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(3) Includes results for the seven months since acquisition or inception.
Intrasegment revenues are reported on a gross basis in each of the above components of the Medicare Advantage segment. These intrasegment revenues are eliminated in the consolidation for the segment totals. The eliminations include premiums received by the IPA's from the Health Plan amounting to $59.1 million and management fees received by the MSO's from the Health Plan and the IPA's amounting to $15.6 million for the seven months since its acquisition.
Heritage operates a health plan through SelectCare, a provider sponsored organization ("PSO"). SelectCare is a Medicare Advantage coordinated care plan operating in Beaumont and Houston, Texas, which had 16,100 members as of May 28, 2004 (the date of acquisition) and receives its premiums primarily from CMS. SelectCare makes capitated risk payments to four IPA's or medical groups in the Houston and Beaumont regions, two of which are affiliated IPA's. In addition, SelectCare retains the risk for certain other types of care, primarily out of area emergency and transplants. As of December 31, 2004, SelectCare had approximately 18,800 members enrolled. For the seven months since its acquisition, SelectCare had revenues of $90.5 million and had a medical loss ratio of 83.3%.
Heritage participates in the profits from the two affiliated IPA's that receive capitated payments from SelectCare. As of December 31, 2004, the affiliated IPA's managed the care for approximately 14,200 SelectCare members. For the seven months since its acquisition, Heritage earned $5.6 million on $58.5 million in fees received from SelectCare.
Heritage owns three MSO's that provide comprehensive management services to SelectCare and its affiliated IPA's as part of long-term management agreements. Services provided include strategic planning, provider network services, marketing, finance and accounting, enrollment, claims processing, information systems, utilization review, credentialing and quality management. For the seven months since its acquisition, these MSO's earned $1.1 million of income on $15.8 million of fees collected.
Starting in the month of June, American Progressive, an insurance subsidiary of Universal American, began enrolling members in its private fee for service product, a Medicare Advantage program that allows its member to have more flexibility in the delivery of their health care services than other Medicare Advantage plans. In addition to premium received from CMS, American Progressive receives modest premium payments from the members as well. As of December 31, 2004, American Progressive had 1,405 members enrolled. For the seven months since inception, American Progressive collected $3.3 million of premium from CMS and the members, and reported a medical loss ratio of 75.4%. In addition,
American Progressive expensed approximately $0.4 million in start-up expenses, primarily during the second quarter of 2004.
SEGMENT RESULTS -- SPECIALTY HEALTH INSURANCE
Years ended December 31, 2004 and 2003
Our Specialty Health Insurance segment results improved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of improvement in loss ratios, as well as the strengthening of the Canadian dollar. The operations of Penncorp Life (Canada), which are included in our Specialty Health segment results, are transacted using the Canadian dollar as the functional currency. The Canadian dollar strengthened relative to the U.S. dollar in 2004. The average conversion rate increased 8%, to C$0.7689 per U.S.$1.00 for 2004, from C$0.7141 per U.S.$1.00 for 2003. This strengthening added approximately $1.0 million of pre-tax income to the Specialty Health segment results for 2004, compared to 2003. See discussion below under the heading "Quantitative and Qualitative Disclosures about Market Risk" for additional information.
REVENUES. Net premiums for the Specialty Health Insurance segment increased by $3.2 million, or 2%, compared to 2003. Approximately, $1.9 million of the increase relates to additional long term care and major medical premiums from the inclusion of the results of operations of Pyramid Life business for a full year in 2004 compared to only nine months in 2003. The balance of the increase is due to rate increases, offset by a reduction in long term care premium as a result of our decision to discontinue marketing that product, beginning in late 2003. Canadian business accounted for approximately 40% of the net premiums of this segment in 2004 and 38% of the net premiums in 2003, the increase attributed to the stronger Canadian dollar.
Net investment income decreased by approximately $0.6 million, or 2%, compared to 2003. The decrease is due primarily to a combination of lower yields and a decrease in invested assets, due to the dividend paid by Penncorp Life (Canada) to our parent holding company in early 2004.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, decreased by $0.4 million, or less than 1%, during 2004 compared to 2003, primarily as a result of improved loss ratios. Overall loss ratios for the segment declined to 65.5% in 2004 compared to 67.2% in 2003. During 2004 we recorded a non-recurring reduction in reserves in the amount of U.S. $1.3 million (C$1.8 million) which was identified during a review in connection with a conversion of the actuarial system used to determine reserves on our Canadian policies. Additionally, during 2004, we increased reserves on the runoff block of Florida home healthcare business by $1.4 million as a result of an actuarial study performed on this block.
The increase in deferred acquisition costs was $2.3 million less in 2004, compared to the increase in 2003. This is as a result of a lower level of new business being written relative to the amortization of amounts previously capitalized.
Commissions and general expenses decreased by $1.3 million, or 2%, in 2004 compared to 2003. Approximately $0.6 million of the decrease relates to reductions in general expenses and the balance relates to lower commission expense as a result of the reduction in new business sold.
Years ended December 31, 2003 and 2002
Our Specialty Health Insurance segment results decreased by $1.2 million, or 5%, to $24.4 million in 2003 compared to 2002, primarily as a result of an increase in loss ratios, offset by strengthening of the Canadian dollar. The operations of Penncorp Life (Canada), which are included in our Specialty Health segment results, are transacted using the Canadian dollar as the functional currency. The Canadian dollar strengthened relative to the U.S. dollar in 2003. The average conversion rate increased 12%, to C$0.7141 per U.S. $1.00 for 2003, from C$0.6370 per U.S. $1.00 for 2002. This strengthening added approximately $1.5 million of pre-tax income to the Specialty Health segment results for 2003, compared to 2002. See discussion below under the heading "Quantitative and Qualitative Disclosures about Market Risk" for additional information.
REVENUES. Net premiums for the Specialty Health Insurance segment increased by $10.4 million, or 8%, compared to 2002. Approximately, $6.7 million of the increase was related to premiums from the Pyramid Life business since its acquisition. The remainder of the increase was primarily due to rate increases. Canadian business accounted for approximately 38% of the net premiums of this segment in 2003 and 43% of the net premiums in 2002.
Net investment income decreased by approximately $0.8 million, or 3%, compared to 2002. The decrease was due primarily to lower yields on invested assets.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, increased by $8.8 million, or 10%, during 2003 compared to 2002. Approximately $6.4 million of the increase was related to benefits from the Pyramid Life business since its acquisition. The balance was primarily a result of higher loss ratios. Overall loss ratios for the segment increased to 67.2% in 2003 compared to 65.8% in 2002. The increase in deferred acquisition costs was $1.3 million less in 2003, compared to the increase in 2002. This was the result of lower levels of new business being written relative to the amortization of amounts previously capitalized.
Commissions and general expenses increased by $0.9 million, or 1%, in 2003 compared to 2002. The increase was due primarily to the additional Pyramid Life business, since its acquisition.
SEGMENT RESULTS -- LIFE INSURANCE/ANNUITIES
Years ended December 31, 2004 and 2003
Results for our Life Insurance/Annuities segment improved by $1.4 million, or 12%, to $13.4 million in 2004 compared to 2003, primarily as a result of an increase in business and more favorable morbidity.
REVENUES. Net premiums for the segment increased by $13.9 million, or 39%, compared to 2003. Approximately, $7.1 million of the increase relates to the net business produced by the former Guarantee Reserve field force acquired in mid 2003. Approximately $2.5 million of the increase relates to additional premiums from the Pyramid Life business as a result of inclusion of the results of operations of the Pyramid business for a full year in 2004 compared to only nine months in 2003. The balance relates to increased sales of our senior life product and an increase in policy fees on our interest sensitive life and annuity business as a result of the growth in the level of deposits for those products. Ceded premiums increased by approximately $2.3 million as a result of the Guarantee Reserve business. During 2003, prior to receiving approval to write the business through the insurance subsidiaries of Universal American, 50% of the business was assumed from Swiss Re. As we received the regulatory approvals, we wrote the business through our insurance subsidiaries and ceded 50% back to Swiss Re. The balance of the increase in the ceded premiums relates to the increase in our senior life business.
Our agents sold $72.0 million of fixed annuities during 2004 and $120.7 million in 2003. Annuity deposits are not considered premiums for reporting in accordance with generally accepted accounting principles. The reduction in annuity sales was the result of lower interest crediting rates on policy account balances and a decrease in minimum guaranteed crediting rates on our policies from the rates existing in 2003.
Net investment income increased by approximately $3.5 million, or 11%, compared to 2003. Approximately $4.9 million relates to the increase in policyholder account balances as a result of the additional deposits received as noted above. This was offset by a decline in yields on the portfolio.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, increased by $8.4 million, or 32%, during 2004 compared to 2003, consistent with the increase in premiums. Claims benefits incurred for the segment declined in 2004 compared to 2003, as a result of more favorable mortality. Interest credited increased by $3.7 million, due to the increase in policyholder account balances as a result of continued annuity sales, offset by a reduction in credited rates. In addition, during the fourth quarter of 2004, we recorded approximately $0.3 million in additional benefits on
certain replacement annuity policies that we determined contained inappropriate disclosure information to the insured. There is no additional liability to these policyholders.
The increase in deferred acquisition costs was approximately $5.7 million more in 2004, compared to the increase in 2003. This is directly related to the increase in commissions and other acquisition costs related to the new life and annuity business produced during the year. The amortization of intangible assets relates to the present value of the future profits of the life business acquired with Pyramid Life. Commissions and general expenses increased by $9.5 million, or 30%, in 2004 compared to 2003, consistent with the increase in premium.
Years ended December 31, 2003 and 2002
Results for our Life Insurance/Annuities segment declined by $2.2 million, or 16%, to $12.0 million in 2003 compared to 2002, primarily as a result of less favorable mortality.
REVENUES. Net premiums for the segment increased by $7.4 million, or 26%, compared to 2002. Approximately $3.6 million of the increase was related to additional premiums from the Pyramid business since its acquisition on March 31, 2003. Approximately, $1.7 million of the increase was related to the net business produced by the former Guarantee Reserve field force acquired in mid 2003. The balance was related to increased sales of our senior life product and an increase in policy fees on our interest sensitive life and annuity business as a result of the growth in the level of deposits for those products. Ceded premiums increased by approximately $0.5 million as a result of the increase in our senior life business.
Our agents sold $120.7 million of fixed annuities during 2003 and $46.1 million in 2002. Annuity deposits are not considered premiums for reporting in accordance with generally accepted accounting principles.
Net investment income increased by approximately $2.9 million, or 10%, compared to 2002. Approximately $4.3 million was related to the increase in policyholder account balances as a result of the additional deposits received as noted above. This was offset by a decline in yields.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change in reserves, increased by $5.8 million, or 28%, during 2003 compared to 2002, consistent with the increase in premiums. Approximately $3.7 million of the increase relates to benefits from the Pyramid Life business since its acquisition. The balance was primarily a result of less favorable mortality in 2003 compared to 2002. Interest credited increased by $3.9 million, due to the increase in policyholder account balances as a result of the continued sales and the Pyramid Life business added since its acquisition on March 31, 2003.
The increase in deferred acquisition costs was approximately $12.8 million more in 2003, compared to the increase in 2002. This was directly related to the increase in commissions and other acquisition costs related to the new life and annuity business produced during the year. The amortization of intangible assets was related to the present value of the future profits of the life business acquired with Pyramid Life. Commissions and general expenses increased by $14.7 million, or 87%, in 2003 compared to 2002. Approximately $5.9 million was related to commissions and expenses relating to the Guarantee Reserve business, approximately $4.3 million was related to commissions and expenses relating to the annuity business and approximately $2.1 million of the increase was related to commissions and expenses for the Pyramid Life business since its acquisition.
SEGMENT RESULTS -- SENIOR ADMINISTRATIVE SERVICES
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(1) In addition to segment income, we also evaluate the results of our Senior Administrative Services segment based on earnings before interest, taxes, depreciation and amortization ("EBITDA"). EBITDA is a common alternative measure of performance used by investors, financial analysts and rating agencies. It is also a measure that is included in the fixed charge ratio required by the covenants for our outstanding bank debt. Accordingly, these groups use EBITDA, along with other measures, to estimate the value of a company and evaluate the Company's ability to meet its debt service requirements. While we consider EBITDA to be an important measure of comparative operating performance, it should not be construed as an alternative to segment income or cash flows from operating activities (as determined in accordance with generally accepted accounting principles).
Included in unaffiliated revenue are fees received to administer certain business of our insurance subsidiaries that is 100% reinsured to an unaffiliated reinsurer, which amounted to $5.3 million in the year ended December 31, 2004, $7.4 million for 2003 and $6.9 million for 2002. These fees, together with the affiliated revenue, were eliminated in consolidation.
Years ended December 31, 2004 and 2003
Our Senior Administrative Services segment income improved by $2.1 million, or 19%, compared to 2003. This improvement was primarily a result of the growth in premiums managed. EBITDA for this segment increased $2.2 million, or 17%, compared to 2003.
Service fee revenue increased by $8.2 million, or 17%, compared to 2003. Affiliated service fee revenue increased by $9.5 million compared to 2003 as a result of the increase in Medicare Supplement/Select business in force at our insurance subsidiaries, including Pyramid, for which CHCS Services began providing service effective January 1, 2004, and fees from the administration of the life insurance products sold by the Guarantee Reserve marketing organization that was acquired in July 2003. Unaffiliated service fee revenue decreased by approximately $1.4 million primarily due to the reduction in the fees from the underwriting work we performed for the consortium that is offering long term care to employees of the federal government and their families. The initial enrollment period for this program, for which we performed underwriting, began in the third quarter of 2002 and ended during the first
quarter of 2003. General expenses for the segment increased by $6.0 million, or 16%, due primarily to the increase in business.
Years Ended December 31, 2003 and 2002
Our Senior Administrative Services segment income improved by $3.4 million, or 44%, compared to 2002. This improvement was primarily a result of the growth in premiums managed and the scheduled reduction in the amortization of intangible assets. EBITDA for this segment increased $2.6 million, or 25%, compared to 2002.
Service fee revenue increased by $5.7 million, or 13%, compared to 2002. Affiliated service fee revenue increased by $6.5 million compared to 2002 as a result of the increase in Medicare Supplement/Select business in force at our insurance subsidiaries, as well as the fees from the administration of the life insurance products sold by the recently acquired Guarantee Reserve marketing organization. Unaffiliated service fee revenue decreased by approximately $0.8 million primarily due to the reduction in the fees from the underwriting work we performed for the consortium that is offering long term care to employees of the federal government and their families. The initial enrollment period for this program, for which we performed underwriting, began in the third quarter of 2002 and ended during the first quarter of 2003.
General expenses for the segment increased by $3.1 million, or 9%, primarily due to the increase in business and the cost of bringing new clients on line.
The amortization of intangible assets relates primarily to the acquisition of CHCS Services, Inc. (formerly American Insurance Administration Group, Inc, "AIAG"). Approximately $7.7 million of the present value of future profits ("PVFP") was established when AIAG was acquired in January 2000. It is being amortized in proportion to the expected profits from the contracts in force on the date of acquisition. During 2003, the amortization of PVFP was approximately $0.4 compared to $1.5 million in 2002.
SEGMENT RESULTS -- CORPORATE
The following table presents the primary components comprising the loss from the segment:
Years Ended December 31, 2004 and 2003
The loss from our Corporate segment increased by $1.8 million, or 16%, compared to the 2003. The increase was due to higher interest cost as a result of an increase in the amount of the debt outstanding during the year, relating to the amendment of our credit facility in connection with our acquisition of Heritage, offset in part, by a reduction in the weighted average interest rates, as compared to the same period of 2003. Our combined outstanding debt was $176.1 million at December 31, 2004 compared to $113.2 million at December 31, 2003. The weighted average interest rate on our loan payable decreased to 4.06% in 2004 from 4.5% in 2003. The weighted average interest rate on our other long term debt
increased slightly to 6.3% for 2004 from 5.9% for 2003. See "Liquidity and Capital Resources" for additional information regarding our loan payable and other long term debt. As noted below, in 2003, we reported a $1.8 million charge relating to the early extinguishment of debt that was incurred during the first quarter of 2003 that did not recur in 2004. Other parent company expenses increased as a result of additional expenses from an increase in corporate governance related activities, as well as management bonuses.
Certain of the companies acquired in July 1999 had post-retirement benefit plans in place prior to their acquisition and Universal American maintained the liability for the expected cost of such plans. In October 2000, participants were notified of the termination of the plans in accordance with their terms. The liability will continue to be reduced as, and to the extent, it becomes certain that we will incur no liabilities for the plans as a result of the termination. During the fourth quarter of 2004, $0.6 million of the liability was released and during the fourth quarter of 2003, $0.4 million of the liability was released. Future projected releases of the liability are anticipated to be $1.9 million in 2005, $0.7 million in 2006, and $0.1 million in 2007.
Years Ended December 31, 2003 and 2002
The loss from our Corporate segment increased by $3.9 million, or 56%, compared to 2002, due primarily to the charge associated with the refinancing of our debt and the increase in financing costs and other parent company expenses. In connection with the acquisition of Pyramid Life, we refinanced our debt. The early extinguishment of the existing debt resulted in the immediate amortization of the related capitalized loan origination fees, resulting in a pre-tax expense of approximately $1.8 million. The increase in financing cost was due to an increase in the amount of the debt outstanding during the year, offset in part, by a reduction in the weighted average interest rates for the year, compared to 2002. We issued $60.0 million of trust preferred securities during 2003, of which $21.0 million was used to pay down the new term loan. Our combined outstanding debt was $113.2 million at December 31, 2003 compared to $65.8 million at December 31, 2002. The weighted average interest rate on our long term debt decreased to 4.5% in 2003 from 5.4% in 2002. Other parent company expenses increased as a result of additional expenses from an increase in acquisition related activities.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Our contractual obligations as of December 31, 2004, are shown below.
- -------- (1) These obligations include contractual interest and reflects scheduled maturities for contractual obligations existing as of December 31, 2004 and does not include any obligations arising as a result of our shelf registration.
(2) Trust preferred securities all have scheduled maturities of 30 years from the date of issue, however they are all callable by us after five years. For the purpose of this schedule, we have assumed that the securities will be redeemed at their scheduled maturities, not the call date. Accordingly, the obligation for repayment of principal relating to these is included in the more than 5 Years column. The trust preferred securities all have floating rate coupons, except for $15 million which has a fixed rate through its no call period and then converts to a floating rate. Additionally, we have entered into separate swap agreements whereby we pay fixed rates on $35 million of the trust preferred securities through the no call period. We did not project future changes in the base interest rates. For the purpose of this schedule, we applied the base rate in effect at December 31, 2004 to all future periods. Additionally, we assumed that, upon the expiration of the swap agreements and the fixed rate, the rate for the respective trust preferred securities adjusted to a variable rate using the current base rate.
(3) Includes scheduled amortization through final maturity in 2009. The loan payable is floating rate debt. We did not project future changes in the base interest rates. For the purpose of this schedule, we applied the rate in effect at December 31, 2004 to all future periods.
(4) Includes minimum obligations on our data center outsourcing contract, as well as payments required under our outsourced administration service contract for our HMO product (See Outsourcing Arrangements above). Our actual monthly payments are affected by the amount of service provided under the contract and the HMO product's premium levels in force and currently exceed the minimums stated in the contracts. Therefore our actual payments will exceed the amounts presented in the above schedule based upon future usage and premium amounts.
(5) The obligations on policy related liabilities represent those payments we expect to make on death, disability and health insurance claims and policy surrenders. These projected values contain assumptions for future policy persistency, mortality and morbidity comparable with our historical experience. The distribution of payments for policy and contract claims includes assumptions as to the timing of policyholders reporting claims for prior periods and the amounts of those claims. Actual amounts and timing of both future policy benefits and policy and contract claims may differ significantly from the estimates above. We anticipate that the liabilities for policyholder account balances and reserves for future policy benefits totaling $1.8 billion, along with future net premiums, investment income and recoveries from our reinsurers, will be sufficient to fund future policy benefit payments. In addition, we anticipate that the policy and contract claims liability totaling $ 102.4 million, along with recoveries from our reinsurers, will be sufficient to fund these claim liability payments.
LIQUIDITY AND CAPITAL RESOURCES
Our capital is used primarily to support the retained risks and growth of our insurance company subsidiaries and health plan and to support our parent company as an insurance holding company. In addition, we use capital to fund our growth through acquisitions of other companies, blocks of insurance or administrative service business.
We require cash at our parent company to meet our obligations under our credit facility and our outstanding debenture held by our subsidiary, Pennsylvania Life. In January 2002, our parent company issued a debenture to Pennsylvania Life in conjunction with the transfer of the business of Pennsylvania Life's Canadian Branch to Penncorp Life (Canada). The outstanding balance on the debenture was $3.4 million at December 31, 2004. We anticipate funding the repayment of the debenture from dividends of Penncorp Life (Canada). We also require cash to pay the operating expenses necessary to function as a holding company (applicable insurance department regulations require us to bear our own expenses), and to meet the costs of being a public company.
We believe that our current cash position, the availability of our $15.0 million revolving credit facility, the expected cash flows of our administrative service company and management service organizations (acquired in the acquisition of Heritage) and the surplus note interest payments from American Exchange (as explained below) can support our parent company obligations for the foreseeable future. However, there can be no assurance as to our actual future cash flows or to the continued availability of dividends from our insurance company subsidiaries.
Credit Facility, as Amended in May 2004
In connection with the acquisition of Pyramid Life, we obtained an $80 million credit facility (the "Credit Agreement") on March 31, 2003 to repay our then existing loan and provide funds for the acquisition of Pyramid Life. The Credit Agreement consisted of a $65 million term loan which was drawn to fund the acquisition and a $15 million revolving loan facility. The Credit Agreement initially called for interest at the London Interbank Offering Rate ("LIBOR") for one, two or three months, at the option of the Company, plus 300 basis points. Effective March 31, 2004, the spread over LIBOR was reduced to 275 basis points in accordance with the terms of the Credit Agreement. Principal repayments were scheduled over a five-year period with a final maturity date of March 31, 2008. We incurred loan origination fees of approximately $2.1 million, which were capitalized and are being amortized on a straight-line basis over the life of the Credit Agreement.
In connection with the acquisition of Heritage on May 28, 2004, the Company amended the Credit Agreement by increasing the facility to $120 million from $80 million (the "Amended Credit Agreement"), including an increase in the term loan portion to $105 million from $36.4 million (the balance outstanding at May 28, 2004) and maintaining the $15 million revolving loan facility. None of the revolving loan facility has been drawn as of December 31, 2004. Under the Amended Credit Agreement, the spread over LIBOR was reduced to 225 basis points. Effective January 1, 2005, the interest rate on the term loan is 4.8%. Principal repayments are scheduled at $5.3 million per year over a five-year period with a final payment of $80.1 million due upon maturity on March 31, 2009. The Company incurred additional loan origination fees of approximately $2.1 million, which were capitalized and are being amortized on a straight-line basis over the life of the Amended Credit Agreement along with the continued amortization of the origination fees incurred in connection with the Credit Agreement. The Company pays an annual commitment fee of 50 basis points on the unutilized revolving loan facility.
The obligations of the Company under the Amended Credit Facility are guaranteed by our subsidiaries, WorldNet Services Corp., CHCS Services Inc., CHCS Inc., Quincy Coverage Corporation, Universal American Financial Services, Inc., Heritage, HHS-HPN Network, Inc., Heritage Health Systems of Texas, Inc., PSO Management of Texas, LLC, HHS Texas Management, Inc. and HHS Texas Management LP (collectively the "Guarantors") and secured by substantially all of the assets of each of the Guarantors. In addition, as security for the performance by the Company of its obligations under the Amended Credit Facility, the Company, WorldNet Services Corp., CHCS Services Inc., Heritage and HHS Texas Management, Inc., have each pledged and assigned substantially all of their respective securities (but not more than 65% of the issued and outstanding shares of voting stock of any foreign subsidiary), all of their respective limited liability company and partnership interests, all of their respective rights, title and interest under any service or management contract entered into between or among any of their respective subsidiaries and all proceeds of any and all of the foregoing.
The Amended Credit Facility requires the Company and its subsidiaries to meet certain financial tests, including a minimum fixed charge coverage ratio, a minimum risk based capital test and a minimum consolidated net worth test. The Amended Credit Facility also contains covenants, which among other things, limit the incurrence of additional indebtedness, dividends, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers, prepayments of other indebtedness, liens and encumbrances and other matters customarily restricted in such agreements.
The Amended Credit Facility contains customary events of default, including, among other things, payment defaults, breach of representations and warranties, covenant defaults, cross-acceleration, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency and judgment defaults.
Due to the variable interest rate for this Credit Agreement, the Company would be subject to higher interest costs if short-term interest rates rise.
We made regularly scheduled principal payments of $5.7 million and paid $3.1 million in interest in connection with our credit facilities during the year ended December 31, 2004. During 2003, we made regularly scheduled principal payments of $8.7 million and paid $2.7 million in interest in connection with our credit facilities.
The following table shows the schedule of principal payments (in thousands) remaining on our Amended Credit Agreement, with the final payment in March 2009:
2003 Refinancing of Debt
In January 2003, we made a scheduled principal payment of $2.8 million on our then current credit facility, and in March, 2003 made an additional principal payment of $5.0 million from a portion of the proceeds from the issuance of Trust Preferred securities. These payments reduced the outstanding balance on our then current credit facility to $42.9 million, which was repaid on March 31, 2003 from the proceeds of the Credit Agreement obtained in connection with the acquisition of Pyramid Life. The early extinguishment of the then existing debt resulted in the immediate amortization of the related capitalized loan origination fees, resulting in a pre-tax expense of approximately $1.8 million.
Other Long Term Debt
We formed statutory business trusts, which exist for the exclusive purpose of issuing trust preferred securities representing undivided beneficial interests in the assets of the trust, investing the gross proceeds of the trust preferred securities in junior subordinated deferrable interest debentures of our parent holding company (the "Junior Subordinated Debt") and engaging in only those activities necessary or incidental thereto. In accordance with the adoption of FIN 46R, we have deconsolidated the trusts.
Separate subsidiary trusts of our parent holding company (the "Trusts") have issued a combined $75.0 million in thirty year trust preferred securities (the "Capital Securities") as of December 31, 2004, as detailed in the following table:
- -------- (1) Effective September, 2003, we entered into a swap agreement whereby it will pay a fixed rate of 6.7% in exchange for a floating rate of LIBOR plus 400 basis points. The swap contract expires in December 2007.
(2) The rate on this issue is fixed at 7.4% for the first five years, after which it is converted to a floating rate equal to LIBOR plus 410 basis points.
(3) Effective April 29, 2004, we entered into a swap agreement whereby it will pay a fixed rate of 6.98% in exchange for a floating rate of LIBOR plus 395 basis points. The swap contract expires in October 2008.
The Trusts have the right to call the Capital Securities at par after five years from the date of issuance. The proceeds from the sale of the Capital Securities, together with proceeds from the sale by the Trusts of their common securities to our parent holding company, were invested in thirty-year floating rate Junior Subordinated Debt of our parent holding company. From the proceeds of the trust preferred securities, $26.0 million was used to pay down debt during 2003. The balance of the proceeds has been used, in part to fund acquisitions, to provide capital to our insurance subsidiaries to support growth and to be held for general corporate purposes.
The Capital Securities represent an undivided beneficial interest in the Trusts' assets, which consist solely of the Junior Subordinated Debt. Holders of the Capital Securities have no voting rights. Our parent holding company owns all of the common securities of the Trusts. Holders of both the Capital Securities and the Junior Subordinated Debt are entitled to receive cumulative cash distributions accruing from the date of issuance, and payable quarterly in arrears at a floating rate equal to the three-month LIBOR plus a spread. The floating rate resets quarterly and is limited to a maximum of 12.5% during the first sixty months. Due to the variable interest rate for these securities, we are be subject to higher interest costs if short-term interest rates rise. The Capital Securities are subject to mandatory redemption upon repayment of the Junior Subordinated Debt at maturity or upon earlier redemption. The Junior Subordinated Debt is unsecured and ranks junior and subordinate in right of payment to all present and future senior debt of our parent holding company and is effectively subordinated to all existing and future obligations of the Company's subsidiaries. Our parent holding company has the right to redeem the Junior Subordinated Debt after five years from the date of issuance.
Our parent holding company has the right at any time, and from time to time, to defer payments of interest on the Junior Subordinated Debt for a period not exceeding 20 consecutive quarters up to each debenture's maturity date. During any such period, interest will continue to accrue and our parent holding company may not declare or pay any cash dividends or distributions on, or purchase, our common stock nor make any principal, interest or premium payments on or repurchase any debt securities that rank equally with or junior to the Junior Subordinated Debt. Our parent holding company has the right at any time to dissolve the Trusts and cause the Junior Subordinated Debt to be distributed to the holders of the Capital Securities. We have guaranteed, on a subordinated basis, all of the Trusts' obligations under the Capital Securities including payment of the redemption price and any accumulated and unpaid distributions to the extent of available funds and upon dissolution, winding up or liquidation but only to the extent the Trusts have funds available to make such payments. The Capital Securities have not been and will not be registered under the Securities Act of 1933, as amended (the "Securities Act"), and will only be offered and sold under an applicable exemption from registration requirements under the Securities Act.
We paid $4.7 million in interest in connection with the Junior Subordinated Debt during the year ended December 31, 2004, and paid $2.1 million during 2003.
Lease Obligations
We are obligated under certain lease arrangements for our executive and administrative offices in New York, Florida, Indiana, Tennessee, Texas, and Ontario, Canada. Rent expense was $2.6 million for the year ended December 31, 2004, $1.9 million for 2003 and $1.7 million for 2002. Annual minimum rental commitments, subject to escalation, under non-cancelable operating leases (in thousands) are as follows:
In addition to the above, Pennsylvania Life and Penncorp Life (Canada) are the named lessees on 71 properties occupied by Career Agents for use as field offices. The Career Agents reimburse Pennsylvania Life and Penncorp Life (Canada) the actual rent for these field offices. The total annual rent paid by the Company and reimbursed by the Career Agents for these field offices during 2004 was approximately $1.1 million.
Shelf Registration
On November 3, 2004, we filed a universal shelf registration statement on Form S-3 with the U.S. Securities and Exchange Commission ("SEC"), pursuant to which we may issue common stock, warrants and debt securities from time to time, up to an aggregate offering of $140 million. The registration statement also covers five million shares of common stock that may be offered for sale by Capital Z Financial Services Fund II, L.P ("Capital Z"), our largest shareholder. In the event that Capital Z sells all of the five million shares, Capital Z would still own 20.3 million shares or approximately 37% of our outstanding common stock, before giving effect to any issuance of shares by us pursuant to the shelf registration. The shelf registration statement was declared effective in December 2004.
The shelf registration statement enables us to raise funds from the offering of any individual security covered by the shelf registration statement, as well as any combination thereof, through one or more methods of distribution, subject to market conditions and our capital needs. The terms of any offering pursuant to this shelf will be established at the time of the offering. We plan to use the proceeds from any future offering under the registration statement for general corporate purposes, including, but not limited to, working capital, capital expenditures, investments in subsidiaries, acquisitions and refinancing of debt. A more detailed description of the use of proceeds will be included in any specific offering of securities in the prospectus supplement relating to the offering. A copy of the shelf registration statement as filed with the SEC on Form S-3 may be obtained at the SEC's website at www.sec.gov, or through the Investor Relations section of the Universal American website at www.uafc.com.
Obligations of the Parent Company to Affiliates
In January 2002, our parent company issued an $18.5 million 8.5% debenture to Pennsylvania Life in connection with the transfer of the business of Pennsylvania Life's Canadian Branch to Penncorp Life (Canada). The debenture is scheduled to be repaid in full during 2005. Our parent company repaid principal of $4.5 million in 2002, $7.1 million in 2003 and $3.5 million in 2004, reducing the outstanding balance to $3.4 million. Our parent holding company paid $0.5 million in interest on these debentures during 2004, $1.0 million in 2003 and $1.5 million in 2002. The interest on these debentures is eliminated in consolidation. Dividends from Penncorp Life (Canada) funded the interest and principal paid on the debenture to date and it is anticipated that they will fund all future payments made on this debenture.
Sources of Liquidity to the Parent Company
We anticipate funding the obligations of the parent company and the capital required to grow our business from the four distinct and uncorrelated sources of cash flow within the organization as follows:
- the expected cash flows of our senior administrative services company,
- the expected cash flows of our senior managed care company (acquired in the acquisition of Heritage),
- dividend payments received from Penncorp Life (Canada), and -
- surplus note principal and interest payments from American Exchange.
In addition, we maintain a large cash position and have access to our unutilized $15.0 million revolving credit facility. However, there can be no assurance as to our actual future cash flows or to the continued availability of dividends from our insurance company subsidiaries.
Senior Administrative Services Company. Liquidity for our senior administrative services subsidiary is measured by its ability to pay operating expenses and pay dividends to our parent company. The primary source of liquidity is fees collected from clients. We believe that the sources of cash for our senior administrative services company exceed scheduled uses of cash and results in amounts available to dividend to our parent holding company. We measure the ability of the senior administrative services company to pay dividends based on its earnings before interest, taxes, depreciation and amortization ("EBITDA"). EBITDA for our Senior Administrative Services segment was $15.3 million for the year ended December 31, 2004, and was $13.1 million for 2003 and $10.5 million for 2002.
Senior Managed Care Company. Liquidity for our managed care company is measured by its ability to pay operating expenses and pay dividends to our parent company. The primary source of liquidity is management fees for administration of SelectCare and services provided to the IPA's. Dividend payments by SelectCare to Heritage are subject to the approval of the insurance regulatory authorities of the state of Texas, SelectCare's state of domicile. SelectCare is not able to pay dividends during 2005 without prior approval. We believe that the sources of cash to our managed care holding company exceed scheduled uses of cash which will result in funds available to dividend to our parent holding company. We measure the ability of the senior managed care holding company to pay dividends based on its EBITDA. EBITDA for our senior managed care holding company was $12.2 million for the seven months since its acquisition on May 28, 2004.
Penncorp Life (Canada) Dividends. Penncorp Life (Canada) is a Canadian insurance company. Canadian law provides that a life insurer may pay a dividend after such dividend declaration has been approved by its board of directors and upon at least 10 days prior notification to the Superintendent of Financial Institutions. Such a dividend is limited to retained net income (based on Canadian GAAP) for the preceding two years, plus net income earned for the current year. In considering approval of a dividend, the board of directors must consider whether the payment of such dividend would be in contravention of the Insurance Companies Act of Canada. During the first quarter of 2004, Penncorp Life (Canada) paid dividends of C$26.7 million (approximately US$20.0 million) to Universal American, relating to 2003 net income. The amount of the dividend was larger than normal due to a benefit received by Penncorp Life (Canada) from an actuarial experience study that allowed Penncorp Life (Canada) to reduce its policy benefit reserves at December 31, 2003 on a Canadian GAAP basis. The actuarial experience study did not have an impact on Penncorp Life (Canada)'s policy benefit reserves on a U.S. GAAP basis. During the remainder of 2004, Penncorp Life (Canada) paid dividends totaling C$7.2 million (US$5.6 million) relating to net income for 2004. Penncorp Life (Canada) paid dividends to Universal American totaling C$11.2 million (US $8.1 million) during 2003 and C$9.3 million (US $5.9 million) during 2002. We anticipate that Penncorp Life (Canada) will be able to pay dividends equal to its net income earned during 2005, less $2.5 million.
Insurance Subsidiaries -- Surplus Note, Dividends and Capital Contributions. Cash generated by our insurance company subsidiaries will be made available to our holding company, principally through periodic payments of principal and interest on the surplus note owed to our holding company by our subsidiary, American Exchange Life. As of December 31, 2004, the principal amount of the surplus note was $48.5 million. The note bears interest to our parent holding company at LIBOR plus 325 basis points. We anticipate that the surplus note will be primarily serviced by dividends from Pennsylvania Life, a wholly owned subsidiary of American Exchange, and by tax-sharing payments among the insurance companies that are wholly owned by American Exchange and file a consolidated Federal income tax return. American Exchange made principal payments totaling $11.6 million during the year ended December 31, 2004. No principal payments were made during 2003. During 2002, the surplus note was reduced by $10.0 million in the form of a capital contribution to American Exchange by our holding company. American Exchange paid interest on the surplus note of $2.4 million during the year ended December 31, 2004, $2.8 million in 2003, and $3.8 million in 2002.
Our parent holding company made capital contributions to American Exchange amounting to $17.8 million during 2004. In March 2004, Pennsylvania Life declared and paid a dividend in the amount of $10.6 million to American Exchange. American Exchange made capital contributions of $12.0 million to Union Bankers, $8.2 million to American Pioneer and $7.0 million to American Progressive during the year ended December 31, 2004.
During the year ended December 31, 2003, no dividends were declared or paid by the U.S. insurance company subsidiaries to American Exchange. During 2003, American Exchange received capital contributions from its parent totaling $35.5 million. American Exchange made capital contributions of $27.0 million to Pennsylvania Life, primarily relating to the acquisition of Pyramid Life, $2.5 million to American Pioneer, $2.5 million to American Progressive and $3.5 million to Union Bankers. Pennsylvania Life contributed $1.0 million to Pyramid Life in 2003.
During 2002, Pennsylvania Life paid dividends amounting to $3.0 million to American Exchange. Universal American contributed 100% of the common stock of American Pioneer and American Progressive to American Exchange during 2002. American Exchange also received capital contributions from its parent totaling $4.2 million during the year. American Exchange made capital contributions of $3.0 million to American Pioneer and $1.2 million to American Progressive during 2002.
Dividend payments by our U.S. insurance companies to our holding company or to intermediate subsidiaries are limited by, or subject to the approval of the insurance regulatory authorities of each insurance company's state of domicile. Such dividend requirements and approval processes vary significantly from state to state. Pennsylvania Life is able to pay ordinary dividends of up to $6.3 million to American Exchange during 2005, without prior approval. Pyramid Life is able to pay ordinary dividends of up to $2.5 million to Pennsylvania Life (its direct parent) with prior notice to the Kansas Insurance Department and Marquette would be able to pay ordinary dividends of up to $0.3 million to Constitution (its direct parent) without the prior approval from the Texas Insurance Department during 2005. American Exchange, American Pioneer, American Progressive, Constitution and Union Bankers had negative earned surplus at December 31, 2004 and are not be able to pay dividends in 2005 without special approval.
Insurance Subsidiaries - Liquidity
Liquidity for our insurance company subsidiaries is measured by their ability to pay scheduled contractual benefits, pay operating expenses, fund investment commitments, and pay dividends to their parent company. The principal sources of cash for our insurance operations include scheduled and unscheduled principal and interest payments on investments, premium payments, annuity deposits, and the sale or maturity of investments. Both the sources and uses of cash are reasonably predictable and we believe that these sources of cash for our insurance company subsidiaries exceed scheduled uses of cash.
Liquidity is also affected by unscheduled benefit payments including benefits under accident and health insurance policies, death benefits and interest-sensitive policy surrenders and withdrawals.
Our accident and health insurance policies generally provide for fixed-benefit amounts and, in the case of Medicare Supplement policies, for supplemental payments to Medicare provider rates. Some of these benefits are subject to medical-cost inflation and we have the capability to file for premium rate increases to mitigate rising medical costs. Our health insurance business is widely dispersed in the United States and Canada, which mitigates the risk of unexpected increases in claim payments due to epidemics and events of a catastrophic nature. These accident and health polices are not interest-sensitive and therefore are not subject to unexpected policyholder redemptions due to investment yield changes.
Some of our life insurance and annuity policies are interest-sensitive in nature. The amount of surrenders and withdrawals is affected by a variety of factors such as credited interest rates for similar products, general economic conditions and events in the industry that affect policyholders' confidence. Although the contractual terms of substantially all of our in force life insurance policies and annuities give the holders the right to surrender the policies and annuities, we impose penalties for early surrenders. As of December 31, 2004 we held reserves that exceeded the underlying cash surrender values of our net
retained in force life insurance and annuities by $34.3 million. Our insurance subsidiaries, in our view, have not experienced any material changes in surrender and withdrawal activity in recent years.
Changes in interest rates may affect the incidence of policy surrenders and withdrawals. In addition to the potential impact on liquidity, unanticipated surrenders and withdrawals in a changed interest rate environment could adversely affect earnings if we were required to sell investments at reduced values in order to meet liquidity demands. We manage our asset and liability portfolios in order to minimize the adverse earnings impact of changing market rates. We have segregated a portion of our investment portfolio in order to match liabilities that are sensitive to interest rate movements with fixed income securities containing similar characteristics to the related liabilities, most notably the expected duration and required interest spread. We believe that this asset/liability management process adequately covers the expected payment of benefits related to these liabilities.
As of December 31, 2004, our insurance company subsidiaries held cash and cash equivalents totaling $129.4 million, as well as fixed maturity securities that could readily be converted to cash with carrying values (and fair values) of $1.2 billion.
The net yields on our cash and invested assets decreased to 4.9% for the year ended December 31, 2004, from 5.3% for 2002 and 6.4% for 2003. A portion of these securities are held to support the liabilities for policyholder account balances, which liabilities are subject to periodic adjustments to their credited interest rates. The credited interest rates of the interest-sensitive policyholder account balances are determined by us based upon factors such as portfolio rates of return and prevailing market rates and typically follow the pattern of yields on the assets supporting these liabilities.
Our insurance subsidiaries are required to maintain minimum amounts of statutory capital and surplus as required by regulatory authorities. However, substantially more than the statutory minimum amounts are needed to meet statutory and administrative requirements of adequate capital and surplus to support the current level of our insurance subsidiaries' operations. Each of our insurance subsidiaries' statutory capital and surplus exceeds its respective minimum statutory requirement at levels we believe are sufficient to support their current levels of operation. Additionally, the National Association of Insurance Commissioners ("NAIC") imposes regulatory risk-based capital ("RBC") requirements on life insurance enterprises. At December 31, 2004, all of our insurance subsidiaries maintained ratios of total adjusted capital to RBC in excess of the "authorized control level". The combined statutory capital and surplus, including asset valuation reserve, of our U.S. insurance subsidiaries totaled $127.9 million at December 31, 2004 and $117.1 million at December 31, 2003. Statutory net income for the year ended December 31, 2004 was $5.4 million, which included after tax net realized gains of $0.9 million, and for the year ended December 31, 2003 was $6.0 million, which included after tax net realized losses of $0.3 million. The net statutory loss for the year ended December 31, 2002 was $9.1 million, which included after tax net realized losses of $16.8 million.
Penncorp Life (Canada) reports to Canadian regulatory authorities based upon Canadian statutory accounting principles that vary in some respects from U.S. statutory accounting principles. Penncorp Life (Canada)'s net assets based upon Canadian statutory accounting principles were C$57.4 million (US$47.8 million) as of December 31, 2004 and were C$82.9 million (US$63.5 million) as of December 31, 2003. Net income based on Canadian generally accepted accounting principles was C$8.4 million (US$6.5 million) for the year ended December 31, 2004, C$34.4 million (US$24.6 million) for 2003 and C$12.8 million (US$8.2 million) for 2002. Penncorp Life (Canada) maintained a Minimum Continuing Capital and Surplus Requirement Ratio ("MCCSR") in excess of the minimum requirement at December 31, 2004.
Investments
Our investment policy is to balance the portfolio duration to achieve investment returns consistent with the preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. We invest in assets permitted under the insurance laws of the various states in which we operate. Such laws generally prescribe the nature, quality of and limitations on various types of investments that may be made. We do not currently have investments in partnerships, special purpose entities, real estate, commodity contracts, or other derivative securities. We currently engage the services of three investment advisors under the direction of the management of our insurance company subsidiaries and in accordance with guidelines adopted by the Investment Committees of their respective boards of directors. Conning Asset Management Company manages the portfolio of all of our United States subsidiaries, except for the portfolio of Pyramid Life, and certain floating rate portfolios, which are managed by Hyperion Capital. MFC Global Investment Management manages our Canadian portfolio. We invest primarily in fixed maturity securities of the U.S. Government and its agencies and in corporate fixed maturity securities with investment grade ratings of "BBB-" (Standard & Poor's Corporation), "Baa3" (Moody's Investor Service) or higher. Our current policy is not to invest in derivative programs or other hybrid securities, except for GNMA's, FNMA's and investment grade corporate collateralized mortgage obligations.
As of December 31, 2004, 99.4% of our fixed maturity investments had investment grade ratings from Standard & Poor's Corporation or Moody's Investor Service. There were no non-income producing fixed maturities as of December 31, 2004. During the year ended December 31, 2004, we did not write down the value of any fixed maturity securities. We wrote down the value of certain fixed maturity securities, considered to have been subject to an other-than-temporary decline in value, by $1.3 million during 2003, and by $10.6 million during 2002 (primarily as a result of the impairment of our World Com holdings). In each case, these write-downs represent our estimate of other than temporary declines in value and were included in net realized gains (losses) on investments in our consolidated statements of operations.
As of December 31, 2004, our insurance company subsidiaries held cash and cash equivalents totaling $129.4 million, as well as fixed maturity securities that could readily be converted to cash with carrying values (and fair values) of $1.2 billion.
FEDERAL INCOME TAXATION OF THE COMPANY
We file a consolidated return for Federal income tax purposes that includes all of the non-life insurance company subsidiaries, including Heritage. American Progressive was included in the consolidated return through March 31, 2002 and American Pioneer was included through June 30, 2002. American Exchange and its subsidiaries and Penncorp Life (Canada) are not current included. American Exchange and its subsidiaries, including American Progressive since April 1, 2002 and American Pioneer since July 1, 2002, file a separate consolidated Federal return. Penncorp Life (Canada) files a separate return with the Canada Revenue Agency.
As of December 31, 2004 we (exclusive of American Exchange and its subsidiaries and Penncorp Life (Canada)) had net operating tax loss carryforwards of approximately $7.9 million (including $6.9 million from Heritage) that expire in 2015 and 2024 and capital loss carryforwards of $1.3 million that expire in 2007. As of December 31, 2004, we also had an Alternative Minimum Tax ("AMT") credit carryforward for Federal income tax purposes of approximately $0.5 million that can be carried forward indefinitely. As a result of our acquisitions of CHCS and Heritage, use of most of our loss carryforwards is subject to annual limitations.
As of December 31, 2004, American Exchange and its subsidiaries had net operating loss carryforwards, most of which relate to the companies acquired in 1999 (and were incurred prior to their acquisition by us), of approximately $6.9 million that expire between 2009 and 2017. At December 31, 2004, American Exchange and its subsidiaries also had capital loss carryforwards of $7.9 million that expire in 2007. As of December 31, 2004, American Exchange and its subsidiaries also had an AMT credit carryforward for Federal income tax purposes of approximately $0.7 million that can be carried forward indefinitely As a result of the change in the ownership of the companies acquired in 1999, use of most of these loss carryforwards is subject to annual limitations.
At December 31, 2004 and 2003, the Company carried valuation allowances of $3.8 million and $0.6 million, respectively, with respect to its deferred tax assets. The Company establishes a valuation allowance based upon an analysis of projected taxable income and its ability to implement prudent and feasible tax planning strategies. As a result of uncertainty regarding the ability to generate taxable capital gains, the Company established a valuation allowance in the amount of $3.2 million for its capital loss carryforwards during 2004 that was recorded as a deferred income tax expense. Additionally, the Company released $3.8 million relating to a portion of reserve amounts established for pre-acquisition tax years of certain life insurance subsidiaries that were being examined by the Internal Revenue Service. At December 31, 2003, the valuation allowance for certain of the life tax operating loss carryforwards no longer was considered necessary. The amount of the valuation allowance released during 2003 was $4.5 million and was recorded as a deferred income tax benefit. In 2003, the Company established a reserve for pre-acquisition tax years of certain life insurance subsidiaries that were being examined by the Internal Revenue Service. As a result of the increased profitability of the Administrative Services segment, valuation allowances for certain of the non-life tax loss carryforwards no longer were considered necessary as of December 31, 2003. The amount of the valuation allowance released during 2003 was $0.1 million and was also recorded as a deferred income tax benefit. Management believes it is more likely than not that the Company will realize the value of the recorded net deferred tax assets.
Our U.S. insurance company subsidiaries, other than Peninsular Life Insurance Company, are taxed as life insurance companies as provided in the Internal Revenue Code. The Omnibus Budget Reconciliation Act of 1990 amended the Internal Revenue Code to require a portion of the expenses incurred in selling insurance products to be capitalized and amortized over a period of years, as opposed to an immediate deduction in the year incurred. Instead of measuring actual selling expenses, the amount capitalized for tax purposes is based on a percentage of premiums. In general, the capitalized amounts are subject to amortization over a ten-year period. Since this change only affects the timing of the deductions, it does not, assuming stability of rates, affect the provisions for taxes reflected in our financial statements prepared in accordance with GAAP. However, by deferring deductions, the change has the effect of increasing our current tax expense and reducing statutory surplus. There was no material increase in our current income tax provision for any of the three years in the period ended December 31, 2004 due to the existence of our insurance company subsidiaries' net operating loss carryforwards.
The Jobs Creation Tax Act of 2004 contains a provision that places a two year moratorium on the imposition of tax on distributions from Policyholder Surplus Accounts ("PSA"). Additionally, the ordering rules were changed to allow for the first dollar of any distribution to reduce the PSA. Any distribution during 2005 and 2006 from an insurance company that has a PSA will be treated as a distribution from its PSA account. However, the distribution will not be subject to federal income tax. As of December 31, 2004, we had $20.2 million of PSA balances, and have accrued $7.1 million in deferred tax liabilities corresponding to those balances. The Jobs Creation Tax Act of 2004 provides the mechanism to eliminate this potential tax without the imposition of any tax payment. However, the transactions required to trigger the elimination of the potential tax would require pre-approval of the Insurance Departments of the respective companies. There can be no assurance that we will receive such approvals.
EFFECTS OF RECENTLY ISSUED AND PENDING ACCOUNTING PRONOUNCEMENTS
There was no material impact on our consolidated financial condition or results of operations as a result of our adoption of the recently issued accounting pronouncements. We do not anticipate any material impact from the future adoption of the pending accounting pronouncements, other than the adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"). SFAS 123R requires all companies to recognize compensation costs for share-based payments to employees based on the grant-date fair value of the award for financial statements for reporting periods beginning after June 15, 2005. Refer to Consolidated Financial Statements Note 2 - Recent and Pending Accounting Pronouncements.
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In general, market risk relates to changes in the value of financial instruments that arise from adverse movements in interest rates, equity prices and foreign exchange rates. We are exposed principally to changes in interest rates that affect the market prices of our fixed income securities as well as the cost of our variable rate debt. Additionally, we are exposed to changes in the Canadian dollar that affects the translation of the financial position and the results of operations of our Canadian subsidiary from Canadian dollars to U.S. dollars.
Investment Interest Rate Sensitivity
Our profitability could be affected if we were required to liquidate fixed income securities during periods of rising and/or volatile interest rates. However, we attempt to mitigate our exposure to adverse interest rate movements through a combination of active portfolio management and by staggering the maturities of our fixed income investments to assure sufficient liquidity to meet our obligations and to address reinvestment risk considerations. Our insurance liabilities generally arise over relatively long periods of time, which typically permits ample time to prepare for their settlement.
Certain classes of mortgage-backed securities are subject to significant prepayment risk due to the fact that in periods of declining interest rates, individuals may refinance higher rate mortgages to take advantage of the lower rates then available. We monitor and adjust our investment portfolio mix to mitigate this risk.
We regularly conduct various analyses to gauge the financial impact of changes in interest rate on our financial condition. The ranges selected in these analyses reflect our assessment as being reasonably possible over the succeeding twelve-month period. The magnitude of changes modeled in the accompanying analyses should not be construed as a prediction of future economic events, but rather, be treated as a simple illustration of the potential impact of such events on our financial results.
The sensitivity analysis of interest rate risk assumes an instantaneous shift in a parallel fashion across the yield curve, with scenarios of interest rates increasing and decreasing 100 and 200 basis points from their levels as of December 31, 2004, and with all other variables held constant. A 100 basis point increase in market interest rates would result in a pre-tax decrease in the market value of our fixed income investments of $70.6 million and a 200 basis point increase in market interest rates would result in $138.6 million decrease. Similarly, a 100 basis point decrease in market interest rates would result in a pre-tax increase in the market value of our fixed income investments of $77.4 million and a 200 basis point decrease in market interest rates would result in a $160.2 million increase.
Debt
We pay interest on our term loan and a portion of our trust preferred securities based on the London Inter Bank Offering Rate ("LIBOR") for one, two or three months. Due to the variable interest rate, the Company would be subject to higher interest costs if short-term interest rates rise. We have attempted to mitigate our exposure to adverse interest rate movements by fixing the rate on $15.0 million of the trust preferred securities for a five year period through the contractual terms of the security at inception and an additional $35.0 million through the use of interest rate swaps.
We regularly conduct various analyses to gauge the financial impact of changes in interest rate on our financial condition. The ranges selected in these analyses reflect our assessment as being reasonably possible over the succeeding twelve-month period. The magnitude of changes modeled in the accompanying analyses should not be construed as a prediction of future economic events, but rather, be treated as a simple illustration of the potential impact of such events on our financial results.
The sensitivity analysis of interest rate risk assumes scenarios increases or decreases in LIBOR of 100 and 200 basis points from their levels as of December 31, 2004, and with all other variables held constant. The following table summarizes the impact of changes in LIBOR, based on the weighted average balance outstanding and the weighted average interest rates for the nine months ended December 31, 2004.
As noted above, we have fixed the interest rate on $50 million of our $176 million of total debt outstanding, leaving $125 million of the debt exposed to rising interest rates. As of December 31, 2004 we had approximately $181 million of cash and cash equivalents and $55 million in short duration floating rate investment securities. We anticipate that the net investment income on this $236 million will be positively impacted by rising interest rates and will mitigate the negative impact of rising interest rates on our debt.
Currency Exchange Rate Sensitivity
Portions of our operations are transacted using the Canadian dollar as the functional currency. As of and for the year ended December 31, 2004, approximately 12% of our assets, 9% of our revenues, excluding realized gains, and 16% of our income before realized gains and taxes were derived from our Canadian operations. As of and for the year ended December 31, 2003, approximately 13% of our assets, 12% of our revenues, excluding realized gains, and 21% of our income before realized gains and taxes were derived from our Canadian operations. Accordingly, our earnings and shareholder's equity are affected by fluctuations in the value of the U.S. dollar as compared to the Canadian dollar. Although this risk is somewhat mitigated by the fact that both the assets and liabilities for our foreign operations are denominated in Canadian dollars, we are still subject to translation gains and losses.
We periodically conduct various analyses to gauge the financial impact of changes in the foreign currency exchange rate on our financial condition. The ranges selected in these analyses reflect our assessment of what is reasonably possible over the succeeding twelve-month period.
A 10% strengthening of the U.S. dollar relative to the Canadian dollar, as compared to the actual average exchange rate for the year ended December 31, 2004, would have resulted in a decrease in our income before realized gains and taxes of approximately $1.2 million for the year ended December 31, 2004 and a decrease in our shareholders' equity of approximately $4.9 million at December 31, 2004. A 10% weakening of the U.S. dollar relative to the Canadian dollar would have resulted in an increase in our income before realized gains and taxes of approximately $1.5 million for the year ended December 31, 2004 and an increase in shareholders' equity of approximately $6.0 million at December 31, 2004. Our sensitivity analysis of the effects of changes in foreign currency exchange rates does not factor in any potential change in sales levels, local prices or any other variables.
The magnitude of changes reflected in the above analysis regarding interest rates and foreign currency exchange rates should, in no manner, be construed as a prediction of future economic events, but rather as a simple illustration of the potential impact of such events on our financial results.
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary schedules are listed in the accompanying Index to Consolidated Financial Statements and Financial Statement Schedules on Page F - 1.
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A - CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of December 31, 2004. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2004, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information that we are required to disclose in the reports that we file or submit under the Exchange Act.
Management's Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management assessed our internal control over financial reporting as of December 31, 2004, the end of our fiscal year. Management based its assessment on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Our management believes that the COSO framework is a suitable framework for its evaluation of our internal control over financial reporting because it is free from bias, permits reasonably consistent qualitative and quantitative measurements of our internal controls, is sufficiently complete so that those relevant factors that would alter a conclusion about the effectiveness of our internal controls are not omitted and is relevant to an evaluation of internal control over financial reporting. Management's assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment.
Based on our assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles. Management has not identified any material weaknesses in our internal control over financial reporting. We reviewed the results of management's assessment with the Audit Committee of our Board of Directors.
Attestation Report of Ernst & Young LLP
Our independent registered public accounting firm, Ernst & Young LLP, audited management's assessment and independently assessed the effectiveness of the company's internal control over financial reporting. Ernst & Young has issued an attestation report on our internal controls that concurs with management's assessment. This report is included on page of our consolidated financial statements included in this Form 10-K.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal controls over financial reporting during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Inherent Limitations on Effectiveness of Controls
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within Universal American have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons or by collusion of two or more people. The design of any system of
controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
ITEM 9B - OTHER INFORMATION
None
PART III
ITEM 10 - MANAGEMENT
The information required by Item 10 is incorporated into Part III of this Annual Report on Form 10-K by reference to our definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 11 - EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated into Part III of this Annual Report on Form 10-K by reference to our definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated into Part III of this Annual Report on Form 10-K by reference to our definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated into Part III of this Annual Report on Form 10-K by reference to our definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 is incorporated into Part III of this Annual Report on Form 10-K by reference to our definitive Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
PART IV
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
1 FINANCIAL STATEMENTS
See separate index to Financial Statements and Financial Statement Schedules on Page F - 1 of this Form 10-K.
2 FINANCIAL STATEMENT SCHEDULES
See separate index to Financial Statements and Financial Statement Schedules on Page F - 1 of this Form 10-K.
3 EXHIBITS
2.1 Agreement and Plan of Merger, dated as of March 9, 2004, among Universal American Financial Corp., HHS Acquisition Corp., Heritage Health Systems, Inc. and Carlyle Venture Partners, L.P., as the stockholder representative, incorporated by reference to Form 8-K dated March 9, 2004.
3.1 Restated Certificate of Incorporation of Universal American Financial Corp. incorporated by reference to Exhibit 3.1 to the registrant's Amendment No. 2 to the Registration Statement (No. 333-62036) on Form S-3 filed on July 11, 2001.
3.2 Amendment No. 1 to the Restated Certificate of Incorporation of Universal American Financial Corp., incorporated by reference to Exhibit 3 to Form 10-Q (File No. 0-11321) for the quarter ended June 30, 2004, filed with the SEC on August 9, 2004.
3.3 Amended and Restated By-Laws of Universal American Financial Corp., incorporated by reference to Exhibit A to Form 8-K (File No. 0-11321) dated August 13, 1999.
3.4 By-Laws, as amended, incorporated by reference to Exhibit A to Form 8-K dated August 13, 1999.
4.1 Form of Indenture dated as of December 2004 between Universal American Financial Corp. and U.S. Bank National Association, as Trustee, incorporated by reference to Exhibit 4.01 to Amendment No. 1 to the Company's Registration Statement on Form S-3 (File No. 333-120190) filed with the Securities and Exchange Commission on December 10, 2004.
4.2 Form of Indenture dated as of December 2004 between Universal American Financial Corp. and U.S. Bank National Association, as Trustee, incorporated by reference to Exhibit 4.02 to Amendment No. 1 to the Company's Registration Statement on Form S-3 (File No. 333-120190) filed with the Securities and Exchange Commission on December 10, 2004.
4.3 Shareholders Agreement dated July 30, 1999, among the Company, Capital Z Financial Services Fund II, L.P., UAFC, L.P., AAM Capital Partners, L.P., Chase Equity Associates, L.P., Richard A. Barasch and others, incorporated by reference to Exhibit A of Form 8-K dated August 13, 1999.
4.4 Registration Rights Agreement, dated July 30, 1999, among the Company, Capital Z Financial Services Fund II, L.P., Wand/Universal American Investments L.P.I., Wand/Universal American Investments L.P. II, Chase Equity Associates, L.P., Richard A. Barasch and others, incorporated by reference to Exhibit A to Form 8-K dated August 13, 1999.
10.1 Amended and Restated Purchase Agreement among the Company, dated December 31, 1999, as amended and restated on July 2, 1999, between Universal American, PennCorp Financial Group, Inc. ("PFG") and several of PFG's subsidiaries, incorporated by reference to Annex B of Proxy Statement dated July 12, 1999.
10.2 Share Purchase Agreement, as of December 31, 1998, between the Company and Capital Z Financial Services Fund II, L.P. as amended by Amendment, dated as of July 2, 1999, incorporated by reference to Annex A of Proxy Statement dated July 12, 1999.
10.3 Credit Agreement dated as of July 30, 1999, among the Registrant and the Chase Manhattan Bank as agent, the lender and signatory thereto, incorporated by reference to Exhibit C to Form 8-K/A dated March 16, 2001.
10.4 Employment Contracts, between Registrant and the following officers:
Richard A. Barasch, dated July 30, 1999 Robert A. Waegelein, dated July 30, 1999 Gary W. Bryant, dated July 30, 1999 William E. Wehner, dated July 30, 1999
incorporated by reference to Exhibits D and E to Form 8-K/A dated March 16, 2001.
10.5 Agent Equity Plan for Agents of Penn Union Companies incorporated by reference to Amendment 1 to Registration Statement on Form S-2, dated July 13, 2000.
10.6 Agent Equity Plan for Regional Managers and Sub Managers of Penn Union Companies incorporated by reference to Amendment 1 to Registration Statement on Form S-2, dated July 13, 2000.
10.7 1998 Incentive Compensation Plan, incorporated by reference to Annex A of Definitive Proxy Statement filed on Form 14A dated April 29, 1998.
10.8 Purchase Agreement dated as of December 20, 2002, by and among Universal American Financial Corp., Pennsylvania Life Insurance Company, Ceres Group, Inc. and Continental General Insurance Company incorporated by reference to Form 8-K dated December 20, 2002.
10.9 Credit Agreement dated March 31, 2003, among the Company, various lending institutions and, Bank of America, N.A., as the Administrative Agent, the Collateral Agent and the L/C Issuer incorporated by reference to Form 8-K dated March 27, 2003.
10.10 Agreement dated as of July 6, 2000, by and between ALICOMP, a division of ALICARE, Inc. and Universal American Financial Corp. incorporated by reference to Form 10-Q/A (Amendment No. 1) for the period ended September 30, 2003, dated December 23, 2003.
10.11 Amended and Restated Credit Agreement dated as of May 28, 2004, among the Company, various lending institutions and Bank of America, N.A., as the Administrative Agent, the Collateral Agent and the L/C Issuer, incorporated by reference to Form 8-K dated May 28, 2004.
10.12 Amendment No. 1 to Universal American Financial Corp. 1998 Incentive Compensation Plan, incorporated by reference to Amendment No. 1 to the registrant's Registration Statement on Form S-4 (No. 333-120190) filed on December, 10, 2004.
10.13* Addendum II for Item 1A