ITEM 1. BUSINESS
ITEM 1A.
ITEM 1A. RISK FACTORS
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2.
ITEM 2. PROPERTIES
ITEM 3
ITEM 3.
LEGAL PROCEEDINGS.
We are not involved in any material legal proceedings nor, to our knowledge, are any material legal proceedings pending or threatened against us. We are typically subject to routine actions and administrative proceedings, which we expect, in the aggregate, not to have a material adverse effect on our business or financial position, results of operations or cash flows.
On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York, both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore, and Gibb are officers of KMG America and former employees of the plaintiffs. The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs’ amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs’ motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs’ motion. The plaintiffs filed a notice of appeal of the court’s ruling with the Minnesota Court of Appeals. On September 5, 2006, the Minnesota Court of Appeals issued a ruling affirming the district court’s denial of plaintiffs’ motion for a temporary injunction. On December 21, 2006, the defendants filed a motion for summary judgment with the district court and a hearing on the motion was held on January 19, 2007. We expect a ruling from the Court in the second quarter of 2007. We believe plaintiffs’ allegations are without merit and intend to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, we believe the outcome of this matter will not have a material adverse effect on our consolidated financial position or results of operations. The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse the Company for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation. The Company also has received partial reimbursement under the insurance policy for defense costs incurred to date. As a result, the Company expects that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on our consolidated financial position or results of operations.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of our shareholders during the fourth quarter of 2006.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Market Information
Our common shares began trading on the New York Stock Exchange on December 16, 2004, under the symbol “KMA.” As of December 29, 2006, the last reported closing price per common share on the New York
Stock Exchange was $9.59. The following table sets forth the high and low sales price per common share reported on the New York Stock Exchange as traded and the dividends paid on the common shares from January 1, 2005, through December 31, 2006.
Shareholder Information
As of February 23, 2007, we had 317 holders of record of our common shares. Our registrar and transfer agent is American Stock Transfer & Trust Company.
Dividends
As a holding company whose principal asset is the capital stock of Kanawha and our indirect subsidiaries, we rely primarily on dividends and other statutorily permissible payments from our subsidiaries to meet our obligations for payment of interest and principal on outstanding debt obligations, dividends to shareholders (including any dividends on our common stock) and corporate expenses. The ability of Kanawha and our other subsidiaries to pay dividends and to make such other payments in the future will depend on their statutory surplus (which is the excess of assets over liabilities as determined in accordance with statutory accounting principles set by state insurance regulatory authorities), future statutory earnings (which are earnings as determined in accordance with statutory accounting principles) and regulatory restrictions.
Kanawha is subject to state insurance laws and regulations and extensive regulatory oversight, including regulations that limit the amount of dividends and other distributions it can pay to KMG America, and consequently, that KMG America can pay to its shareholders. The payment of dividends to KMG America by Kanawha in excess of a certain amount (i.e., extraordinary dividends) must be approved by the State of South Carolina Department of Insurance. Extraordinary dividends, for which regulatory approval is required, include dividends whose fair market value together with that of other dividends made within the preceding twelve months: (1) when paid from other than earned surplus, exceed the lesser of (a) ten percent of the insurer’s surplus as regards policyholders or (b) the net gain from operations, not including net realized capital gains or losses; or (2) when paid from earned surplus, exceed the greater of (a) ten percent of the insurer’s surplus as regards policyholders or (b) the net gain from operations, not including net realized capital gains or losses. If insurance regulators determine that payment of an ordinary dividend or any other payments by our insurance subsidiary to us (such as payments under a tax sharing agreement or payments for employee or other services) would be adverse to policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval. We cannot assure you that there will not be further regulatory actions restricting the ability of our insurance subsidiary to pay dividends. If the ability of our insurance subsidiary to pay dividends or make other payments to us is materially restricted by regulatory requirements, it could adversely affect our ability to pay any dividends on our common stock and/or service our debt and pay our other corporate expenses.
Our non-insurance subsidiary generally is not subject to state insurance laws, regulations and oversight. However, because our non-insurance subsidiary is owned, directly or indirectly, by Kanawha, any dividends or distributions that Kanawha receives from it are subject to state insurance regulations that limit dividends and
distributions that Kanawha can make to KMG America, and consequently, that KMG America can pay to its shareholders.
We currently intend to retain any profits to provide capacity to write insurance and reinsurance and to accumulate reserves and surplus for the payment of claims. As a result, our board of directors currently does not intend to declare dividends or make any other distributions. Our board of directors plans to periodically reevaluate our dividend policy. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our results of operations, financial condition and other factors deemed relevant by our board of directors. Consequently, it is uncertain when, if ever, we will declare dividends to our shareholders.
Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan
Prior to our initial public offering, our shareholders approved an equity compensation plan, the KMG America Corporation 2004 Equity Incentive Plan. The following table summarizes information with respect to the plan as of December 31, 2006:
Equity Compensation Plan Information
We have no equity compensation plan that has not been approved by our shareholders.
Performance Graph
The following graph is presented to compare the cumulative total return for the Corporation’s Common Stock to the cumulative total returns of the Dow Jones US Insurance Index and the S&P Smallcap 600 Index for the period from December 31, 2004 (the end of the Corporation’s short fiscal year following its initial public offering of Common Stock on December 16, 2004), through the close of the market on December 31, 2006, assuming an investment of $100 was made in the Corporation’s Common Stock and in each index on December 31, 2004, and that all dividends were reinvested.
Summary
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA.
The following table presents:
•
Selected historical consolidated financial and other data as of December 31, 2002, 2003, and 2004 for our predecessor. The historical consolidated financial data as of December 31, 2003, and for each of the two years ended December 31, 2003 have been derived from, and should be read together with, our predecessor’s audited consolidated financial statements and the related notes;
•
Selected historical financial and other data for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004, for KMG America. For such period, KMG America had insignificant operations and cash flows. See KMG America’s audited financial statements and the related notes included in this report; and
•
Selected historical consolidated financial and other data as of and for the year ended December 31, 2005 and 2006 for KMG America. The historical consolidated financial data as of December 31, 2005 and 2006, for KMG America have been derived from, and should be read together with, KMG America’s audited consolidated balance sheet and the related notes included in this report.
For GAAP accounting purposes, Kanawha is treated as our predecessor entity and is referred to in this table as our “predecessor.” For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, selected historical consolidated financial and other data as of any date prior to, or for any period ending on or prior to, December 31, 2004, are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Selected historical financial data and other data as of any date on or after, or for any period ending after, December 31, 2004, reflect GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
While Kanawha is our predecessor for accounting purposes, we caution you that the financial information presented in this report is neither comparable with nor representative of the actual results that we expect to achieve in the future. Many factors may cause our actual results to differ materially from our predecessor’s historical results including, but not limited to, the following:
•
the businesses of our predecessor are intended to be only a portion of our business in the future and are not entirely representative of the principal business strategy we plan to pursue; and
•
our acquisition of Kanawha was subject to GAAP purchase accounting, which caused us to adjust the recorded amounts of our predecessor’s assets and liabilities to fair value following the acquisition; and
•
the risk factors described in Item 1A of this report.
The financial data set forth below should be read in conjunction with, and is qualified in its entirety by reference to “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our predecessor’s and our audited financial statements and the related notes included in this report.
KMG AMERICA CORPORATION AND PREDECESSOR
SELECTED CONSOLIDATED FINANCIAL DATA
(1)
Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessor’s outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG America’s acquisition of Kanawha.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our audited financial statements and related notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly in Items 1 and 1A of this report.
Overview
KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol “KMA.” Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products.
For GAAP accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to herein as our “predecessor.” For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
Worksite insurance business. Our worksite insurance business is a provider of life and health insurance products to employers and their employees. Our predecessor's marketing and sales efforts were primarily in the southeastern United States, predominately in Florida, South Carolina and North Carolina. Since acquiring our predecessor, we have begun to implement our business strategy to market our products nationwide. The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; critical illness insurance; and employer excess risk insurance. For the year ended December 31, 2006, our worksite insurance business produced premiums, commissions and fees, excluding
intercompany payments, of $83.8 million, which accounted for 58.0% of our premiums, commissions and fees, excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which have added a new set of employer-paid life insurance, disability and health products to our existing voluntary products. Since December 2004, we have opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb and we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; Morristown, New Jersey; Atlanta, Georgia; Dallas, Texas; Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New Orleans, Louisiana; San Diego and San Francisco, California; Phoenix, Arizona; Denver, Colorado; and Minneapolis, Minnesota. We will base future expansion of our sales organization on developing market trends and our profit margins. The costs associated with any expansion of our sales organization will be recognized before we recognize revenues resulting from new sales activity. Consequently, we expect negative cash flow and operating losses in the short term.
Senior market insurance business. Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance product included in this business is long-term care insurance that we underwrote. For the year ended December 31, 2006, our senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $41.5 million, which accounted for 28.7% of our premiums, commissions and fees, excluding intercompany payments, in that period.
Effective January 1, 2006, we ceased actively underwriting long-term care insurance policies. Significant factors that contributed to our decision to cease actively underwriting long-term care insurance policies include, among others: (1) sales for this business were significantly lower than originally projected; and (2) the lack of strategic fit between the underwriting and distribution of long-term care products and our current strategy of focusing on worksite marketing of life and health insurance products. We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims).
Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the year ended December 31, 2006, our third-party administration business produced commissions and fees, excluding intercompany payments, of $16.1 million, which accounted for 11.2% of our premiums, commissions and fees, excluding intercompany payments, in that period. Our primary business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.
In addition, we have retained our predecessor’s closed block of life and health insurance business reported in the acquired business segment and the investment and marketing activities reported in the corporate and other segment. While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.
We expect to realize earnings from our investment portfolio. Insurance companies in both the life and health and property and casualty insurance industries earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid-out under the policy. Volatility in the capital markets, changes in interest rates and changes in economic conditions can all impact the amount of earnings that we will realize from our investment portfolio.
Marketplace Conditions and Trends
Described below are some of the significant recent events and trends affecting the life and health insurance industry and the possible effects they may have on our operations in the future.
•
The trend to shift health care costs to employees and rising healthcare costs in general are causing individuals to purchase a wider array of life and health insurance products. We believe these trends will result in greater demand for our voluntary worksite insurance products.
•
The worksite insurance industry is increasingly focused on integration, coordination and simplification of products and services. Human resource departments often have limited resources with which to address the significant administrative complexity associated with many worksite insurance products. Our technology based administrative solutions and coordination of sales and service of voluntary group insurance products are designed to address these issues.
•
Insurance intermediaries are consolidating throughout the United States. This increases the focus on revenue growth by intermediaries, which creates demand for our unique voluntary benefit products.
•
The volatility in the equity markets over the past few years has posed a number of problems for some participants in the life and health insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We and our predecessor have historically had minimal equity exposure (less than 1% of total invested assets as of December 31, 2006) and we plan to continue to manage equity asset allocations conservatively in the future.
•
Corporate bond defaults and credit downgrades, which have resulted in other than temporary impairment in the value of many securities, have had a material impact on life and health insurers in the past few years. While our debt investments have not been immune to corporate credit problems, losses from defaults have historically not been material to our predecessor’s financial condition. We intend to manage our investment portfolio conservatively in the future to attempt to mitigate the risk of losses from defaults.
•
Some life and health insurance companies have suffered significant reductions in capital and will have to improve their capital adequacy ratios to support their business or divest a portion of their business. We expect these trends to have a positive impact on our competitive position in the industry as carriers become more disciplined with product pricing and/or exit markets or product lines in which we will compete.
•
Many of the events and trends affecting the life and health insurance industry have had an equal (or greater) impact on the life and health reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, and we plan to continue this practice, diminishing reinsurance capacity has negatively impacted our predecessor in the past and may further negatively impact our operations in the future. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we will have to reduce our underwriting commitments.
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There is a trend of consolidation of insurance carriers, product lines and services in the insurance marketplace, which increases the likelihood that insureds or their employers will elect not to renew existing policies with their existing carrier and will purchase new policies with another carrier. This trend benefits new entrants to the insurance markets, such as KMG America, by increasing the opportunities to place new policies. Consolidation in the insurance market also reduces the number of products and service choices, which creates opportunities for insurance companies to grow by creating new and specialized insurance products to fill niches.
•
We have observed that our earnings in the first and second quarters of our fiscal year are typically less than our earnings in the third and fourth quarters of our fiscal year. This seasonality is due, in part, to the fact that a majority of our outstanding long term care insurance policies have anniversary dates in the first half of the fiscal year, and policy reserve increases, (which are reflected as an expense on our statement of operations) are made as of the policy anniversary date. We expect that this seasonality effect will diminish as our long term care policies become a smaller portion of our total liabilities, although we anticipate this seasonality effect will occur again in 2007. Also contributing to the seasonality effect is that more of our voluntary benefit sales occur in the second half of our fiscal year, which increases our revenue for that period. This seasonality effect is due, in large part, to a significant number of employers offering their employees open enrollment for benefits purchases during the last half of the calendar year.
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Pricing in the medical excess risk insurance market has proven to be cyclical, with periods of competitively lower pricing and periods of competitively higher pricing. Over the past two years, we have experienced a cycle where the market is offering this product line at competitively low prices. In order to compete in the market, we must consider offering our medical excess risk insurance product at lower prices, which may
reduce our profit margins. We have seen evidence of the excess risk insurance market firming over the past few quarters, which suggests a developing trend towards higher competitive pricing for this product line.
Critical Factors Affecting Results
Our profitability depends on the adequacy of our product pricing and underwriting, the accuracy of assumptions about future experience used in establishing reserves for future policyholder benefits and claims, returns on invested assets and our ability to manage our costs and expenses. Factors affecting these items may have a material adverse effect on our business, results of operations or financial condition. In addition, our profitability depends in large part on accurately predicting benefits, claims and other costs, including medical and dental costs. It also depends on our ability to manage future benefit and other costs through product design, underwriting criteria, utilization review or claims management and, in health and dental insurance, negotiation of favorable provider contracts. Changes in market conditions and numerous other factors may also materially adversely affect our ability to manage claim costs. As a result of one or more of these factors or other factors, claims could substantially exceed our expectations, which could have a material adverse effect on our business, results of operations or financial condition.
Critical Accounting Policies
We consider the following accounting policies to be critical due to the amount of judgment and uncertainty inherent in the application of these policies. In calculating financial statement estimates, the use of different assumptions could produce materially different estimates. In addition, if factors such as those described in Item 1A of this report cause actual events to differ from the assumptions used in applying the accounting policies and calculating financial estimates, our business, results of operations, financial condition and liquidity could be materially adversely affected.
Revenues. We derive our revenues primarily from the sale of our insurance policies and, to a lesser extent, fee income from administrative services and commissions on the placement of third-party insurance products. Sales of insurance policies are recognized in revenue when earned as insurance premiums, while sales of administrative services and commission income are recognized as fee income on our consolidated statements of operations when earned.
Our premium, fee and commission income is supplemented by income earned from our investment portfolio. We recognize revenue from interest payments, dividends and sales of investments when earned. Our investment portfolio is currently primarily invested in fixed maturity securities. Both investment income and realized capital gains on these investments can be significantly impacted by changes in interest rates.
Interest rate volatility can reduce unrealized gains or create unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, fixed maturity and short-term investments.
The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair market value 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 maturity 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. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, mortgage loan obligations and bonds in our investment portfolio are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates, and we may be required to reinvest funds in lower interest-bearing investments.
Expenses. Our expenses primarily consist of policyholder benefits, insurance commissions, premium taxes, licenses, fees, amortization of deferred acquisition costs, or DAC, and value of business acquired, or VOBA, and general insurance operating expenses.
Reserves. Policy benefit reserves and other claim reserves are established according to generally accepted actuarial principles and are based on a number of factors. These factors include historical claim payments experience
and actuarial assumptions used to estimate expected future claims experience. These assumptions and other factors include trends in claims severity, frequency and other factors discussed below, the incidence of incurred claims, the extent to which all claims have been reported and internal claims processing changes. The methods of making these estimates and establishing the related reserves are periodically reviewed and updated.
Policy benefit and claim reserves do not represent an exact calculation of our ultimate liability, but instead represent our probability-based estimate of what we expect the ultimate settlement and administration of a claim or group of claims will cost based on our assessment of facts and circumstances then known. Policy benefit reserves represent reserves established for claims not yet incurred. Claim reserves represent liabilities established for claims that have been incurred and have future benefits to be paid as of the balance sheet date. The adequacy of reserves will be impacted by future trends in claims severity, frequency and other factors including:
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changes in the economic cycle;
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the level of market interest rates and inflation;
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emerging medical perceptions regarding physiological or psychological causes of disability;
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emerging health issues and new methods of treatment or accommodation;
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legislative changes and changes in taxation;
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inherent claims volatility in a new book of business, such as our employer excess risk insurance; and
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claims handling procedures.
Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops. Adjustments to reserves, both positive and negative, are reflected in the consolidated statements of operations of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, there can be no certainty that ultimate losses will not exceed existing reserves. Future loss development could require reserves to be increased, which could have a material adverse effect on earnings in the periods in which such increases are made.
Reserving Methodology. Policy benefit reserves for life insurance, long-term care insurance, individual and group accident and health insurance, disability insurance and group life and health insurance are recorded at the present value of future benefits to be paid to policyholders less the present value of the future net premiums (this method is called the “net level premium method”). These amounts are estimated and include assumptions made when the policy is issued as to the expected investment yield, inflation, mortality, morbidity, claim termination rates, awards for social security and withdrawal rates, as well as other assumptions that are based on our experience. These assumptions reflect anticipated trends and include provisions for possible unfavorable deviations. Throughout the life of the policy, reserves are based on these original assumptions and cannot be modified pursuant to GAAP unless policy reserves prove inadequate. We also record an unearned premium reserve which represents the portion of premiums collected or due and unpaid which is intended to pay for insurance coverage in a period after the current accounting period.
Loss recognition testing of our policy benefit reserves is performed annually. This testing involves a comparison of our actual net liability position (all liabilities less DAC and VOBA) to the present value of future net cash flows calculated using then-current assumptions. These assumptions are based on our best estimate of future experience. To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of operations and a corresponding reduction in DAC or VOBA. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.
In accordance with GAAP purchase accounting requirements, our predecessor’s policy and contract reserves were recorded at fair value upon the closing of the Kanawha acquisition. The policy and contract reserves were calculated as the present value of future benefits and expenses less the present value of future net premiums. These values were actuarially determined and were based upon assumed future interest rates, administrative expenses, mortality, morbidity and policy lapse rates as appropriate for the particular benefit on the purchase date. For long-term care insurance, assumptions for the present value of net premiums in the fair value calculation are consistent with current and anticipated premium increases, including those approved in the last twelve to eighteen months in certain jurisdictions for policies currently in force. These assumptions now serve as the original assumptions described in the first paragraph above.
Reserve interest assumptions (i.e., discount rates) used by us in establishing our current policy benefit reserves were modified on the purchase date. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio. Benefit reserves for limited payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
The discount rate is the interest rate at which future net cash flows are discounted to determine the present value of such cash flows. If the discount rate chosen is higher than actual future investment returns, our investment returns will be insufficient to support the interest rate assumed when reserves were established. In this case, the reserves may eventually be insufficient to support future benefit payments. Alternatively, if a discount rate is chosen that is lower than actual future investment results, the reserves, and, for products such as long-term care insurance, the claims incurred in the current period will be overstated and profits will be accumulated in the reserves rather than reported as current earnings. We set our discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate chosen at future financial reporting dates will vary accordingly.
Deferred Acquisition Costs. The costs of acquiring new business that vary with and are primarily related to the production of new business have been deferred to the extent that these costs are deemed recoverable from future premiums or gross profits and are amortized into income as discussed below. Acquisition costs primarily consist of commissions, policy issuance expenses and some direct marketing expenses.
For most insurance products, amortization of DAC and VOBA is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. DAC is amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.
A premium deficiency is recognized immediately by a charge to the statement of operations as a reduction of DAC to the extent that future policy premiums, including anticipated interest income, are not adequate to recover all DAC and related claims, benefits and expenses. If the premium deficiency is greater than unamortized DAC, a liability will be accrued for the excess deficiency.
We eliminated all of our predecessor’s DAC upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. We began recording DAC prospectively on January 1, 2005.
Value of Business Acquired. VOBA is the value assigned to the insurance in force of acquired insurance companies or blocks of business at the date of acquisition. The amortization of VOBA is recognized using amortization schedules established at the time of the acquisitions based upon expected patterns of premiums, mortality, policy lapses, and morbidity as adjusted to take into account variances between expected and actual costs. VOBA is amortized over the expected life of the underlying business reinsured (or acquired).
We eliminated all of our predecessor’s historical VOBA upon the closing of the Kanawha acquisition as part of our application of GAAP purchase accounting requirements. We simultaneously re-established VOBA for the value of our predecessor’s in force business. VOBA interest rate assumptions to amortize the VOBA were also reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% on both December 31, 2005 and December 31, 2006.
Under our assumptions as of December 31, 2006, we estimate that the amortization of VOBA, for the next five years will be as follows:
Year Ended December 31:
Amortization
4.96%
4.93
5.24
5.23
5.14
If actual lapse and mortality experience is higher or lower than assumed for the table above, then actual amortization will be faster or slower, respectively, than indicated in the table.
Investments. We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued and that any impairment is charged against earnings in the proper period. Our investment portfolio is managed by an external asset management firm, with the exception of certain invested assets that are managed internally. Our methodology used to identify potential impairments requires judgment by us in conjunction with our investment managers.
Changes in individual security values are monitored on a monthly basis in order to identify potential problem credits. In addition, pursuant to our impairment testing process, each month the portfolio holdings are reviewed with additional screening for securities whose market price is equal to 80% or less of their original purchase price. Management then makes an assessment as to which of these securities are other than temporarily impaired. Assessment factors include, but are not limited to, the financial condition and rating of the issuer, any collateral held and the length of time the market value of the security has been below cost. Each month the watch list is distributed to our investment committee and the outside investment managers, and discussions are held as needed in order to make any impairment decisions. Each quarter any security deemed to have been other than temporarily impaired is written down to its then current market value, with the amount of the write-down reflected in the statement of operations for that quarter. Previously impaired issues are also monitored monthly, with additional write-downs taken quarterly if necessary.
There are risks and uncertainties involved in making these judgments. Changes in circumstances and critical factors such as a continued weak economy, a pronounced economic downturn or unforeseen events which affect one or more companies, industry sectors or countries could result in additional write-downs in future periods for impairments that are deemed to be other-than-temporary.
Reinsurance. As part of our overall risk and capacity management strategy, we purchase reinsurance for loss protection to manage individual and aggregate risk exposure and concentration, to free up capital to allow us to write additional business and, in some cases, effect business dispositions. We utilize ceded reinsurance for those product lines where there is exposure on a per risk basis or in the aggregate which exceeds our internal risk retention and concentration management guidelines.
Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in our and our predecessor’s consolidated balance sheets.
Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006, 2005 and 2004, there were no allowances for doubtful accounts.
Results of Operations
Consolidated Overview. The following table presents:
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Historical consolidated financial information for the year ended December 31, 2004 for our predecessor.
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Historical consolidated financial information for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004 and for the years ended December 31, 2005 and 2006, for KMG America.
For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
(1)
Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessor’s outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG America’s acquisition of Kanawha.
(2)
The benefits to premiums ratio is equal to policyholder benefits divided by insurance premiums.
Discussion of Results by Business Segment
The following section discusses significant factors that impact our revenues and insurance underwriting results segregated into the following five business segments:
Worksite insurance business. The worksite insurance business provides life and health insurance products to employers and their employees. This business segment includes worksite business as well as individual insurance business sold directly to the end consumer and not considered part of the senior market business. The primary insurance products sold by this business include life, short-term disability, long-term disability, dental, indemnity health, employer excess risk and critical illness. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums. The worksite insurance business also includes business sold through our career agency distribution channel, which is a group of agents and managers that are our employees that sell life and health insurance products directly to individuals and small businesses.
Senior market insurance business. Throughout the reporting period, the senior market insurance business provided individual insurance products, primarily long-term care insurance, tailored to the needs of older
individuals. The level of operating earnings reported in any period during the reporting period for our senior market insurance business generally depended on growth in underwritten business, business mix, risk concentration, the ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues were generated primarily from new and renewal premiums. As a result of our decision to cease actively underwriting long-term care insurance after December 31, 2005, operating earnings from this business segment will be dependent on our ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues will be generated primarily from renewal premiums.
Third-party administration business. The third-party administration business provides administrative services to both the worksite insurance business and the senior insurance market business, as well as to third parties such as employers with self-funded insured health plans, other insurance carriers who do not administer the plans they offer, reinsurers and managed care plans. Fees paid by our insurance operations to our third-party administrative services subsidiary are eliminated in our consolidated financial statements. Fees received from third parties for these services are recorded as commissions and fee income in our consolidated statements of operations. Costs associated with the operation of this business primarily reflect general overhead expenses and related information technology costs that are reflected in our consolidated statements of operations as general insurance expenses.
Acquired business. Our predecessor obtained over time through assumption and indemnity reinsurance transactions, a number of blocks of life and health insurance business in which it has since elected to discontinue accepting new business. Revenue from this business reflects renewal premiums and other considerations on business in force that will continue to decline over time as policies lapse. The earnings generated by acquired blocks of business in any period will be affected by, among other things, historical pricing levels together with approved premium rate increases if any, diversification of the underlying insurance policies, persistency and loss frequency and severity.
Corporate and other. The corporate and other segment includes investment income earned on the investment portfolio related to capital and surplus not allocated to the insurance segments. This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily deferred compensation and incentive compensation costs, and other unallocated immaterial items. The results of this business segment are reflected in the following discussions of net investment income, realized investment gains and losses, and general insurance expenses.
Definitions of Insurance Terms
The following list includes definitions of insurance terms used in the discussion of our consolidated results of operations. Terms are listed in alphabetical order.
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Amortization of DAC and VOBA: DAC relating to most insurance products is amortized over the premium-paying period of related policies in a manner consistent with the establishment of benefit reserves. The amortization of VOBA is comparable to the amortization of DAC and is recognized using amortization schedules established at the time of acquisition based upon expected patterns of premiums, mortality, policy lapses and morbidity, and adjustments are made to take into account certain variances between expected and actual costs.
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Assumed Premiums: Assumed premiums represent premiums written and issued by other insurance companies and subsequently reinsured by us.
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Benefits and expenses: Benefits and expenses consist primarily of policyholder benefits, insurance commissions, general insurance expenses, insurance taxes, licenses and fees, depreciation and amortization and the amortization of DAC and VOBA.
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Benefits to premiums ratio: Benefits to premiums ratio equals policyholder benefits divided by net premiums. In general, an increase in the ratio indicates a decrease in underwriting margins of the relevant business segment. Conversely, a decrease in the ratio generally indicates an increase in underwriting margins for the relevant business segment. Our management believes that this ratio is more meaningful in evaluating the changes in underwriting margins on our products from period to period than comparing absolute dollar changes in premiums and reserves because growth in net premiums produces corresponding increases in reserves.
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Ceded Premiums: Ceded premiums represent premiums either written by or assumed by us and subsequently reinsured by other insurance companies.
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Commission and fee income: Commission and fee income consists of the commissions received by our insurance marketing business for the sale by us of insurance products underwritten by other insurance companies and fees generated by our third-party administration business. In addition, both of these businesses provide services to us. The commission and fee income for services that these businesses provide to us is eliminated from the financial statement amounts referenced in this report.
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Depreciation and amortization: This item includes depreciation of fixed assets such as information technology hardware and amortization of intangible assets such as software licenses. This item is not discussed in detail in this Management’s Discussion and Analysis of Financial Condition and Results of Operations because it does not generally fluctuate significantly from period to period and is not a significant performance statistic considered by our management.
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Direct Premiums: Direct premiums represent premiums on insurance products written and issued by us.
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General insurance expenses: General insurance expenses include primarily selling, general and administrative expenses incurred by corporate headquarters personnel in conducting operations including marketing, policy set-up, administration, adjudication and customer service.
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Insurance commissions: Insurance commissions represent renewal commissions on products after the first anniversary date as well as first year commissions that are not deferred.
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Insurance taxes, licenses and fees: Insurance taxes, licenses and fees are primarily comprised of employment taxes, premium taxes and various filing fees required by the jurisdictions in which we do business.
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Net premiums: Net premiums represent the sum of direct premiums and assumed premiums, less ceded premiums.
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New premiums: New premiums represent premiums collected within the first twelve months following the initial policy date.
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New sales: New sales represent annualized premiums on new policies issued.
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Other income: Other income is comprised primarily of commission and expense allowances from reinsurance companies relating to insurance ceded from us to the reinsurance companies.
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Other Operating Measures: These are measures that do not appear in the consolidated statement of operations, but are used by our management to evaluate our operating results.
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Policyholder benefits: Policyholder benefits consist of the policy benefit claims paid to policyholders and the increase or decrease in benefit reserves. The primary factors affecting policyholder benefits are premium growth, claims experience and reserve assumptions including persistency, morbidity, mortality and interest rates.
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Premiums: Premiums are categorized as direct, assumed, ceded, and net. Each of these categories are further categorized as new or renewal.
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Renewal premiums: Renewal premiums represent the premiums derived from policies greater than twelve months from the original policy date.
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Revenues: Revenues consist primarily of premiums, net investment income, commission and fee income, realized investment gains and losses and other income.
Consolidated Results of Operations
The following discussion reflects our and our predecessor’s results for the years ended December 31, 2006, 2005, and 2004.
We were incorporated on January 21, 2004, and completed our initial public offering of common stock on December 21, 2004.
Concurrently with the completion of our initial public offering, we completed the acquisition of Kanawha and its subsidiaries. For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material.
Our future results may not be consistent with the historical results of our predecessor. The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report.
The following represents a summary of our and our predecessor’s statement of operations and asset composition by reportable segment. Except as noted, the financial statement information of the Predecessor set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition of the predecessor.
During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors. While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments. This reallocation has been reflected in the current results of the affected segments.
The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings results from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.
This reallocation of reserves between business segments does impact the comparability of the current reported policyholder benefits and the resulting reported benefit ratios by segment.
(1) KMG America at December 31, 2004, adjusted for purchase accounting adjustments to reflect the Kanawha acquisition.
(2)Aggregate total assets for our predecessor as of December 31, 2004, is not reported because our predecessor had been acquired by KMG America at that date and our predecessor’s assets had been consolidated into the KMG America balance sheet at that date.
Year Ended December 31, 2006, Compared to Year Ended December 31, 2005
Financial Results Overview. Net income for the year ended December 31, 2006, increased $ 2.5 million, or 53.2%, to $ 7.2 million from net income of $ 4.7 million in 2005.The increase in net income was primarily due to increases in premiums, net investment income, and net realized gains, offset by increases in policyholder benefits and general expenses, all of which are described in greater detail below.
Revenues. Total revenues for the year ended December 31, 2006, increased $27.7 million, or 18.1%, to $181.1 million from total revenues of $153.4 million in 2005. The primary factors causing the fluctuations are explained below under the captions “Premiums,” “Net Investment Income” “Commission and Fee Income” “Realized Investment Gains and Losses” and “Other Income”.
Premiums. The following table presents the distribution of premiums by type and business segment.
Worksite net new premiums increased $22.1 million, or 133.9%, to $38.6 million for the year ended December 31, 2006, from $16.5 million for the year ended December 31, 2005, due to increased sales volumes generated by the new KMG America sales force. There were direct new premiums of $44.7 million, offset by $8.8 million of ceded new premiums. In addition, there was $2.7 million of new reinsurance assumed premium for the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.
Effective September 1, 2006, KMG America’s subsidiaries Kanawha and Kanawha HealthCare Solutions entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (“CLIC”) and Columbian Mutual Life Insurance Company (“CMLIC”). CLIC and CMLIC are affiliates of each other. Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC. Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, “UNIQ Benefit Solutions”.
Senior market net new premiums decreased $0.5 million, or 62.5%, to $0.3 million for the year ended December 31, 2006, from $0.8 million for the year ended December 31, 2005 due to decreased sales volumes as the Company effective December 31, 2005, ceased actively underwriting new long term care policies. Sales in 2006 result from business submitted prior to December 31, 2005 and issued in 2006, as well as the exercise of guaranteed purchase options on in force policies. Net renewal premiums decreased $ 0.2 million, or 0.5% to $41.2 million for the year ended December 31, 2006, from $41.4 million for the year ended December 31, 2005. This business represents the insurance in force created by prior year sales.
Acquired business premiums decreased $1.4 million, or 34.1%, to $2.7 million for the year ended December 31, 2006 from $4.1 million for the year ended December 31, 2005. We have not acquired any blocks of business in this segment since 1999 and the decline is a result of policy lapses.
Net Investment Income. Net investment income increased $2.2 million, or 7.9%, to $29.9 million in the year ended December 31, 2006, from $27.7 million in the year ended December 31, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income in 2006 occurred primarily as a result of investing in longer term securities in combination with higher interest rates in 2006. Cash and invested assets on an amortized cost basis increased $7.3 million, or 1.3%, to $590.9 million as of December 31, 2006, from $583.6 million as of December 31, 2005. Generally, an increase in invested assets is due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.
The average yield on cash and invested assets on an amortized cost basis was 5.06 % for the year ended December 31, 2006, compared to an average yield of 4.78 % for the year ended December 31, 2005. This increase resulted from higher interest rates combined with the significantly lesser amount of assets held in cash during 2006.
Net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment. Assets attributed to the senior market insurance segment continue to increase as a result of policy reserve increases in this segment, while assets attributed to the acquired segment continue to decline as this business lapses. In addition, the reallocation of reserves has a corresponding reallocation of attributed assets between business segments. This balance sheet impact is further discussed in Note 16 Business Segments,” of the “Notes to Consolidated Financial Statements” included in this report, which is incorporated herein by reference.
Commission and Fee Income. Commission and fee income increased $1.9 million, or 13.0%, to $16.5 million for the year ended December 31, 2006, from $14.6 million for the year ended December 31, 2005. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increased sales of our administrative services.
Realized Investment Gains and Losses. Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2006 increased by $0.8 million to $1.2 million from $0.4 million in the year ended December 31, 2005. The net loss realized on fixed maturity securities in the year ended December 31, 2006, totaled $0.6 million compared to a net gain realized on fixed maturity securities of $0.1 million in the year ended December 31, 2005. The capital losses recognized in 2006 resulted from the sale of assets as is necessary from time to time in order to keep the portfolio properly structured. Offsetting these capital losses in 2006 were capital gains of $0.6 million which were recognized due to marking to market investments held in the Company’s trading account. These investments represent the assets purchased to support the deferred compensation liability of the Company, and realized gains and/ or losses are directly offset with increases and /or decreases in compensation expenses. Also, there was recognition of $1.3 million of additional capital gains in 2006 as the result of the sale of our investment in a limited liability company owned by a subsidiary of Kanawha Insurance Company. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Gain on extinguishment of debt. In the fourth quarter of 2006 the Company realized a $1.0 million gain on the payoff of its subordinated promissory note to the former owners of Kanawha.
Other Income. Other income increased $0.6 million, or 15.4%, to $4.5 million in the year ended December 31, 2006, from $3.9 million in the year ended December 31, 2005, reflecting increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums. Also, there was $0.2 million of other income from the new reinsurance assumed universal life policies’ premium loads and fees for the block acquisition from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.
Benefits and Expenses. Total benefits and expenses increased $23.2 million, or 15.8 %, to $170.0 million in the year ended December 31, 2006, from $146.8 million in the year ended December 31, 2005. The primary factors causing this increase are explained below under the captions “Policyholder Benefits”, “Insurance Commissions”, “General Insurance Expenses”, “Insurance Taxes, Licenses and Fees” and “Amortization of DAC and VOBA.”
Policyholder Benefits. Policyholder benefits increased $15.5 million, or 18.4 %, to $99.8 million in the year ended December 31, 2006, from $84.3 million in the year ended December 31, 2005. This produced a benefits to premium ratio of 78.0 % in 2006 compared to 78.9 % in 2005. The primary drivers behind the benefits to premium ratio change by segment is discussed in the next three paragraphs.
Worksite marketing policyholder benefits increased $12.1 million, or 27.8%, to $55.7 million for the year ended December 31, 2006, from $43.6 million for the year ended December 31, 2005. This produced a benefits to premium ratios of 66.4% for the year ended December 31, 2006, compared to 72.0% for the year ended December 31, 2005. The 2006 ratio is impacted by the $6.3 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006 , and resulted in decreased benefits coupled with an increase in new premiums with more favorable benefit ratios. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 73.9%. The unfavorable benefit experience in the worksite segment is driven by a few factors. The Company increased loss reserves on its stop loss cases by $2.0 million in the fourth quarter of 2006 related to the continued transition from formula reserving to actual claims experience as claims associated with cases written in 2005 and early 2006 continue to exceed pricing expectations. The Company had also recognized additional loss reserves of $0.9 million in the third quarter of 2006. Volatility, both favorable and unfavorable, is not uncommon in small, growing books of business. Cases giving rise to these excess claims have since been re- priced or did not renew.
Senior market policyholder benefits increased $33.3 million, or 94.1%, to $68.7 million for the year ended December 31, 2006, from $35.4 million for the year ended December 31, 2005. This produced a benefits to premium ratios of 165.7% for the year ended December 31, 2006, compared to 83.7% for the year ended December 31, 2005. The 2006 ratio is impacted by the $37.5 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006, and resulted in increased benefits. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 75.3%.
Acquired business policyholder benefits decreased $29.9 million to $(24.5) million for the year ended December 31, 2006, from $5.4 million for the year ended December 31, 2005. This produced benefits to premium ratios of (913.5)% for the year ended December 31, 2006, compared to 130.5% for the year ended December 31, 2005. The 2006 ratio is impacted by the $31.2 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006, and resulted in decreased benefits. Also, coupled with this is the fact that these benefits to premium ratios are impacted by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 248.9%.
Insurance Commissions. Commission expenses increased $3.1 million, or 32.3%, to $12.7 million in the year ended December 31, 2006, from $9.6 million in the year ended December 31, 2005. The increase consists of normal increases related to increased renewal premiums, in addition to an increase in first year commissions that were not deferred, a large portion of which relates to the increased sales of excess risk products.
General Insurance Expenses. General insurance expenses increased $3.5 million, or 8.4%, to $45.4 million in the year ended December 31, 2006, from $41.9 million in the year ended December 31, 2005. The increased expenses in the year ended December 31, 2006, are primarily attributable to increases in salaries and related benefits due to the additional staff associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel. Also, there was the recognition of employee and director stock option and common stock expense of $1.4 million as a result of the adoption of SFAS123(R) - Share Based Compensation. Fourth quarter 2006 expenses include a one-time pretax benefit of $1.0 million related to the discount associated with retiring and replacing the Company's $15 million subordinated note with bank debt.
Insurance Taxes, Licenses and Fees. Insurance taxes, licenses and fees increased $0.6 million, or 12.8%, to $5.3 million in the year ended December 31, 2006 from $4.7 million in the year ended December 31, 2005. The increase is driven by employment taxes related to additional staffing and additional premium taxes due to the increased premiums primarily as a result of new business in the worksite segment.
Amortization of DAC and VOBA. First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $15.6 million and $15.0 million for the years ended December 31, 2006 and 2005, respectively. The increase in deferrals was primarily due to the increase in net new premiums and the associated increase in commissions and expenses in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior segment.
The amortization of deferred acquisition costs (“DAC”) and the value of business acquired (“VOBA”) increased $0.6 million, or 17.1%, to $4.1 million for the year ended December 31, 2006, from $3.5 million for the year ended December 31, 2005. The DAC balance at December 31, 2006 has increased by $14.5 million, or 103.6%, over the balance at December 31, 2005. This is due to the fact that our predecessor’s DAC balance was eliminated at December 31, 2004, when the acquisition was completed. Therefore, as of December 31, 2005 there was only one year of deferrals compared to two years of deferrals as of December 31, 2006. The increase in the DAC balance accounts for the related increase in amortization expense.
Provision for Income Taxes. Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2006, and 2005 were 34.8 % and 32.2 % respectively. The variations in these rates are due to the fact that a portion of our consolidated income for the years ended December 31, 2006 and December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company. The variation in the overall consolidated rate between periods is driven by the level of the subsidiary’s contribution to total income.
Year Ended December 31, 2005, Compared to Year Ended December 31, 2004
Financial Results Overview. Net income for the year ended December 31, 2005, decreased $1.5 million, or 24.2%, to $4.7 million from net income of $6.2 million in 2004. The decrease in net income was primarily due to decreases in revenues as the result of decreases in net realized gains offset by increases in premiums. In addition there were increases in expenses offset by decreases in policyholder benefits, all of which are described in greater detail below.
Revenues. Total revenues for the year ended December 31, 2005, decreased $0.7 million, or 0.5%, to $153.4 million from total revenues of $154.1 million in 2004. The primary factors causing the fluctuations are explained below under the captions “Premiums,” “Net Investment Income” “Commission and Fee Income” “Realized Investment Gains and Losses” and “Other Income”.
Premiums. The following table presents the distribution of premiums by type and business segment.
Worksite net new premiums increased $3.8 million, or 29.9%, to $16.5 million for the year ended December 31, 2005, from $12.7 million for the year ended December 31, 2004, due to increased sales volumes. New sales increased $1.7 million, or 12.8%, to $15.0 million in the year ended December 31, 2005, from $13.3 million in the year ended December 31, 2004, due to increased emphasis on this core business segment. Net renewal premiums increased $0.4 million, or 0.9%, due to the increased amount of insurance in force created by prior year sales.
Senior market net new premiums decreased $0.8 million, or 50.0%, to $0.8 million for the year ended December 31, 2005, from $1.6 million for the year ended December 31, 2004, due to a decrease in new sales. New
sales decreased $1.7 million, or 53.1%, to $1.5 million in the year ended December 31, 2005, from $3.2 million in the year ended December 31, 2004. A sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums, continued into 2005. In addition, decisions were made to no longer actively underwrite long term care insurance policies after December 31, 2005 and to close our primary long term care distribution office in October, 2005. We intend to retain and actively manage the existing in force block of long term care. Net renewal premiums increased $0.9 million, or 2.2%, due to the increased amount of insurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.
Acquired business premiums decreased $0.5 million, or 10.9%, to $4.1 million for the year ended December 31, 2005, from $4.6 million for the year ended December 31, 2004. Neither we nor our predecessor has acquired any blocks of business since 1999 and the decline is a result of policy lapses.
Net Investment Income. Net investment income increased $2.5 million, or 9.9%, to $27.7 million in the year ended December 31, 2005, from $25.2 million in the year ended December 31, 2004. Net investment income for 2004 was negatively impacted by a non-recurring $1.6 million incentive payment to one of Kanawha’s outside investment managers at the conclusion of the contract period. Excluding this item, net investment income increased $0.9 million in the year ended December 31, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income in 2005 occurred as a result of an increase in total cash and investments of approximately $58.0 million that occurred in conjunction with the completion of our initial public offering on December 21, 2004. These proceeds were held in short term investments or cash equivalents for the majority of 2005, which produced lower effective yields for that portion of the portfolio. Invested assets increased by $82.2 million or 17.8%, to $543.3 million as of December 31, 2005, from $461.1 million as of December 31, 2004, reflecting the investment of cash generated by 2004 asset sales and our initial public offering. Generally, increases in cash and invested assets are due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.
The average yield on cash and invested assets on an amortized cost basis was 4.78% for the year ended December 31, 2005, compared to an average yield of 5.14% for the year ended December 31, 2004, excluding the effects of the non-recurring $1.6 million incentive payment to one of Kanawha’s outside investment managers. This decline resulted from lower interest rates combined with the significantly larger amount of assets held in cash for a significant period of time during the year ended December 31, 2005. The incentive payment made in 2004 was charged directly to the corporate and other segment, while all other net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment.
In conjunction with the application of GAAP purchase accounting requirements, assets attributed to the worksite insurance business, the senior insurance business and the acquired business all increased at December 31, 2004. For 2005, total assets attributed to the worksite insurance business have not experienced any significant fluctuations. Total assets attributed to the senior market insurance business have increased significantly due to the accumulation of long-term care insurance premiums retained to establish policy reserves for the payment of future policyholder benefits. Assets attributed to the third-party administration business consist primarily of operating cash and receivables with respect to administrative claims payments awaiting settlement. These assets are subject to significant variations due to timing of payments made, and there is no investment income attributed to them. Assets attributed to the acquired business have declined since 1999 as a result of policy lapses and the fact that no blocks of business have been acquired since 1999. Assets attributed to the corporate and other segment are subject to significant fluctuations because changes in unrealized gains are all allocated to the corporate and other segment.
Commission and Fee Income. Commission and fee income increased $1.1 million, or 8.1%, to $14.6 million for the year ended December 31, 2005, from $13.5 million for the year ended December 31, 2004. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increased sales of our administrative services.
Realized Investment Gains and Losses. Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2005 decreased by $9.0 million to $0.4 million from $9.4 million in the year ended December 31, 2004. The net gain realized on fixed maturity securities in the year ended December 31, 2005, totaled $0.1million compared to a net gain realized on fixed maturity securities of $7.1 million in the year ended December 31, 2004. In 2004, our predecessor’s investment committee elected to take advantage of favorable market conditions for fixed maturity securities by
selling certain fixed maturity securities to recognize gains. Realized gains on fixed maturity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.2 million and $0.5 million, respectively. The net gain realized on equity securities in the year ended December 31, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the year ended December 31, 2004. The 2004 gains on equity securities were due to our predecessor’s investment committee’s election to take advantage of favorable market conditions by selling certain common stocks to recognize gains on these sales. Realized gains on equity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.0 million and $0.2 million, respectively. The net gain realized on other investments in the year ended December 31, 2005, totaled $0.2 million compared to a net gain realized on other investments of $0.4 million for the year ended December 31, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Other Income. Other income increased $0.8 million, or 25.8%, to $3.9 million in the year ended December 31, 2005, from $3.1million in the year ended December 31, 2004. In 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigation matters. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.
Benefits and Expenses. Total benefits and expenses increased $2.5 million, or 1.7%, to $146.8 million in the year ended December 31, 2005, from $144.3 million in the year ended December 31, 2004. The primary factors causing this increase are explained below under the captions “Policyholder Benefits”, “Insurance Commissions”, “General Insurance Expenses”, “Insurance Taxes, Licenses and Fees” and “Amortization of DAC and VOBA.”
Policyholder Benefits. Policyholder benefits decreased $5.9 million, or 6.5 %, to $84.3 million in the year ended December 31, 2005, from $90.2 million in the year ended December 31, 2004. This produced a benefits to premium ratio of 78.9% in 2005 compared to 87.7% in 2004. The benefits to premium ratio declined primarily as a result of the GAAP purchase accounting adjustments described in the next three paragraphs.
Worksite marketing policyholder benefits decreased $0.7 million, or 1.6 %, to $43.6 million for the year ended December 31, 2005, from $44.3 million for the year ended December 31, 2004. This produced benefits to premium ratios of 72.0 % for the year ended December 31, 2005, compared to 78.7% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.
Senior market policyholder benefits decreased $0.4 million, or 1.1 %, to $35.4 million for the year ended December 31, 2005, from $35.8 million for the year ended December 31, 2004. This produced benefits to premium ratios of 83.7% for the year ended December 31, 2005, compared to 85.2% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by an increase in open active claims due to an increase in the number of policies in force and the aging of our policyholders, which resulted in increases in actual claims paid and additional claims reserves.
Acquired business policyholder benefits decreased $4.7 million, or 46.5%, to $5.4 million for the year ended December 31, 2005, from $10.1 million for the year ended December 31, 2004. This produced benefits to premium ratios of 130.5% for the year ended December 31, 2005, compared to 225.1% for the year ended December 31, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.
Insurance Commissions. Commission expenses decreased $0.1 million, or 1.0 %, to $9.6 million in the year ended December 31, 2005, from $9.7 million in the year ended December 31, 2004. This change resulted from normal fluctuations related to renewal premiums.
General Insurance Expenses. General insurance expenses increased $14.1million, or 50.7%, to $41.9 million in the year ended December 31, 2005, from $27.8 million in the year ended December 31, 2004. General insurance expenses for 2005 include approximately $13.3 million of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors. During 2005, we incurred $0.7 million in defense costs related to the ReliaStar litigation and shut down costs of $0.3 million associated with the sale of our Ft. Myers based senior market insurance agency office. We also incurred deferred compensation expenses of $0.2 million associated with the increase in market value of the deferred compensation plan assets. The deferred compensation expenses are directly offset with realized investment gains of the same amount.
Insurance Taxes, Licenses and Fees. Insurance taxes, licenses and fees were unchanged at $4.7 million in the years ended December 31, 2005 and 2004. Premium income, which drives premium taxes, was relatively flat between 2005 and 2004.
Amortization of DAC and VOBA. First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $15.0 million and $13.1 million for the years ended December 31, 2005 and 2004, respectively. The increase in deferrals was primarily due to the increase in net new premiums in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior market.
Our predecessor assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in 2005 or 2004.
The amortization of DAC and VOBA decreased $6.0 million, or 63.2%, to $3.5 million for the year ended December 31, 2005, from $9.5 million for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, our predecessor’s DAC and VOBA were eliminated, and a new VOBA was established for the value of the in-force business as of December 31, 2004. This adjustment resulted in decreased DAC and VOBA balances, which cause smaller amortization charges going forward.
Provision for Income Taxes. Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2005, and 2004 were 32.2% and 36.5%, respectively. The variations in these rates is due to the fact that a portion of our consolidated income for the year ended December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company.
The following table shows the carrying value of our investments by type of security as of the dates indicated.
Of the fixed maturity securities shown above, 77.3% and 77.6% (based on total carrying value), were invested in securities rated “A” or better as of December 31, 2006, and 2005, respectively.
The following table provides the cumulative net unrealized gains (pre-tax) on the Company’s fixed maturity securities and equity securities as of the dates indicated.
Net unrealized losses on fixed maturity securities were $10.9 million as of December 31, 2006 and $7.7 million as of December 31, 2005.
Effective December 31, 2004, our investments were recorded at fair value, thereby eliminating all unrealized gains and losses, as part of the application of GAAP purchase accounting requirements. As a result, the mark to market adjustments to the investment portfolio occurred at a time when very low market interest rates prevailed. Therefore, as interest rates rise, we would expect substantial unrealized investment losses. Due to the long range nature of our liabilities, the majority of these interest related unrealized losses are not expected to materialize into realized losses, and therefore should not have an adverse effect on our operations.
Unrealized losses were reviewed for other than temporary impairment in conjunction with our investment policies. Impairment charges of $0.0 million and $0.2 million were taken in 2006 and 2005, respectively.
Loss Impairment. All fixed maturity securities are classified as available-for-sale and marked to market through other comprehensive income. All securities with gross unrealized losses at the consolidated balance sheet date are subjected to our process for identifying other-than-temporary impairments. Securities deemed to be other-than-temporarily impaired are written down to fair value in the period the securities are deemed to be so impaired. The assessment of whether such impairment has occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. Management considers a wide range of factors, as described below, about the issuer of the security and uses its best judgment in evaluating the cause of the decline in
the estimated fair value of the security and in assessing its prospects for near term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential.
Considerations used by management in the impairment evaluation process include, but are not limited to, the following:
•
length of time and the extent to which the market value of the security has been below amortized cost;
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when the issuer is experiencing significant financial difficulties, a review of all securities of the issuer, including its known subsidiaries and affiliates;
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conditions of the industry sector or subsector in which the issuer operates;
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economic conditions in the issuer’s geographic location;
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catastrophic loss suffered by the issuer or the industry in which the issuer operates; and
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other subjective factors, including information obtained from regulators and rating agencies.
The review of fixed maturity securities for impairments includes an analysis of the total gross unrealized losses for three categories of securities: (1) securities where the estimated fair value had declined and remained below amortized cost by less than 20%; (2) securities where the estimated fair value had declined and remained below amortized cost by 20% or more for less than six months; and (3) securities where the estimated value had declined and remained below amortized cost by 20% or more for six months or greater. Securities in the first two categories have generally been adversely impacted by the downturn in the financial markets, overall economic conditions and certain industry trends. The first category generally includes securities that have declined in value as a result of fluctuations in interest rates, rather than due to difficulties experienced by the issuer of the securities. While all of these securities are monitored for potential impairment, our experience indicates that securities in the first two categories do not present as great a risk of impairment and securities in these categories often recover their fair value over time as the factors that caused the declines improve. In addition, the Company has the intent and ability to hold these securities until they recover in value.
Writedowns are recorded as investment losses and the cost bases of the securities are adjusted accordingly. The revised cost basis is not changed for subsequent recoveries in value. Writedowns of fixed maturities were $0.0 million and $0.2 million for the years ended December 31, 2006 and 2005, respectively. The writedowns in 2005 reflected other than temporary impairments on Delta Airlines and Triton Aviation fixed income securities. Both of these securities were impacted by the negative conditions affecting the airline industry generally.
Reserves
The following table presents insurance policy benefit and contract-related liabilities information as of the dates indicated, by reserve type:
Life and annuity reserves decreased by $46.8 million, or 15.6%, to $252.7 million as of December 31, 2006, from $299.5 million as of December 31, 2005. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999, and therefore represents a significant portion of the decrease in reserves for the year ended December 31, 2006 as well as the conversion to PGAAP seriatim reserves ( Refer to Note 16 - Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference for further explanation). Accident and health reserves increased by $66.9 million or 29.4%, to $294.6 million as of December 31, 2006, from $227.7 million as of December 31, 2005. These reserve increases are consistent with
growth in the underlying business, with the majority of the reserve growth being accumulated from long-term care renewal premiums received as well as the conversion to PGAAP seriatim reserves (refer to Note 16 - Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference for further explanation).
Policy and contract claims, which represent liabilities for actual claims reported and payable, increased by $4.5 million, or 45.2%, to $14.5 million as of December 31, 2006, from $10.0 million as of December 31, 2005. The majority of the increase represents claim reserves established for the new excess risk business sold in 2005 and early 2006. Although there are always fluctuations in policy and contract claim reserves from period to period, we are not aware of other significant events or trends for the periods discussed in this paragraph that would produce any material changes in our claim reserves.
Other policyholder liabilities, which are comprised primarily of dividend accumulations and advance premiums, decreased by $0.1 million, or 1.2%, to $10.6 million as of December 31, 2006, from $10.7 million as of December 31, 2005.
Participating Policies
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Company’s total ordinary life insurance in force at December 31, 2006, and 2005. Dividends paid to policyholders in 2006, 2005, and 2004 were approximately $1.5 million, $2.1 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 39% in 2006, 46% in 2005, and 51% in 2004.
Ceded Reinsurance
As part of our overall risk and capacity management strategy, we purchase reinsurance for loss protection, to manage individual and aggregate risk exposure and concentration, to free up capital to allow us to write additional business and, in some cases, effect business dispositions. We utilize ceded reinsurance for those product lines where there is exposure on a per risk basis or in the aggregate which exceeds our internal risk retention and concentration management guidelines.
Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in the consolidated balance sheets.
The following table sets forth reinsurance recoverables by category as of the dates indicated:
Reinsurance recoverables increased by $10.8 million, or 13.8 %, to $89.1 million as of December 31, 2006, from $78.3 million as of December 31, 2005. The increase in the recoverable balance is attributable to underlying business growth, specifically the growth in long-term care and excess risk business reinsured.
Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to
monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006 and 2005, there was no allowance for doubtful accounts.
The following table sets forth our individual reinsurance recoverables exposure to specific reinsurers and their corresponding A.M. Best financial strength rating as of December 31, 2006:
Liquidity and Capital Resources
KMG America is a holding company and had minimal operations of its own prior to the completion of its initial public offering and the Kanawha acquisition. KMG America’s assets consist primarily of the capital stock of Kanawha and its non-insurance subsidiary. Accordingly, KMG America’s cash flows depend upon the availability of dividends and other statutorily permissible payments, such as payments under tax allocation agreements and under management agreements, from Kanawha. Kanawha’s ability to pay dividends and to make other payments is limited primarily by applicable laws and regulations of South Carolina, the state in which Kanawha is domiciled, which subjects insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that Kanawha, KMG America’s insurance subsidiary, maintain minimum solvency requirements and limit the amount of dividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offered and rating agency status are some of the factors used in determining the amount of capital available for dividends. In general, South Carolina will permit annual dividends from insurance operations equal to the greater of (1) the most recent calendar year’s statutory net income or (2) 10% of total capital and surplus of the insurance operations at the end of the previous calendar year, provided that the dividend payment does not exceed earned surplus, in which case further limitations apply.
For 2007, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $7.2 million. If KMG America is able to successfully execute its business plan and accelerate Kanawha’s earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG America’s ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.
The primary sources of funds for KMG America’s subsidiaries consist of insurance premiums and other considerations, fees and commissions collected, proceeds from the sales and maturity of investments and investment income. Cash is primarily used to pay insurance claims, agent commissions, operating expenses, product surrenders and withdrawals and taxes. KMG America generally invests its subsidiaries’ excess funds in order to generate income. The primary use of dividends and other distributions from subsidiaries to KMG America will be to pay certain expenses of the holding company. We currently have no intention of paying dividends to our shareholders and will reinvest cash flows from operations into our businesses for the foreseeable future.
On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition. The remaining $1.0 million available under the credit facility may be used to finance the Company’s working capital, liquidity needs and general working requirements and those of its subsidiaries. Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Company’s option, a base rate or the LIBOR rate plus an applicable percentage. The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing. Wachovia’s obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007. As of December 31, 2006, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an initial interest rate of 6.60%.
The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha. The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business. The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.
On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York ("ReliaStar"), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs. We believe the plaintiffs' allegations are without merit and intend to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on our consolidated financial position or results of operations. We have been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse us for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation. We also have received partial reimbursement under the insurance policy for defense costs incurred to date. As a result, we expect that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on the Company’s future consolidated financial position or results of operations. For a discussion of the litigation involving ReliaStar, see the fourth paragraph of "Note 13 Commitments and Contingencies" of the "Notes to Consolidated Financial Statements" included in this report, which is incorporated hereby by reference.
While our primary focus is organic growth of our existing businesses by expanding our product and marketing capabilities, we do evaluate opportunities to grow through strategic alliances and acquisitions of blocks of business and/or companies that are compatible with our core businesses. If such opportunities arise we may make significant capital expenditures or acquisitions in 2007 or subsequent years. However, our primary focus is on significantly expanding outlays relating to marketing and sales activities over the next several years including outlays required to continue to build a national sales organization, which is a key component of our strategy. These outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial,
actuarial and underwriting personnel, infrastructure development and back-office expenses, as well as costs associated with our being a public company.
We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale.
Analysis of Change in Financial Condition and Cash Flows
The nature of the life insurance business is that premiums are collected and invested and will be used for the payment of claims when they arise, and policy reserve liabilities are established in anticipation of these future claims. As a result, the change in financial condition directly corresponds to the cash flows and they are discussed here in tandem.
We monitor cash flows at both the consolidated and subsidiary levels. Cash flow forecasts at the consolidated and subsidiary levels are provided on a monthly basis, and we use trend and variance analyses to project future cash needs, making adjustments to the forecasts when needed.
The table below shows the Company’s and our predecessor’s recent net cash flows:
Cash Flows for the Years Ended December 31, 2006, 2005 and 2004. In the table shown above, increases in net cash provided by operating activities generally result from collected premiums while decreases in net cash flow provided by investing activities generally are a result of the investment of collected premiums. Policy and contract liabilities increase when premiums collected are retained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurance companies are reflected in reinsurance balances recoverable.
As a function of our third party administration business, we manage insurance funds for our clients. These funds are held in suspense accounts pending appropriate disposition, and the balances held in suspense vary on a day-to-day basis as insurance funds are received and applied by us.
Other changes in cash flows for the years ended December 31, 2006, 2005, and 2004 are as follows:
2006: We held approximately $32.6 million in cash and cash equivalents at December 31, 2005, primarily consisting of investments in short term commercial paper. We invested a significant portion of this in longer term securities during 2006, resulting in the net cash outflow from investing activities of $24.9 million for the year ended December 31, 2006. This produced a corresponding increase in invested assets.
Excluding the offset to other comprehensive income for the adoption of SFAS158, other assets increased by $4.7 million in 2006, primarily as a result of claims reimbursements due from self funded Administrative Services Only (“ASO”) clients increasing $3.4 million. These claims are not actually disbursed until receipt of these funds, so there is nothing at risk with these assets, and fluctuations from day to day are typical. The balance of the increase in other assets can be attributed to an increase in uncollected premiums of $1.3 million due primarily to the timing of reinsurance settlements.
Accounts payable and accrued expenses increased by $4.4 million in 2006, primarily due to increases in our reinsurance settlements related to the acquired business.
Notes payable including interest decreased $1.7 million as the Company entered into a credit agreement with Wachovia on December 21, 2006 which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the previous five year subordinated promissory note at a discount. (See “Note 13 - Commitments and Contingencies” of Item 8 of this report, which is incorporated herein by reference).
Federal income tax recoverable remained constant from the December 31, 2005 balance. There was a federal income tax accrued liability established for $0.5 million at the year ended December 31, 2006. The deferred tax asset increased by $0.6 million and the deferred tax liability increased by $1.6 million. The combination of these items resulted in a net increase in tax liabilities of $1.5 million, inclusive of a decrease of $3.8 million related to the decrease in fair market value of the invested assets and a decrease of $1.1 million related to the pension liability established for SFAS 158.
Share based compensation expense of $1.4 million was also recognized for the year ended December 31, 2006 as we adopted SFAS 123(R).
2005: We held approximately $117.4 million in cash at December 31, 2004, primarily consisting of cash proceeds from sales and maturities of our invested assets and from our initial public offering of common stock. We invested a significant portion of this cash in fixed maturity securities in 2005, resulting in the net cash outflow from investing activities of $96.0 million. This produced a corresponding increase in invested assets.
Other assets increased by $0.8 million in 2005, primarily representing a $2.9 million prepaid pension assets, offset by the receipt of a $2.2 million receivable for a securities trade that had not settled as of December 31, 2004.
Accounts payable and accrued expenses increased by $1.3 million in 2005, primarily due to a $1.6 million increase in reinsurance settlements due to the acquired business.
The liability for benefits for employers and agents increased by $1.5 million in 2005, primarily resulting from additional pension plan liability accruals of $1.0 million established to fund future payments under the pension plan as well as additional deferred compensation balances of $0.3 million.
Federal income tax recoverable increased by $0.9 million in 2005 as a result of losses incurred in Kanawha that will be carried back to prior years. The deferred tax asset increased by $5.8 million and the deferred tax liability increased by $6.6 million. The combination of the three items results in a net decrease in tax liabilities of $0.1 million, inclusive of a decrease of $2.7 million related to the decrease in fair market value of invested assets.
2004: Accounts payable and accrued expenses increased by $4.5 million in 2004, primarily due to an increase in reinsurance payables of $6.8 million relating to acquired business, and a decrease in accrued compensation expense of $1.8 million relating to payments of accrued compensation that were made in 2004.
Other assets decreased by $2.2 million in 2004, primarily due to the timing of payments and receipts from our reinsurers.
The liability for benefits for employees and agents decreased by $2.1 million in 2004 as the result of payments for accrued pension plan contributions of $3.1 million. The remaining increase is attributable to additional pension plan liability accruals of $1.2 million established to fund future payments under the pension plan.
In 2004, our predecessor had realized gains of $9.4 million primarily due to its decision to sell its convertible bond portfolio and the majority of its equity securities.
In connection with our acquisition of Kanawha in 2004, outstanding Kanawha stock options were exercised, resulting in cash receipts of $6.1 million and a tax benefit of $3.3 million. The exercise of these outstanding stock options produced the majority of the $3.8 million increase in federal income tax recoverable.
Commitments and Contingencies
We have obligations and commitments to third parties as a result of our operations. These obligations and commitments, as of December 31, 2006, are detailed in the following table:
(1)
The information technology and document management outsourcing contract is a ten-year contract that began in November 2003. This contract is subject to cancellation by us at any time starting in November 2006, with the payment of a termination penalty that is based on the number of months remaining in the contract.
(2)
The development of these anticipated payments by period entailed the use of actuarial projections of expected future benefits and expected future net premiums from current in force business.
Recently Issued Accounting Standards
See “Note 2 - Significant Accounting Policies - Recently Issued Accounting Standards” of Item 8 of this report, which is incorporated herein by reference, for a discussion of Recently Issued Accounting Standards.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market Risk Disclosures
As a provider of insurance products, effective risk management is fundamental to our ability to protect both our customers’ and shareholders’ interests. We are exposed to potential loss from various market risks, in particular interest rate risk and credit risk. Additionally, we are exposed to inflation risk and, to a small extent, to foreign currency exchange risk and equity price risk.
Interest rate risk is the possibility that the fair value of liabilities will change more or less than the market value of investments in response to changes in interest rates, including changes in the slope or shape of the yield curve and changes in spreads due to credit risk and other factors.
Equity price risk represents the risk associated with investments in equity securities that expose us to changes in equity prices.
Credit risk is the possibility that counterparties may not be able to meet payment obligations when they become due. We assume counterparty credit risk in many forms. A counterparty is any person or entity from which cash or other forms of consideration are expected to extinguish a liability or obligation to us. Primarily, our credit risk exposure is concentrated in our fixed income investment portfolio and, to a lesser extent, in our reinsurance recoverables.
Inflation risk is the possibility that a change in domestic price levels produces an adverse effect on earnings. This typically happens when only one of invested assets or liabilities is indexed to inflation.
Foreign currency exchange risk is the possibility that changes in exchange rates produce an adverse effect on earnings and equity when measured in domestic currency. This risk is most significant when assets backing liabilities payable in one currency are invested in financial instruments of another currency.
Interest Rate Risk. We invest substantial funds in interest-sensitive fixed income assets, such as fixed maturity investments, mortgage-backed and asset-backed securities and mortgage loans, primarily in the United States. We are exposed to two forms of interest rate risk-price risk and reinvestment risk. Price risk occurs when fluctuations in interest rates have a direct impact on the market valuation of these investments. As interest rates rise, the market value of these investments falls, and conversely, as interest rates fall, the market value of these investments rises. Reinvestment risk occurs when fluctuations in interest rates have a direct impact on expected cash flows from mortgage-backed and asset-backed securities. As interest rates fall, an increase in prepayments on these assets results in earlier than expected receipt of cash flows, forcing us to reinvest the proceeds in an unfavorable lower interest rate environment, and conversely as interest rates rise, a decrease in prepayments on these assets results in later than expected receipt of cash flows, forcing us to forgo reinvesting in a favorable higher interest rate environment. As of December 31, 2006 we held $520.6 million of fixed maturity securities at fair market value and $13.9 million of mortgage loans for a combined total of 95.7 % of total invested assets.
We are also exposed to interest rate risk in establishing our policy benefit reserves. Life insurance, disability and other policy benefit reserves are discounted at the valuation date using a valuation interest rate. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio, with adjustments for investment expenses and provisions for adverse deviation.
Equity Price Risk. We manage equity price risk on an integrated basis with other risks through our asset and liability management strategies. Risk exposures to equity securities are also managed through industry and issuer diversification and asset allocation.
Asset and Liability Management. We evaluate interest rate risk by periodically projecting our asset and liability cash flows to evaluate the potential sensitivity of our securities investments and liabilities to interest rate movements. Creating these projections involves evaluating the potential gain or loss on most of our in-force business under various increasing and decreasing interest rate environments. We manage interest rate risk and attempt to mitigate against a mismatch greater than acceptable tolerance levels in the duration of our assets and liabilities by selecting investments with characteristics such as duration, yield, currency and liquidity that are tailored to allow us to meet the anticipated cash outflow characteristics of our insurance and reinsurance liabilities. We believe that the duration of our invested assets are appropriate for our business given the nature of our liabilities and the current interest rate environment.
Liability durations cannot be calculated precisely due to the uncertainty of the timing and amount of liability cash flows. As a result, there is no generally recognized method of computation of liability durations.
For acquired blocks of business and other products, the average duration of the associated assets is within or close to the liability duration range. For long-term care, the liability duration range is longer than the average duration of the associated assets. This duration mismatch results in reinvestment risk when assets mature prior to the termination of the associated liabilities and funds must be reinvested, but does not result in liquidity risk. However, we do not believe that this reinvestment risk is significant given our belief that future investment conditions will be at least as favorable as present conditions.
As a result of the duration profile of our investment portfolio and product liabilities, as well as our internal cash flow projections, we do not anticipate having to dispose of investment securities at inopportune times and/or market prices or access credit facilities to obtain required liquidity in the future.
The interest rate sensitivity of our fixed maturity security assets is assessed using hypothetical test scenarios that assume several positive and negative parallel shifts of the underlying yield curve. The individual securities are repriced under each scenario using a valuation model. For investments such as mortgage-backed and asset-backed securities, a prepayment model was used in conjunction with a valuation model. Our actual experience may differ from the results noted below if actual experience differs from assumptions utilized or if events occur that were not included in the assumptions. The following table summarizes the results of this analysis for fixed maturity securities held in our investment portfolio:
Interest Rate Movement Analysis of Market Value of Fixed Maturity Securities Investment Portfolio
As of December 31, 2006
Asset and liability management is currently the responsibility of our investment committee and chief actuary, which are responsible for setting a broad asset and liability management policy and strategy, reviewing and approving target portfolios, establishing investment guidelines and limits and providing oversight of the portfolio management process.
The portfolio managers and asset sector specialists that have been assigned by our third-party investment managers and who have responsibility on a day-to-day basis for risk management of their respective investing activities implement the goals and objectives established by our investment committee. The goals of the investment process are to optimize after-tax, risk-adjusted current investment income and after-tax, risk-adjusted total return while ensuring that the assets and liabilities are managed on a cash flow and duration basis. The risk management objectives established by our investment committee stress quality, diversification, asset/liability matching, liquidity and investment return.
Credit Risk. We are exposed to credit risk primarily as a holder of fixed income securities and as a party to reinsurance cessions.
Our risk management strategy and investment policy is to invest in debt instruments of issuers with high credit ratings and to limit the amount of credit exposure with respect to any one issuer. We attempt to limit our credit exposure by imposing fixed maturity portfolio limits on individual issuers based upon credit ratings. Currently, our portfolio limits are 2.00 % for issuers rated AAA, 1.5 % for issuers rated AA- to AA+, 1.00 % for issuers A- to A+, 0.50 % for issuers rated BBB- to BBB+ and 0.25 % for issuers rated BB- to BB+. These portfolio limits are further reduced for some issuers with whom we have credit exposure on reinsurance agreements. We use the lower of Moody’s or Standard & Poor’s ratings to determine an issuer’s rating.
The following table presents our fixed maturity investment portfolio by ratings of the nationally recognized securities rating organizations as of December 31, 2006:
We are also exposed to the credit risk of our reinsurers. When we reinsure, we are still liable to our insureds regardless of whether we receive reimbursement from our reinsurer. In the event one or more of our reinsurers defaults on its obligations, it could adversely affect our financial condition and the results of our operations. As part of our overall risk and capacity management strategy, we purchase reinsurance for some risks underwritten by our various businesses.
Approximately 40% of our $89.1 million of reinsurance recoverables at December 31, 2006, are protected from credit risk because the reinsurer has placed amounts in a trust account that is pledged to us. The trust account values are at least equal to the recoverable amounts from the underlying reinsurance agreements. For recoverables that are not protected by these mechanisms, we depend solely on the credit of the reinsurer. Substantially all of our reinsurance exposure has been ceded to companies rated “A-” or better by A.M. Best.
Inflation Risk. We are exposed to inflation risk because we invest substantial funds in nominal assets, which are not indexed to the level of inflation, but the underlying liabilities are indexed to the level of inflation. Life insurance policies with reserves of approximately $6.5 million as of December 31, 2006 (representing 1.2% of our total reserves), have death benefits that are guaranteed to grow based on inflation linked indices. Substantially all of these policies are subject to caps that limit the amount by which the death benefits can grow each year. In times of rapidly rising inflation the credited death benefit growth on these liabilities increases relative to the investment income earned on the nominal assets, resulting in an adverse impact on earnings.
In addition, we are exposed to inflation risk with respect to some major medical insurance policies to the extent that medical costs increase with inflation at a greater pace than our ability to increase premiums.
Foreign Currency Exchange Risk. We have no exposure to foreign exchange risk arising from our insurance and other business operations. We also have little foreign currency exchange exposure in our investment portfolio. Total invested assets from foreign issuers were less than 10% of our total invested assets at December 31, 2006, but all of these foreign investments were denominated in dollars.
Derivatives. Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the prices of securities or commodities. Derivative financial instruments may be exchange-traded or contracted in the over-the-counter market and include swaps, futures, options and forward contracts.
Under insurance statutes, insurance companies may use derivative financial instruments to hedge actual or anticipated changes in their assets or liabilities, to replicate cash market instruments or for some income-generating activities. These statutes generally prohibit the use of derivatives for speculative purposes.
Prior to the completion of the Kanawha acquisition, our predecessor historically had not used derivative financial instruments. However, we are considering and in the future may elect to utilize derivatives in order to hedge some exposures.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Management on the Consolidated Financial Statements and Management’s Assessment of Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2006, and 2005
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the “Predecessor”) for the year ended December 31, 2004
Consolidated Statements of Shareholders’ Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004
Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004
Notes to Consolidated Financial Statements
Schedule III - Supplementary Insurance Information*
*All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
REPORT OF MANAGEMENT ON THE CONSOLIDATED FINANCIAL STATEMENTS AND MANAGEMENT’S ASSESSMENT OF INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of KMG America Corporation (“KMG”) is responsible for the preparation, integrity and fair presentation of Consolidated Financial Statements of KMG and for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13(a) - 15(f). The accompanying Consolidated Financial Statements, including Notes to Financial Statements, have been prepared by management in accordance with U.S. generally accepted accounting principles (GAAP), and reflect management’s estimates and judgments, the use of which are inherent in the preparation of financial statements. In the opinion of management, the accompanying Consolidated Financial Statements present fairly KMG’s financial position and results of operations, giving due consideration to materiality.
KMG’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. KMG's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of KMG's assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that KMG's receipts and expenditures are being made only in accordance with authorization of KMG's management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of KMG's assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
KMG management conducted an evaluation of the effectiveness of KMG's internal control over financial reporting as of December 31, 2006. In making this evaluation, it used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on the evaluation under the framework in Internal Control - Integrated Framework, our management concluded, that as of December 31, 2006, KMG's internal control over financial reporting was effective.
KMG’s Consolidated Financial Statements and assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their reports which appear on pages 75 and page 76, respectively.
By: /s/ Kenneth U. Kuk
Kenneth U. Kuk
Principal Executive Officer
Date: March 14, 2007
By: /s/ Scott H. DeLong III
Scott H. DeLong III
Principal Financial Officer
Date: March 14, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors and Shareholders of KMG America Corporation
We have audited management’s assessment, included in the accompanying Report of Management on the Consolidated Financial Statements and Management’s Assessment of Internal Control over Financial Reporting, that KMG America Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). KMG America Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.
In our opinion, management’s assessment that KMG America Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, KMG America Corporation, maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of KMG America Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and our report dated March 8, 2007, expressed an unqualified opinion thereon.
/s/ Ernst & Young, LLP
Charlotte, North Carolina
March 8, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of KMG America Corporation
We have audited the accompanying consolidated balance sheets of KMG America Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flow of KMG America Corporation for the years ended December 31, 2006 and 2005 and the period January 21, 2004 (inception) through December 31, 2004, and the consolidated statements of operations, shareholders’ equity and cash flow of the Predecessor, as defined in Note 1, for the year ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of KMG America Corporation at December 31, 2006 and 2005, and the consolidated results of KMG America Corporation’s operations and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and the Predecessor’s consolidated results of operations and cash flow for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, in 2006 the Company changed its method of accounting for share based payments and defined benefit pension plan and has adopted Financial Accounting Standards Board Statement No. 123(R), Share Based Payments and Financial Accounting Standards Board Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of KMG America Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 8, 2007 expressed an unqualified opinion thereon.
Charlotte, North Carolina
March 8, 2007
KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS
See accompanying notes.
KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS (Continued)
See accompanying notes.
KMG AMERICA CORPORATION AND PREDECESSOR
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
KMG AMERICA CORPORATION AND PREDECESSOR
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Predecessor from January 1, 2004, through December 31, 2004,
and KMG America Corporation from January 21, 2004, through December 31, 2006
Common Stock
Paid-In Capital
Deferred Stock Based Compensation
Retained Earnings
Accumulated Other Comprehensive Income (Loss)
Total Shareholders' Equity
Predecessor:
Balance at January 1, 2004
$
4,048,393
$
21,722,289
$
(207,067
)
$
134,114,967
$
13,797,947
$
173,476,529
Net income
-
-
-
6,190,499
--
6,190,499
Change in net unrealized gains (losses)
-
-
-
-
(1,652,222
)
(1,652,222
)
Minimum pension liability
-
-
-
-
31,151
31,151
Comprehensive income
-
-
-
-
-
4,569,428
Stock option compensation expense
-
-
207,067
-
-
207,067
Stock options exercised
576,076
5,571,627
-
-
-
6,147,703
Tax benefit of stock options exercised
-
1,512,877
-
-
-
1,512,877
Balance at December 31, 2004
$
4,624,469
$
28,806,793
$
-
$
140,305,466
$
12,176,876
$
185,913,604
KMG America:
Incorporation and initial public offering
$
220,716
$
187,742,702
$
-
$
-
$
-
$
187,963,418
Net loss
-
-
-
(175,553
)
-
(175,553
)
Balance at December 31, 2004
220,716
187,742,702
-
(175,553
)
-
187,787,865
Net income
-
-
-
4,659,532
-
4,659,532
Change in net unrealized gains (losses)
-
-
-
-
(4,995,049
)
(4,995,049
)
Comprehensive loss
-
-
-
-
-
(335,517
)
Share based compensation expense
480,934
(450,703
)
-
-
30,775
Balance at December 31, 2005
221,260
188,223,636
(450,703
)
4,483,979
(4,995,049
)
187,483,123
Net income
7,218,950
7,218,950
Change in net unrealized gains (losses)
-
-
-
-
(2,058,098
)
(2,058,098
)
Pension liability
-
-
-
-
(1,971,370
)
(1,971,370
)
Comprehensive income
-
-
-
-
-
3,189,482
Adoption of SFAS 123(R)
-
(450,703
)
450,703
-
-
-
Share based compensation expense
1,378,026
-
-
-
1,378,882
Balance at December 31, 2006
$
222,116
$
189,150,959
$
-
$
11,702,929
$
(9,024,517
)
$
192,051,487
See accompanying notes.
KMG AMERICA CORPORATION AND PREDECESSOR
CONSOLIDATED STATEMENTS OF CASH FLOW
See accompanying notes.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Organization, Kanawha Acquisition, Initial Public Offering, and Nature of Operations
Unless the context requires otherwise, references to “we”, “us,” “our,” KMG America” or the “Company” are intended to mean KMG America Corporation and its consolidated subsidiaries, including, without limitation, Kanawha Insurance Company (“Kanawha”). References to our “predecessor” mean Kanawha prior to it being acquired by KMG America.
KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol “KMA.” Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha and its subsidiaries, which are KMG America’s primary operating subsidiaries and which underwrite and sell life and health insurance products.
Kanawha, the primary operating subsidiary of KMG America, is licensed to issue life and accident and health insurance. Kanawha is domiciled in South Carolina. Kanawha has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-party administrator with operations in Lancaster and Greenville, South Carolina.
The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. The Company ceased actively underwriting new long-term care insurance policies after December 31, 2005. The Company intends to retain and actively manage the Company's existing block of in force long-term care policies. The Company's third-party administration and medical management businesses include a wide array of services with the primary emphasis on the offering of administrative service-only products.
The Company's sales historically have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales are made through an internal sales force, full-time agents, general agents and brokers. Under the Company’s current business strategy, the Company expects group lines of business to account for an increasing percentage of the Company's premium revenues.
Effective September 1, 2006, KMG America’s subsidiaries Kanawha and Kanawha HealthCare Solutions, Inc. entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (“CLIC”) and Columbian Mutual Life Insurance Company (“CMLIC”). CLIC and CMLIC are affiliates of each other. Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC. Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, “UNIQ Benefit Solutions”.
This transaction is expected to enhance KMG America’s presence in the voluntary term life market, create access to additional distribution and is expected to favorably impact the financial results.
2.
Significant Accounting Policies
Basis of Presentation
For accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to in these Notes as the “Predecessor.” For financial reporting purposes, management has treated the acquisition of the Predecessor as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to the Predecessor’s consolidated statements of operations, cash flows, and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to the Predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the year ended December 31, 2004 is reported on a historical basis without GAAP (generally accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor. Financial information
relating to the Company’s financial position as of December 31, 2004, has been adjusted for GAAP purchase accounting adjustments reflecting the Predecessor’s acquisition.
The accompanying consolidated financial statements include the accounts of the Company and the Predecessor after elimination of all significant intercompany balances and transactions. The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (“SAP”) and are significantly different from financial statements prepared in accordance with GAAP (see Note 10).
Use of Estimates and Assumptions
The presentation of the accompanying consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
Cash and Cash Equivalents
The Company includes with cash and cash equivalents its holdings of highly liquid investments with maturities of three months or less from the date of acquisition.
Investments
Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Fixed Maturity and Equity Securities, requires that all fixed maturity and equity securities be classified into one of three categories-held to maturity, available-for-sale, or trading. The Company has no securities classified as held to maturity. Management determines the appropriate classification of fixed maturities at the time of purchase.
Investments are reported on the following basis:
Fixed maturities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders’ equity as accumulated other comprehensive income. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.
Equity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders’ equity as accumulated other comprehensive income.
Assets supporting the deferred compensation plan are classified as trading and are included in other investments. Trading account assets are held for resale in anticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fair value. Gains and losses, both realized and unrealized, are included in realized gains and losses.
Mortgage loans on real estate are stated at unpaid balances, net of allowances for unrecoverable amounts. Valuation allowances for mortgage loans are established when the Company determines it is probable that it will be unable to collect all amounts (both principal and interest) due according to the contractual terms of the loan agreement. Such allowances are based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, if foreclosure is probable, on the estimated fair value of the underlying real estate.
Policy loans are stated at their unpaid balances.
Interest on loans is generally recorded over the term of the loan based on the unpaid principal balance. Accrual of interest is discontinued when either principal or interest becomes 90 days past due or when, in management’s opinion, collection of such interest is doubtful. In addition, any previously accrued interest is reversed when the loan becomes 90 days past due.
Other investments are stated at fair value, or the lower of cost or fair value, as appropriate.
Amortization of premiums and accrual of discounts on investments in fixed maturity securities is reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.
The Company regularly reviews its investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, the Company first screens for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, the Company utilizes the following information:
•
length of time the fair value was below amortized cost;
•
industry factors or conditions related to a geographic area negatively affecting the security;
•
downgrades by a rating agency;
•
past due interest or principal payments or other violation of covenants; and
•
deterioration of the overall financial condition of the specific issuer.
In analyzing its potentially distressed securities list for other-than-temporary impairments, the Company pays special attention to securities that have been on the list for a period greater than six months. The Company assumes that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than twelve months has incurred an other-than-temporary impairment. Reliable contradictory evidence might include, among other factors, a liquidation analysis performed by the Company’s investment advisors or outside consultants, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.
Should the Company conclude that the decline is other-than-temporary, the security is written down to fair value through a charge to realized investment gains and losses. The Company adjusts the amortized cost for securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. The Company considers factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
Real Estate and Equipment
Company-occupied real estate, primarily buildings, is carried at cost less accumulated depreciation and are depreciated principally by the straight-line method over estimated useful lives generally ranging from 15 to 30 years. Equipment is stated at cost, less accumulated depreciation, and depreciated principally by the straight-line method over their estimated useful lives, generally 3 to 5 years.
Expenditures for improvements are capitalized, and expenditures for maintenance and repairs are charged to operations as incurred. Upon sale or retirement, the cost and related accumulated depreciation and amortization are removed from the accounts and the resulting gain or loss, if any, is reflected in operations. For the years ending December 31, 2006, 2005 and 2004, total depreciation expense was approximately $1.9 million, $1.8 million and $2.5 million, respectively.
Deferred Policy Acquisition Costs
Acquisition costs incurred by the Predecessor and the Company in the process of acquiring new business are deferred and amortized into income as discussed below. Costs deferred consist primarily of commissions and certain policy underwriting, issue and agency expenses that vary with and are primarily related to production of new business.
For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.
Value of Business Acquired
Value of business acquired is the value assigned to the insurance in force of acquired insurance companies or blocks of insurance business at the date of acquisition.
The amortization of value of business acquired is recognized using amortization schedules established at the time of the acquisitions based upon expected annual premium. Certain of these amortization schedules include actual to expected adjustments to reflect actual experience as it emerges. The value of business acquired is amortized over the premium-paying period of the policies.
Impairment of Long-Lived Assets
Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Company’s long-lived assets are appropriately valued at December 31, 2006 and 2005.
Benefit Reserves
Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are associated with earned premiums so as to recognize profits over the premium-paying period. This association is accomplished by recognizing the liabilities for insurance reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on the Company’s experience. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Company’s experience, as appropriate. Life reserves are calculated using mean reserve factors. Accident and health reserves are calculated using mid-terminal reserve factors. Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.
Benefit reserves as reported are shown on a GAAP purchase accounting basis (“PGAAP”). Prior to the quarter ending June 30, 2006, this conversion was based on an adjustment to benefit reserves developed on a historical GAAP basis. Effective June 30, 2006, a refinement in methodology was implemented whereby the benefit reserves are now being developed directly on a purchase GAAP basis. This seriatim factor approach was not implemented in prior quarters because of the significant amount of time it has taken to develop the complete set of reserve factors that was needed. The refinement of the methodology to use seriatim developed reserves had no material impact on income but does have an impact on the balance sheet on a segment by segment basis. This balance sheet impact is further discussed in Note 16 (Business Segments).
Loss recognition testing of the Company’s policy benefit reserves is performed annually. This testing involves a comparison of the Company’s actual net liability position (all liabilities less DAC) to the present value of future liabilities calculated using then-current assumptions. These assumptions are based on the Company’s best estimate of future experience. To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of operations and a corresponding reduction in DAC. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.
Claims and Claim Adjustment Expenses
Claim reserves relating to short duration contracts generally are recorded when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reserves for known but unpaid claims as of the balance sheet date; (2) incurred but not reported (“IBNR”) reserves for claims where the insured event has occurred but has not been reported as of the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Case base reserves and the IBNR reserves are recorded at an amount equal to the net present value of the expected future claims payments. Factors considered when setting IBNR reserves include patterns in elapsed time from claim incidence to claim reporting, and elapsed time from claim reporting to claim payment. Claim reserves generally equal the Company’s estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from historical experience as to claim duration, as well as the specific characteristics of the claimant such as benefits available under the policy, the benefit period, and the age and occupation of the claimant. Although considerable variability is inherent in such estimates, management believes that the reserves for claims and claim adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations.
Reinsurance
Reinsurance premiums, benefits and reserves are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the insurance contracts. Benefit reserves and claim liabilities are reported gross of reinsured amounts. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balance due from reinsurers, reinsurer solvency, Company experience and current economic conditions.
Recognition of Revenue
Premiums on life insurance products are reported as revenue when due unless received in advance of the due date. Premiums on accident and health insurance are reported as earned over the contract period. A reserve is provided for the portion of premiums written which relate to unexpired coverage terms.
Revenue from annuity and interest sensitive products including universal life products includes charges for the cost of insurance, for initiation and administration of the policy and for surrender of the policy. Revenue from these products is recognized in the year assessed to the policyholder, except that any portion of an assessment, which relates to services to be provided in future years, is deferred and recognized over the period during which services are provided.
Revenue from commission and fee income is recognized over the related contract periods.
Realized Capital Gains (Losses)
Realized capital gains and losses are reported in the income statement on a pretax basis in the period that the asset giving rise to the gain or loss is sold. Impairment writedowns are recorded when there has been a decline in value deemed other than temporary, in which case the write down for such impairments is charged to income.
Recognition of Benefits
Benefits related to traditional life and accident and health insurance products are recognized when incurred in a manner designed to match them with related premiums and spread income recognition over expected policy lives. For annuity and interest sensitive products including universal life products, benefits include interest credited to policyholders’ accounts, which is recognized as it accrues.
Pension Costs
The Company has adopted the provisions of SFAS 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans - An Amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS 158 required the Company to recognize a pension liability of $3,032,877 and a prepaid pension asset of $3,127,725 as of December 31, 2006. The reported net asset of $94,848 represented the overfunded status of the defined benefit pension plan. Also, as the pension liability was established the recognized change was reported in accumulated other comprehensive income which after tax effects was $1,971,370.
Share-Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including stock options and restricted common stock based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting for periods beginning in 2006.
The Company had adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by FASB Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“SFAS 148”) through December 31, 2005. As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations ("APB No. 25"). Accordingly, the Company recognized no compensation expense for stock option awards to employees or directors when the option exercise price was not less than the market value of the stock at the date of award.
In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized under SFAS 123(R) as of December 31, 2006 was $1,378,882, which consisted of share-based compensation expense related to director and employee stock options and common stock grants.
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company has used a Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statement of Operations.
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Consolidated Statement of Operations as of December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the Consolidated Statement of Operations for the year ended December 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS 123 for the periods prior to 2006, the Company accounted for forfeitures as they occurred.
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance.
Income Taxes
Income taxes are computed using the liability method required by SFAS No. 109, Accounting for Income Taxes. Under this Statement, deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.
Participating Policies
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Company’s total ordinary life insurance in force at December 31, 2006 and 2005. Dividends paid to policyholders in 2006, 2005 and 2004 were approximately $1.5 million, $2.1 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 39% in 2006, 46% in 2005 and 51% in 2004.
Recently Issued Accounting Standards
In September 2006, the FASB issued SFAS No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans - An Amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS No. 158”). SFAS No. 158 requires companies to (1) recognize as an asset or liability, the overfunded or underfunded status of defined pension and other postretirement benefit plans; (2) recognize changes in the funded status through other comprehensive income in the year in which the changes occur; (3) measure the funded status of defined pension and other postretirement benefit plans as of the date of the company’s fiscal year-end; and (4) provide enhanced disclosures. The provisions of SFAS No. 158 are effective for the Company’s year-ending December 31, 2006. The Company adopted SFAS 158 at December 31, 2006.
In June 2006, the Financial Accounting Standards Board (“FASB”), issued Interpretation (“FIN”) No.48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement 109.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its financial statements.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position 05 -1 (SOP 05 -1), Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP 05 -1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from Sale of Investments. SOP 05 -1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05 -1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 with earlier adoption encouraged. Retrospective application of SOP 05 -1 to previously issued financial statements is not permitted. The Company is currently assessing the impact of SOP 05-1 on its financial statements.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3.
Investments
Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table.
The amortized cost and fair value of fixed maturity securities at December 31, 2006, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sales of investments in fixed maturity securities during the years ending December 31, 2006, 2005 and 2004 were $47.1 million, $61.6 million and $99.2 million, respectively. Gross gains of $0.0 million and gross losses of $0.6 million were realized in 2006 on those sales. Gross gains of $0.8 million and gross losses of $0.6 million were realized in 2005 on those sales. Gross gains of $7.9 million and gross losses of $0.7 million were realized in 2004 on those sales.
Proceeds from the sale of investments in equity securities during the years ended December 31, 2006, 2005 and 2004, were $1.4 million, $0.0 million and $2.7 million, respectively. Gross gains of $1.3 million and gross
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
losses of $0.0 million were realized from those sales in 2006. These gains were due to the sale of Kanawha Healthcare Solutions, Inc.'s investment in the limited liability company, Risk Based Solutions, Inc. in 2006.
Gross gains of $2.6 million and gross losses of $0.0 million were realized in 2004 on those sales.
Net gains of $0.6 million, $0.2 million, and $0.4 million were realized on the trading portfolio in 2006, 2005, and 2004, respectively.
At December 31, 2006, fixed maturity securities and short-term investments with an amortized cost of $4.7 million and fair value of $4.8 million were on deposit with state insurance departments to satisfy regulatory requirements. At December 31, 2006, the Company held bonds with an amortized cost of $102.6 million and fair value of $102.2 million in trust accounts for our reinsurance assumed treaties with Equitable Life, Metropolitan Life, and Security Benefit Life (part of reinsurance assumed reserves in Note 8, which is incorporated herein by reference).
Changes during the years ended December 31, 2006, 2005 and 2004, in amounts affecting the net unrealized gains and losses, reduced by deferred income taxes, included in shareholders’ equity as accumulated other comprehensive income are as follows:
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
At December 31, 2006, the Company held certain fixed income investments with unrealized losses. Information regarding these investments is as follows:
Management has reviewed these securities which either have been in an unrealized loss position for more than twelve months or have significant unrealized losses relative to cost and have concluded that these securities have not experienced an other-than-temporary impairment. Factors considered in making this evaluation included issue-specific drivers of the decrease in price, near-term prospects of the issuer, the length of time the value has been depressed, and the financial condition of the industry. Based on this review, no unrealized losses were considered to be other than temporary during 2006. Unrealized losses of $0.2 million and $0.7 million were considered to be other-than-temporary for this review and were recognized as realized losses during 2005 and 2004, respectively.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Major categories of the Company’s and Predecessor’s net investment income for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:
There were no new mortgage loans originated in 2006. At the issuance of a loan, the percentage of loan to value on any one loan does not exceed 75%. All properties covered by mortgage loans have fire insurance equal to at least the loan excess over the maximum loan that would be allowed on the land without the building.
The Company’s mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by office (3.6%), apartments (4.6%) and residential (91.8%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value ratios. Approximately 97.3% of the loans are on properties located in the South Atlantic region. Other geographic regions include mortgaged property representing 2.7% of the aggregate principal amount of the Company’s mortgage loans as of December 31, 2006.
Interest is recognized as revenue when earned according to the terms of the loans and when, in the opinion of management, it is collectible. The accrual of interest on the loans is discontinued at the time the loan is 90 days past due or when, in management’s opinion, collection of such interest is doubtful. Past due status is based on the contractual terms of the loan. Loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful. The Company maintains an allowance for potentially uncollectible loans. Additions to the allowance are based on assessments of certain factors, including but not limited to historical loan loss experience of similar types of loans, the Company’s loan loss experience, the amount of past due and non-performing loans and current and anticipated economic and interest rate conditions. Evaluation of these factors involves subjective estimates and judgments that may change. Additions to the allowance are provided through a charge to earnings. There was no balance in the allowance account at December 31, 2004. There were no additions to the allowance for the years ended December 31, 2006 and 2005.
At December 31, 2006 the Company held $0.1 million in residential mortgage loans with interest overdue more than 90 days.
4.
Other Intangible Assets
Under FAS No. 142, goodwill and intangible assets with indefinite useful lives are not amortized. Effective December 31, 2004, historical goodwill of the Predecessor was eliminated as a part of the application of GAAP purchase accounting requirements. The fair value of net assets of the Predecessor was greater than the acquisition purchase price, therefore no goodwill was recorded, effective December 31, 2004. Certain other intangibles were recorded as a result of the acquisition effective December 31, 2004. The weighted-average useful life, gross carrying
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
value, accumulated amortization and net carrying value of other intangible assets, which are included in other assets in the consolidated balance sheet, as of December 31, 2006, and 2005, were as follows:
Amortization expense relating to intangible assets was $0.57 million in 2006, $0.57 million in 2005, and $0.0 million in 2004. Estimated future amortization expense relating to intangible assets for the years ending December 31 are as follows:
Real estate and equipment consist of the following at December 31:
6.
Deferred Policy Acquisition Costs and Value of Business Acquired
In connection with the Kanawha acquisition, the Company recorded the value of business acquired for the value of the Predecessor’s in force business. The interest rate assumption used to amortize the value of business acquired was approximately 6.0% at December 31, 2006. Information about deferred policy acquisition costs and value of business acquired are summarized below:
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company accounts for value of business acquired in a manner similar to deferred acquisition costs. The interest rates used to amortize deferred acquisition costs were 6.00%, 6.06 % and 6.58 % in 2006, 2005 and 2004, respectively.
The interest rate used in 2004 to amortize value of business acquired was approximately 7.0%. Periodically, the Company performs tests to determine whether the value of business acquired remains recoverable from future premiums on the acquired business. No write-offs were incurred in 2004, 2005 or 2006 from impairments as a result of such recoverability tests. The interest rate assumption used to amortize the value of business acquired was reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% at December 31, 2004. Under the Company’s assumptions, as of December 31, 2006, the Company estimated that the amortization of value of business acquired for the next five years will be as follows:
Year ending December 31:
Amortization
4.96%
4.93
5.24
5.23
5.14
If actual lapse and mortality experience is higher or lower than assumed for the table above, then actual amortization will be faster or slower than indicated in the table.
Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are computed using the net level premium method, including
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
assumptions based on our experience, modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. Reserve interest assumptions are graded and range from 3.0% to 8.5% for historical GAAP purposes and for current Purchase GAAP the interest assumptions range from 5.75% to 6.60% The weighted average assumed investment yield for all life and accident and health policy reserves was 6.07% in 2006, 6.04% in 2005 and 6.84% in 2004. Benefit reserves for limited-payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
Interest crediting rates for investment products ranged from 3.5% to 5.0% in 2006, 2005, 2004, respectively.
During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors. While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments. This reallocation has been reflected in the second quarter results of the affected segments.
The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings resulted from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.
Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The assumption agreements provide the Company with increased economies of scale and the ceded agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources and, in some cases, effect business dispositions. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. All reinsurers for which we hold an amount recoverable have a financial strength rating from A.M. Best of at least an A- (excellent) (with the exception of Scottish Re, which is rated B, but to which we have limited exposure as the current amount recoverable as of December 31, 2006 is $125,619) and the majority of our reinsurers have a rating of A+ (superior). In some cases, reinsurers have placed amounts in trusts equivalent to the amount recoverable from the reinsurer. The following represent reinsurance amounts included in the accompanying financial statements:
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9.
Federal Income Taxes
Income taxes as reported in the consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:
The provision for federal income taxes incurred is different from that which would be obtained by applying the statutory Federal income tax rate to income before income taxes. The significant items causing this difference are:
The tax effects of temporary differences that result in significant deferred income tax assets and deferred income tax liabilities at December 31 are as follows:
Reconciliation to balance sheet:
Deferred income tax liabilities
$
14,735,262
$
13,061,136
Less: deferred income tax asset
6,578,604
6,015,462
Net deferred income tax liabilities
$
8,156,658
$
7,045,674
The Predecessor’s federal income tax returns for all years through 2000 are closed. In the opinion of management, recorded income tax liabilities adequately provide for all remaining open years.
The Company and its subsidiaries have filed separate federal income tax returns as required by regulations regarding the consolidation for tax purposes of life insurance and non-life insurance companies. The Company and its subsidiaries have incurred net operating losses which will expire between 2024 and 2026. Under SFAS No. 109, management must provide a valuation allowance for any deferred tax amounts that it does not believe will be realized. Management believes that there is more likely than not that these net operating losses will be realized; therefore, no valuation allowance has been established. The valuation allowance decreased by $0.2 million and $1.6 million in 2006 and 2005, respectively. The Company paid income taxes of $0.0 million and $0.0 million, during the years ended December 31, 2006 and 2005, respectively.
Prior to 1984, a portion of the Predecessor’s income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” Kanawha, the Company’s insurance subsidiary, has approximately $4.3 million of untaxed “Policyholders’ Surplus” on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. The Company does not believe that any significant portion of the account will be taxed in the foreseeable future and no related deferred tax liability has been recognized. If the entire balance of the account became taxable under the current federal rate, the tax would approximate $1.5 million.
10.
Statutory Financial Information
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices. The Company does not have any permitted accounting practices that differ from prescribed practices.
Statutory accounting practices (“SAP”) prescribed or permitted by regulatory authorities for the Company differ from GAAP. Shareholders’ equity and net loss, as determined in accordance with statutory accounting practices, for Kanawha are summarized as follows:
Net (loss) for the year ended December 31, 2006
$
(14,717,792
)
Capital and surplus as of December 31, 2006
$
72,283,775
Net (loss) for the year ended December 31, 2005
$
(8,887,046
)
Capital and surplus as of December 31, 2005
$
85,063,165
Net (loss) for the year ended December 31, 2004
$
(1,745,291
)
Capital and surplus as of December 31, 2004
$
83,707,749
Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2007, dividends, loans or advances by Kanawha in excess of $7.2 million will require the approval of the South Carolina Insurance Commissioner.
Risk-Based Capital (“RBC”) requirements promulgated by the NAIC require life insurers to maintain minimum capitalization levels that are determined based on formulas incorporating credit risk pertaining to its
investments, insurance risk, interest rate risk and general business risk. As of December 31, 2006, the Company’s adjusted SAP capital and surplus exceeded its authorized control level RBC.
11.
Unpaid Claims
The following table provides a reconciliation of the beginning and ending balances of unpaid accident and health claim liabilities, net of reinsurance recoverables, for years ended December 31:
Unpaid accident and health claims at beginning of year
$
31,226,917
$
25,380,187
$
22,703,423
Less reinsurance recoverables
5,571,595
4,474,339
3,896,612
Net balance at beginning of year
25,655,322
20,905,848
18,806,811
Add provision for claims occurring in:
Current year
69,478,729
54,175,099
50,308,966
Prior years
(622,038
)
217,926
(670,441
)
Incurred losses during the current year
68,856,691
54,393,025
49,638,525
Deduct payments for claims occurring in:
Current year
44,375,012
36,435,423
35,075,480
Prior years
15,299,157
13,208,128
12,464,008
Claim payments during the current year
59,674,169
49,643,551
47,539,488
Net balance at end of year
34,837,844
25,655,322
20,905,848
Plus reinsurance recoverables
8,733,357
5,571,595
4,474,339
Unpaid accident and health claims at end of year
$
43,571,201
$
31,226,917
$
25,380,187
Unpaid accident and health claims at end of year
$
43,571,201
$
31,226,917
$
25,380,187
Life policy and contract claims
1,475,570
1,190,986
1,323,144
Accident and health policy reserves
264,065,013
205,296,068
183,442,027
$
309,111,784
$
237,713,971
$
210,145,358
Accident and health reserves per balance sheet
$
294,581,002
$
227,705,619
$
200,801,846
Policy and contract claims per balance sheet
14,530,782
10,008,352
9,343,512
$
309,111,784
$
237,713,971
$
210,145,358
The foregoing reconciliation reflects a redundancy in the December 31, 2005 and 2004, reserves of $0.6 million, and a deficiency in the December 31, 2004 reserves of $0.2 million that emerged in 2006 and 2005, respectively. The changes in those reserves were primarily the result in changes in estimates as more information became available.
The Company adopted the Predecessor’s defined benefit retirement plan, defined contribution plan, and deferred compensation plan. These plans were amended during 2006. These changes are discussed in detail below.
Defined Benefit Retirement Plan
The Company’s defined benefit retirement plan complies with two principal standards: the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), which, in conjunction with the Internal Revenue Code, determines legal minimum and maximum deductible funding requirements; and Statement of Financial Accounting Standards No.158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans - An Amendment of FASB Statements No. 87,88,106, and 132R (“SFAS No. 158”) which was issued in September 2006 and effective for the Company as of December 31, 2006. The measurement date for the Company’s defined benefit plan is December 31.
Plan benefits are based on years of service and compensation during the last five years of service. The Company’s funding policy is to make the minimum annual contributions required by applicable regulations, including amortization of unfunded prior service costs over the maximum period allowed by ERISA.
The assets of the plan are held in a trust account and are invested in equity securities, debt securities and related instruments, and cash and cash equivalents.
On January 31, 2006, the Company adopted two amendments to the defined benefit retirement plan that froze participation in the plan and froze accrual of any additional benefits under the plan. As of March 31, 2006, no new participants were allowed to enter the plan. Effective as of September 30, 2006, no additional benefits accrue under the plan with respect to service after that date. As a result, final average earnings will be determined as of September 30, 2006, for all future benefit payments, and will not be adjusted for future changes in employee compensation.
Beneficiaries may elect to receive benefits in the form of lump-sum distribution, subject to certain dollar limitations, or through one of several annuity options. Based on the plan’s current funding status and ERISA guidelines, no required contributions to the plan are anticipated for 2007.
The net periodic retirement benefit cost of the plan included the following components:
Expected benefit payments are as follows for the years ended December 31:
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The defined benefit plan’s change in benefit obligation, change in plan assets, funded status and amounts recognized in the Company’s consolidated balance sheets are as follows:
Amounts recognized in the Statement of Financial Position consists of:
Noncurrent Assets Net
$
94,848
Current Liabilities
Noncurrent Liabilities
Net Amount Recognized
$
94,848
Amounts recognized in Accumulated Other Comprehensive Income consists of:
Net Actuarial Loss
$
3,032,877
(Before tax effects)
Prior Service Cost / (Credit)
Total
3,032,877
Net Amount Recognized
$
1,971,370
(After tax effects)
The initial amount recognized in accumulated other comprehensive income of $1,971,370 after tax is the result of adopting SFAS No. 158 as of December 31, 2006. An additional pension liability of $3,032,877 was established as the result of the requirement to recognize the funding status of the defined benefit pension plan on the balance sheet as of December 31, 2006. Previously, under SFAS No. 87 and 132R the Company only needed to recognize its pension obligation to the extent of the minimum liability represented by the accumulated benefit obligation. The Company had historically funded the plan to the extent of the minimum liability, thus to avoid the adjustment to other comprehensive income prior to 2006 year end which would have been required under SFAS 132R if the Company was under funded. The newly adopted accounting pronouncement required the recognition of the full projected benefit obligation when measuring the funded status as of December 31, 2006. The net position of the prepaid pension asset and the pension liability results in the amount recognized in the statement of financial position of $94,848 representing the Company’s over funded status of the defined benefit pension plan.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into periodic benefit cost over the next fiscal year are $172,000 and $0, respectively.
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the retirement plans with accumulated benefit obligations in excess of plan assets were as follows:
The expected long-term rate of return on plan assets is estimated based on input from the Company’s actuaries and the Company’s investment committee using a variety of factors including long-term historical returns, inflation assumptions, targeted allocation of plan assets and expectations regarding future market returns for both equity and debt securities.
The key assumptions used in the calculation of the benefit obligations above for years ended December 31 are as follows:
Measurement Date
Weighted-average assumptions:
Discount rate
6.00
%
6.00
%
6.25
%
Rate of compensation increase
3.75
%
3.75
%
4.00
%
The key assumptions used to determine Net Periodic Benefit Cost for years ended December 31:
Discount rate
6.00
%
6.25
%
6.75
%
Expected return on plan assets
8.50
%
8.50
%
8.50
%
Rate of compensation increase
3.75
%
4.00
%
4.50
%
The actuarial present value of accumulated plan benefits does not reflect the actual benefits that will be paid on retirement, but rather the liability that would exist if the Plan were terminated as of the valuation date.
The pension plan asset allocation at December 31, 2006, and 2005 by asset category is as follows:
The Company’s investment strategy for pension plan assets is for approximately one-half of the equity investments to be invested in a large capitalization diversified equity portfolio. During the fourth quarter of 2005, the Company terminated Morgan Stanley as investment manager of the equity portfolio and redeemed the portfolio’s investment in an absolute return hedge fund, the Mangan & McColl Offshore Arbitrage Fund.
Defined Contribution Plan
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible. Plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified defined benefit or defined contribution plans. Until October 1, 2006, the Company contributed 25% of the first 6% of base compensation that a participant contributed to the Plan. The Company also could make an additional contribution up to 25% at its discretion.
Effective as of October 1, 2006, the Company matches 100% of the first 3% of salary deferral contributions that a participant contributes to the plan and 50% of the next 2% of salary deferral contributions a participant contributes to the plan. Effective January 1, 2007, participants will be 100% vested in all matching contributions made by the Company to the plan on and after that date.
Deferred Compensation Plan
The Company has a non-qualified deferred compensation plan for senior management that allows the deferment of a portion of their compensation until their services with the Company have terminated. The plan includes deferred contributions, which were not elected by employees to be transferred to the 401(k) plan upon adoption of the 401(k) plan. The plan’s investments include mutual funds and are recorded in investments as held for trading. The corresponding deferred obligations to participants are recorded in other liabilities.
The Predecessor’s Stock Option Plan
The Predecessor followed Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its stock options issued to senior management. Under APB 25, for options issued where the exercise price of the issuer’s stock option equals the market value of the underlying stock on the date of grant, no compensation expense is recognized. Conversely, for options issued where the exercise price of the option is less than the market value on the date of grant, the difference between the exercise price and the market value on the date of the grant is recognized as unearned compensation, included as a component of shareholders’ equity and amortized over the vesting period.
The Predecessor granted options for a total of 371.8 shares of the Predecessor’s common stock. Stock options for 191 shares were granted in 1985 and the exercise price was 100% of the estimated fair market value of the common stock on the date of the grant, $16,534 per share. These options were fully vested at the closing of the Company’s acquisition of the Predecessor. In 1998, options for the remaining 180.8 shares were granted with an exercise price of $16,536 per share, and an estimated fair market value at the grant date of $45,688 per share.
Approximately $5.3 million of compensation expense was recorded as unearned upon the issuance of these options.
These options generally vested 30% in 1998 and 10% annually thereafter. Amortization of deferred stock option compensation expense of approximately $0.2 million was recognized in 2004.
Pro forma information regarding net income and net income per share is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Predecessor had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
Risk-free Interest Rate
5.71
%
Expected Dividend Yield
-
Expected Volatility
35.00
%
Expected life (years)
In connection with the closing of the acquisition of the Predecessor, on December 21, 2004, all 371.8 options became 100% vested and were exercised and the Predecessor stock option plan was terminated. No additional stock options can be granted under the Predecessor’s plan.
KMG America 2004 Equity Incentive Plan
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SFAS 123 required the presentation of pro forma information as if the Company had accounted for its employee and director stock options granted after December 31, 1994, under the fair value method of that Statement.
The following is a reconciliation of reported net income and pro forma information as if the Company and the Predecessor had adopted SFAS 123 for its employee and director stock option awards:
The Company also followed APB 25 for 2005 and 2004 and related interpretations in accounting for its stock options issued to senior management.
During 2005, the Company issued options to purchase a total 229,250 shares of Company common stock, at a weighted average exercise price of $9.35 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of the grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. During 2005, 61,500 shares were forfeited. During 2005, the Company also issued 54,357 shares of restricted common stock at a weighted average of $8.86, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These shares of restricted stock generally vest with respect to one fourth of the shares granted on each of the first, second, third and fourth anniversaries of grant. On December 15, 2004, the Company issued options to purchase a total of 1,246,000 shares of Company common stock at an exercise price of $9.50 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. Options to purchase 310,000 shares, however, generally vest one third on each of the first, second and third anniversaries of the date of grant.
Pro forma information regarding net income and net income per share is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
Risk-free Interest Rate
4.35
%
Expected Dividend Yield
-
Expected Volatility
20.00
%
Expected life (years)
As of December 31, 2005, 321,458 options to purchase shares of the Company’s common stock were exercisable. All options granted under the Plan are exercisable for ten years from the date of grant, subject to earlier termination of the optionholders’ rights to exercise such options under the terms of the plan and the option agreements relating to such options.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company adopted SFAS 123(R) as of January 1, 2006. Below is the presentation of the Company’s employee and director stock options and common stock grants under the fair value method.
Common Stock Grants
The activity related to the common stock grants is set forth below:
Stock Options
Black-Scholes option-pricing model assumptions used:
Average Risk-free Interest Rate
4.96
%
Expected Dividend Yield
-
Expected Volatility
20.0
%
Expected Life (years)
The activity related to the stock options is set forth below:
The following table sets forth share-based compensation and the related tax benefit:
Year Ended
December 31, 2006
Total Share-Based Compensation
Included in income before income taxes
$
1,378,882
Included in net income, net of tax effects
$
896,273
Excess tax benefits related to options exercised
$
Excess tax benefits related to share-based compensation (1)
$
(1) Represents the tax benefit, recognized in additional paid-in-capital for stock options exercised.
As of December 31, 2006, there was $3,474,667 of total unrecognized compensation cost related to nonvested share-based compensation arrangements.
Performance Share Plan
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On January 1, 2000, the Predecessor established its Performance Share Plan and authorized the issuance of up to 80,000 stock units to attract and retain quality employees and to allow such employees to participate in the growth of the Predecessor. Awards could be made to participants in the form of stock units. The Performance Share Plan provided for vesting over the 10 years subsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change in the book value of the Predecessor’s common stock from the date of grant to the date of exercise, adjusted for dividends, stock redemption proceeds and capital contributions subsequent to the date of grant. Eligible participants under the Performance Share Plan included executives or key employees of the Predecessor. During 2004, 7,354 units were forfeited or redeemed resulting in 65,864 outstanding units at December 20, 2004. The plan continued in effect through the closing of the Company’s acquisition of the Predecessor on December 21, 2004, when it terminated and all outstanding stock units were redeemed. No additional stock units may be awarded under the plan. The Company does not intend to implement a stand-alone successor performance share plan, but the Company’s 2004 Equity Incentive Plan permits the Company to award performance shares.
13.
Commitments and Contingencies
On December 21, 2004, the Company entered into a $15.0 million five-year subordinated promissory note to fund a portion of the purchase price for the Kanawha acquisition. Interest on the promissory note accrued at 5% per annum and was added to the principal balance on December 31 of each year.
On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition. The remaining $1.0 million available under the credit facility may be used to finance the Company’s working capital, liquidity needs and general working requirements and those of its subsidiaries. Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Company’s option, a base rate or the LIBOR rate plus an applicable percentage. The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing. Wachovia’s obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007. As of December 31, 2006, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an initial interest rate of 6.60%.
The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha. The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business. The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.
Fourth quarter 2006 expenses include a pretax benefit of $1.0 million related to the discount associated with retiring and replacing the Company's $15 million subordinated note with bank debt.
The Company is occasionally named as a defendant in various legal actions arising principally from claims made under insurance policies and contracts. Those actions are considered by the Company in estimating the policy and contract liabilities and management believes adequate reserves have been established for such cases. Management believes that the resolution of those actions will not have a material effect on the Company’s financial position or results of operations.
On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York (“ReliaStar”), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs. The complaint alleges misappropriation of trade secrets, conversion, tortious interference contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs’ amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs’ motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs’ motion. The plaintiffs filed a notice of appeal of the court’s ruling with the Minnesota Court of Appeals. On September 5, 2006, the Minnesota Court of Appeals issued a ruling affirming the district court’s denial of plaintiffs' motion for a temporary injunction. On December 21, 2006, the defendants filed a motion for summary judgment with the district court and a hearing on the motion was held on January 19, 2007. We expect a ruling from the Court in the second quarter of 2007. The Company believes plaintiffs’ allegations are without merit and intends to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations. The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse the Company for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation. The Company also has received partial reimbursement under the insurance policy for defense costs incurred to date. As a result, the Company expects that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on the Company’s future consolidated financial position or results of operations.
The Company had no commitments to fund mortgage loans at December 31, 2006.
The Company is assessed amounts by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated insurance companies. Those mandatory assessments may be partially recovered through a reduction in future premium taxes in certain states. The Company recognizes its obligation for guaranty fund assessments and records an estimated accrual for any potential assessment. There were no such accruals as of December 31, 2005, and 2006.
The Company leases office equipment under noncancellable leases. Total rental expense amounted to $0.1 million in 2004 and $0.2 million in 2005 and $0.2 million in 2006. As of December 31, 2006, future minimum lease payments under noncancellable operating leases with initial or remaining terms in excess of one year are as follows:
$
188,000
180,000
176,000
$
544,000
During February 2005, the Company entered into a lease agreement, pursuant to which it has agreed to pay an aggregate of $551,250 to lease its principal executive offices located in Minnetonka, Minnesota for the period from April 1, 2005, through June 30, 2010. This lease is not cancelable by the Company except in connection with specified events that are generally beyond the Company’s control.
During November 2003, the Predecessor entered into a contract for IT and document management. Expenses incurred during 2004, 2005, and 2006 were $5.0 million, $6.8 million, and $7.5 million respectively. This ten-year contract is subject to cancellation by the Company at any time after 42 months, with the payment of a termination penalty that is subject to the number of months remaining in the contract. The document management portion of the agreement is variable by transaction volume. Future payments under this contract are as follows:
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
$
7,689,000
8,121,000
8,534,000
8,829,000
9,137,000
Thereafter
19,244,000
Total 2006 through 2013
$
61,554,000
14.
Concentrations of Credit Risk
At December 31, 2006 and 2005, the Company had no significant exposure to unrated or less-than-investment grade bonds.
The Company’s investment in mortgage loans principally involves residential and commercial real estate primarily in South Carolina and North Carolina. Such investments consist primarily of first mortgage liens on single-family residences; the mortgage outstanding on any individual property does not exceed $1.1 million.
The following methods and assumptions were used by the Company in estimating the “fair value” disclosures for financial instruments in the accompanying financial statements and notes thereto:
Cash and Cash Equivalents: The carrying amounts reported in the accompanying balance sheets for these financial instruments approximate their fair values.
Investment Securities: The carrying amount for fixed maturity and equity securities classified as available-for-sale is fair value, which is based on quoted market prices, where available. For fixed maturity and equity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.
Mortgage Loans: The fair values for mortgage loans are estimated using discounted cash flow analyses based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations.
Policy Loans: The carrying amounts reported in the accompanying balance sheets for these financial instruments approximate their fair values.
Investment Contracts: The fair values of the Company’s liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued.
The fair values of the Company’s insurance contracts other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company’s overall management of interest rate risk, such that the Company’s exposure to changing interest rates is minimized through the matching of investment maturities with amounts due under insurance contracts.
Additional data with respect to fair values of the Company’s investments is disclosed in Note 3.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The carrying amounts and fair values of the Company’s cash and investments at December 31 are summarized in the following table.
The carrying amounts and fair values of the Company’s liabilities for investment-type insurance contracts at December 31 are summarized in the following table.
The Company has five reportable segments that are differentiated by their respective methods of distribution and the nature of the related products: worksite insurance business, senior market insurance business, third party administration business, acquired business and corporate and other. Management makes decisions regarding the Company’s business based on these segment classifications.
The worksite insurance business provides life and health insurance products to employers and employees. The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. This segment also includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.
The senior market insurance business consists primarily of the Company’s in-force block of long-term care insurance policies that the Company actively manages, including the right to receive renewal premiums and liability for future claims. The Company ceased actively underwriting long-term care insurance policies after December 31, 2005.
The third party administration business provides fee-based administrative and managed care services to employers with self funded health care plans, insurance carriers, reinsurance companies and others.
The acquired business represents closed blocks of life and health insurance business that have been acquired through reinsurance transactions over a period of years.
The corporate and other segment includes investment income earned on the investment portfolio allocated to capital and surplus, as well as all realized capital gains and losses, which are not allocated by line of business.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily costs associated with being a public company, deferred compensation, incentive compensation and stock based compensation, and other non-allocated items such as the costs associated with the litigation with ReliaStar.
During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors. While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments. This reallocation has been reflected in the current results of the affected segments.
The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings resulted from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.
This reallocation of reserves between the business segments does impact the comparability of the current reported policyholder benefits and the resulting reported benefit ratios by segment.
The following represents a summary of the Company’s and Predecessor’s statement of operations and asset composition by reportable segment. Except as noted, the financial statement information of the Predecessor set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the Company’s acquisition of the Predecessor.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) KMG America at December 31, 2004, adjusted for purchase accounting adjustments to reflect the Kanawha acquisition.
(2) Aggregate total assets for the Predecessor as of December 31, 2004 is not reported because the Predecessor had been acquired by KMG America at that date and the Predecessor’s assets had been consolidated into the KMG America balance sheet at that date.
KMG AMERICA CORPORATION AND PREDECESSOR
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
17.
Selected Quarterly Financial Data (Unaudited)
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2006 and 2005:
KMG AMERICA CORPORATION AND PREDECESSOR AND SUBSIDIARY
SCHEDULE III-SUPPLEMENTAL INSURANCE INFORMATION
Segment
DAC and
VOBA
Asset
Policy
Reserves
Liability
Unearned
Premiums
Liability
Contract
Claims
and Other
Policy
Liabilities
Insurance
Premiums
Net
Investment
Income
Policyholder
Benefits
Amortization
of
DAC and
VOBA
Other
Expenses
Year Ended December 31, 2006
Worksite insurance
$38,094,067
$151,811,850
$781,654
$18,170,549
$83,795,394
$7,180,951
$55,650,934
$2,712,883
$24,836,899
Senior market insurance
40,256,998
247,085,789
7,692,034
4,354,639
41,486,187
7,868,932
68,737,309
1,586,879
8,113,371
Third party administration
-
-
-
-
-
-
-
-
14,049,613
Acquired business
20,869,075
139,400,374
467,491
2,599,819
2,687,116
8,056,398
(24,545,954)
(194,140)
2,885,649
Corporate and other
-
-
-
-
-
6,839,525
-
-
15,188,713
Total
$99,220,140
$538,298,013
$8,941,179
$25,125,007
$127,968,697
$29,945,806
$99,842,289
$4,105,622
$65,074,245
Year Ended December 31, 2005
Worksite insurance
$24,415,261
$151,625,690
$916,931
$13,859,018
$60,528,639
$6,524,218
$43,556,110
$3,657,962
$20,068,492
Senior market insurance
41,580,646
181,949,150
7,748,415
4,191,516
42,239,844
4,641,343
35,355,291
553,539
9,490,509
Third party administration
-
-
-
-
-
-
-
-
12,838,087
Acquired business
20,674,935
184,050,462
869,143
2,684,006
4,119,035
7,807,899
5,376,325
(744,002)
3,139,511
Corporate and other
-
-
-
-
-
8,771,411
-
-
13,519,416
Total
$86,670,842
$517,625,302
$9,534,489
$20,734,540
$106,887,518
$27,744,871
$84,287,726
$3,467,499
$59,056,015
Year-ended December 31, 2004*
Worksite insurance
$ 14,134,393
$156,098,046
$ 964,052
$ 12,698,888
$ 56,308,493
$5,028,355
$ 44,292,442
$ 6,208,791
$ 13,746,725
Senior market insurance
40,586,764
148,442,031
7,750,320
4,189,333
42,060,326
3,878,429
35,829,058
641,079
9,176,989
Third party administration
-
-
-
-
-
-
-
-
12,200,228
Acquired business
19,760,138
196,461,950
1,025,732
3,285,085
4,466,726
8,507,129
10,053,493
2,618,432
3,257,933
Corporate and other
-
-
-
-
-
7,788,499
-
-
6,272,750
Total
$ 74,481,295
$501,002,027
$ 9,740,104
$ 20,173,306
$ 102,835,545
$25,202,412
$ 90,174,993
$ 9,468,302
$ 44,654,625
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES.
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decision regarding required disclosure. An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of December 31, 2006. Based upon that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2006. There was no change in our internal control over financial reporting during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
See “Management’s Report on Internal Control over Financial Reporting” in Item 8, which is incorporated herein by reference.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information presented under the captions “Information Concerning Nominees,” “Directors Continuing in Office,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Executive Officers”” of our definitive Proxy Statement for our Annual Meeting of Shareholders to be held May 3, 2007 (the “2007 Proxy Statement”) and the information presented under the caption “Availability of Reports, Certain Committee Charters and Other Information” of “Item 1. Business” of this report is incorporated herein by reference.
Because our common stock is listed on the NYSE, our Chief Executive Officer is required to make an annual certification to the NYSE stating that he is not aware of any violation by us of the corporate governance listing standards of the NYSE. Our Chief Executive Officer made his annual certification to that effect for 2006 on July 18, 2006. In addition, we have filed, as an exhibit to this Annual Report on Form 10-K, the certification of our principal executive officer and principal financial officer required under Section 302 of the Sarbanes Oxley Act of 2002 to be filed with the Securities and Exchange Commission regarding the quality of our public disclosure.
We have a separately designated standing Audit Committee established in accordance with Section 3(a)58(A) of the Securities Exchange Act of 1934. Information regarding the members of the Audit Committee and the Audit Committee financial expert is reported under the captions “Corporate Governance” and “Committees of the Board” of our 2007 Proxy Statement, and is incorporated herein by reference.
The information presented under the captions “Director Compensation for 2006”, “Executive Compensation” and “Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report” of our 2007 Proxy Statement is incorporated herein by reference.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information presented under the caption “Security Ownership of Certain Beneficial Owners and Management” of our 2007 Proxy Statement is incorporated herein by reference.
The information presented under the caption “Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan” in Part II of this Form 10-K is incorporated herein by reference.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
The information presented under the captions “Transactions with Related Persons” and "Corporate Governance" of our 2007 Proxy Statement is incorporated herein by reference.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information presented under the captions “Audit Committee Pre-Approval Policy” and “Fees of the Corporation’s Independent Registered Public Accounting Firm” of our 2007 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(1) The following documents are filed as part of Item 8 of this report:
Report of Management on Consolidated Financial Statements and Management's Assessment of Internal Control Over Financial Reporting.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements.
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2006, and 2005.
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the “Predecessor”) for the year ended December 31, 2004.
Consolidated Statements of Shareholders’ Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.
Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.
Notes to Consolidated Financial Statements.
(2) The following financial statement schedules are filed as part of Item 8 of this report:
Schedule III - Supplementary Insurance Information.*
* All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
(3) Exhibits.
The exhibits that are required to be filed or incorporated by reference herein are listed in the Exhibit Index beginning on page 119 hereof. Exhibits 10.01 - 10.19 hereto constitute management contracts or compensatory plans or arrangements required to be filed as exhibits hereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
By: /s/ Kenneth U. Kuk
Kenneth U. Kuk
Director and Chairman, President & Chief Executive Officer
(Principal Executive Officer)
By: /s/ Scott H. DeLong III
Scott H. DeLong III
Director and Senior Vice President & Chief Financial Officer
(Principal Financial Officer)
By: /s/ John H. Flittie
John H. Flittie
Director
By: /s/ Stanley D. Johnson
Stanley D. Johnson
Director and Chairman & Chief Executive Officer of Kanawha
By: /s/ Robert L. Laszewski
Robert L. Laszewski
Director
By: /s/ Dennis M. Mathisen
Dennis M. Mathisen
Director
By: /s/ James J. Ritchie
James J. Ritchie
Director
By: /s/ Glenn S. Sackett
Glenn S. Sackett
Vice President & Controller (Principal Accounting Officer)
Each of the above signatures is affixed as of March 14, 2007.
EXHIBIT INDEX
2.01
Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A and KMG America Corporation (incorporated by reference from Exhibit 2.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
2.02
Amendment No. 1 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
2.03
Amendment No. 2 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.03 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
3.01
Amended and Restated Articles of Incorporation (incorporated by reference from Exhibit 3.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
3.02
Bylaws (incorporated by reference from Exhibit 3.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
4.01
Form of Common Stock Share Certificate (incorporated by reference from Exhibit 4.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
4.02
Form of Restricted Stock Award Agreement (incorporated by reference from Exhibit 10.04 attached to KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 17, 2005).
4.04
Credit Agreement between KMG America Corporation, as Borrower, and Wachovia Bank, a National Association, as Lender (incorporated by reference from Exhibit 10.01 attached to the KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.01
KMG America Corporation 2004 Equity Incentive Plan, as amended April 18, 2006 (incorporated by reference from Exhibit 10.01 attached to KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).
10.02
Form of Nonqualified Stock Option Agreement (incorporated by reference from Exhibit 10.01 from KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).
10.03
Employment Agreement between KMG America Corporation and Kenneth U. Kuk (incorporated by reference from Exhibit 10.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.04
Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Kenneth U. Kuk dated December 21, 2004 (incorporated by reference from Exhibit 10.05 attached to KMG America Corporation's Annual Report on Form 10-K for the year ended December 31, 2005).
10.05
Employment Agreement between KMG America Corporation and Scott H. DeLong III (incorporated by reference from Exhibit 10.03 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.06
Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Scott H. DeLong III dated December 21, 2004 (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation's Annual Report on Form 10-K from the year ended December 31, 2005)..
10.07
Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass (incorporated by reference from Exhibit 10.09 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.08
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass dated December 21, 2004.
10.09
Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer (incorporated by reference from Exhibit 10.06 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.10
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer dated December 21, 2004. (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.11
Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore (incorporated by reference from Exhibit 10.08 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.12
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore dated December 21, 2004.
10.13
KMG America Corporation Supplemental Retirement and Deferred Compensation Plan, Restated and Amended (incorporated by reference from Exhibit 10.10 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.14
2007 Base Salaries and other compensation for Named Executive Officers and Directors.
10.15
Outsourcing Services Agreement, dated November 11, 2003, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.16
Amendment No. 1 to the Outsourcing Services Agreement, dated April 1, 2004, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc. (incorporated by reference from Exhibit 10.08 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.17
Lease Agreement, dated February 2, 2005, between KMG America Corporation and Metropolitan Life Insurance Company in respect of KMG America Corporation’s principal executive offices located in Minnetonka, Minnesota (incorporated by reference from Exhibit 10.13 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.18
$15,000,000 Credit Agreement, dated December 21, 2006, between KMG America Corporation and Wachovia Bank, National Association (incorporated by reference from Exhibit 10.01 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.19
$15,000,000 Note, dated December 21, 2006, made by KMG America Corporation payable to the order of Wachovia Bank, National Association (incorporated by reference from Exhibit 10.03 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.20
Note Settlement Agreement, dated December 21, 2006, by and among KMG America Corporation, The Springs Company, Stanley D. Johnson, SDJ Partners, LP and Elliott S. Close (incorporated by reference from Exhibit 10.02 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
21.01
List of Subsidiaries of the Registrant.
23.01
Consent of Ernst & Young, LLP.
31.01
Rule 13a-14(a) / 15d-14(a) Certifications of Chairman, President & Chief Executive Officer.
31.02
Rule 13a-14(a) / 15d-14(a) Certifications of Senior Vice President & Chief Financial Officer.
32.01
Section 1350 Certification of Chairman, President & Chief Executive Officer.
32.02
Section 1350 Certification of Senior Vice President & Chief Financial Officer.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information presented under the caption “Security Ownership of Certain Beneficial Owners and Management” of our 2007 Proxy Statement is incorporated herein by reference.
The information presented under the caption “Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan” in Part II of this Form 10-K is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
The information presented under the captions “Transactions with Related Persons” and "Corporate Governance" of our 2007 Proxy Statement is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information presented under the captions “Audit Committee Pre-Approval Policy” and “Fees of the Corporation’s Independent Registered Public Accounting Firm” of our 2007 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(1) The following documents are filed as part of Item 8 of this report:
Report of Management on Consolidated Financial Statements and Management's Assessment of Internal Control Over Financial Reporting.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements.
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2006, and 2005.
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the “Predecessor”) for the year ended December 31, 2004.
Consolidated Statements of Shareholders’ Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.
Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.
Notes to Consolidated Financial Statements.
(2) The following financial statement schedules are filed as part of Item 8 of this report:
Schedule III - Supplementary Insurance Information.*
* All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
(3) Exhibits.
The exhibits that are required to be filed or incorporated by reference herein are listed in the Exhibit Index beginning on page 119 hereof. Exhibits 10.01 - 10.19 hereto constitute management contracts or compensatory plans or arrangements required to be filed as exhibits hereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
By: /s/ Kenneth U. Kuk
Kenneth U. Kuk
Director and Chairman, President & Chief Executive Officer
(Principal Executive Officer)
By: /s/ Scott H. DeLong III
Scott H. DeLong III
Director and Senior Vice President & Chief Financial Officer
(Principal Financial Officer)
By: /s/ John H. Flittie
John H. Flittie
Director
By: /s/ Stanley D. Johnson
Stanley D. Johnson
Director and Chairman & Chief Executive Officer of Kanawha
By: /s/ Robert L. Laszewski
Robert L. Laszewski
Director
By: /s/ Dennis M. Mathisen
Dennis M. Mathisen
Director
By: /s/ James J. Ritchie
James J. Ritchie
Director
By: /s/ Glenn S. Sackett
Glenn S. Sackett
Vice President & Controller (Principal Accounting Officer)
Each of the above signatures is affixed as of March 14, 2007.
EXHIBIT INDEX
2.01
Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A and KMG America Corporation (incorporated by reference from Exhibit 2.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
2.02
Amendment No. 1 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
2.03
Amendment No. 2 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.03 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
3.01
Amended and Restated Articles of Incorporation (incorporated by reference from Exhibit 3.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
3.02
Bylaws (incorporated by reference from Exhibit 3.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
4.01
Form of Common Stock Share Certificate (incorporated by reference from Exhibit 4.01 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
4.02
Form of Restricted Stock Award Agreement (incorporated by reference from Exhibit 10.04 attached to KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on August 17, 2005).
4.04
Credit Agreement between KMG America Corporation, as Borrower, and Wachovia Bank, a National Association, as Lender (incorporated by reference from Exhibit 10.01 attached to the KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.01
KMG America Corporation 2004 Equity Incentive Plan, as amended April 18, 2006 (incorporated by reference from Exhibit 10.01 attached to KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).
10.02
Form of Nonqualified Stock Option Agreement (incorporated by reference from Exhibit 10.01 from KMG America Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).
10.03
Employment Agreement between KMG America Corporation and Kenneth U. Kuk (incorporated by reference from Exhibit 10.02 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.04
Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Kenneth U. Kuk dated December 21, 2004 (incorporated by reference from Exhibit 10.05 attached to KMG America Corporation's Annual Report on Form 10-K for the year ended December 31, 2005).
10.05
Employment Agreement between KMG America Corporation and Scott H. DeLong III (incorporated by reference from Exhibit 10.03 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.06
Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Scott H. DeLong III dated December 21, 2004 (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation's Annual Report on Form 10-K from the year ended December 31, 2005)..
10.07
Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass (incorporated by reference from Exhibit 10.09 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.08
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass dated December 21, 2004.
10.09
Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer (incorporated by reference from Exhibit 10.06 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.10
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer dated December 21, 2004. (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.11
Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore (incorporated by reference from Exhibit 10.08 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.12
Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore dated December 21, 2004.
10.13
KMG America Corporation Supplemental Retirement and Deferred Compensation Plan, Restated and Amended (incorporated by reference from Exhibit 10.10 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.14
2007 Base Salaries and other compensation for Named Executive Officers and Directors.
10.15
Outsourcing Services Agreement, dated November 11, 2003, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.16
Amendment No. 1 to the Outsourcing Services Agreement, dated April 1, 2004, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc. (incorporated by reference from Exhibit 10.08 attached to KMG America Corporation’s Registration Statement on Form S-1 (Registration No. 333-117911)).
10.17
Lease Agreement, dated February 2, 2005, between KMG America Corporation and Metropolitan Life Insurance Company in respect of KMG America Corporation’s principal executive offices located in Minnetonka, Minnesota (incorporated by reference from Exhibit 10.13 attached to KMG America Corporation’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).
10.18
$15,000,000 Credit Agreement, dated December 21, 2006, between KMG America Corporation and Wachovia Bank, National Association (incorporated by reference from Exhibit 10.01 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.19
$15,000,000 Note, dated December 21, 2006, made by KMG America Corporation payable to the order of Wachovia Bank, National Association (incorporated by reference from Exhibit 10.03 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
10.20
Note Settlement Agreement, dated December 21, 2006, by and among KMG America Corporation, The Springs Company, Stanley D. Johnson, SDJ Partners, LP and Elliott S. Close (incorporated by reference from Exhibit 10.02 attached to KMG America Corporation’s Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).
21.01
List of Subsidiaries of the Registrant.
23.01
Consent of Ernst & Young, LLP.
31.01
Rule 13a-14(a) / 15d-14(a) Certifications of Chairman, President & Chief Executive Officer.
31.02
Rule 13a-14(a) / 15d-14(a) Certifications of Senior Vice President & Chief Financial Officer.
32.01
Section 1350 Certification of Chairman, President & Chief Executive Officer.
32.02
Section 1350 Certification of Senior Vice President & Chief Financial Officer.