<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE PERIOD ENDED SEPTEMBER 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________ TO _________
Commission file number 0-8483
CERES GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 34-1017531
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
17800 Royalton Road
Strongsville, Ohio 44136
------------------------
(Address of principal executive offices)
(Zip Code)
(440) 572-2400
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter periods that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes (X) No ( )
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practical date.
Common Stock, $.001 Par Value - 13,686,155 shares as of September 30, 1999
<PAGE> 2
INDEX
CERES GROUP, INC. AND SUBSIDIARIES
<TABLE>
<CAPTION>
Part I. Financial Information Page
----
<S> <C> <C>
Item 1. Financial Statements (Unaudited) 3
Condensed consolidated balance sheets - September 30, 1999 and December 31, 1998 3
Condensed consolidated statements of operations - Three months
ended September 30, 1999 and 1998; Nine months ended September
30, 1999 and 1998. 4
Condensed consolidated statements of cash flows - Nine months ended September 30, 5
1999 and 1998
Notes to condensed consolidated financial statements (unaudited) - September 30, 1999 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of 13
Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk 25
Part II. Other Information 25
Item 1. Legal Proceedings 25
Item 2. Changes in Securities and Use of Proceeds 26
Item 5. Exhibits and Reports on Form 8-K 26
Signatures 27
Exhibits 28
</TABLE>
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<PAGE> 3
PART I. FINANCIAL INFORMATION- ITEM 1. FINANCIAL STATEMENTS
-----------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30 DECEMBER 31
ASSETS 1999 1998
------------------ ------------------
Investments (UNAUDITED)
<S> <C> <C>
Fixed maturities:
Held to maturity at amortized cost $ - $ 8,899,659
Available for sale, at fair value 301,033,541 80,832,097
------------------ ------------------
Total fixed maturities 301,033,541 89,731,756
Mortgage loans 96,004 -
Policy loans 3,736,107 94,432
------------------ ------------------
Total investments 304,865,652 89,826,188
Cash and cash equivalents 24,229,658 15,031,058
Cash and cash equivalents - restricted 4,402,658 4,345,322
Accrued investment income 5,573,332 1,343,297
Premiums receivable 5,538,654 2,203,690
Note receivable - 7,367,556
Reinsurance receivable 279,283,325 41,417,031
Deferred acquisition costs 17,914,574 3,809,737
Value of business acquired 17,505,391 -
Goodwill 23,061,754 -
Property and equipment, net 17,696,936 10,061,688
Deferred federal income taxes 2,886,526 1,409,479
Other assets 10,656,100 3,418,089
------------------ ------------------
Total assets $ 713,614,560 $ 180,233,135
================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
Policy liabilities and accruals:
Future policy benefits, losses and claims $ 365,407,154 $ 22,717,862
Unearned premiums 32,449,207 2,023,436
Other policy claims and benefits payable 142,992,273 72,371,769
------------------ ------------------
540,848,634 97,113,067
Deferred reinsurance gain 22,332,200 13,400,000
Other policyholders' funds 15,518,007 8,845,829
Federal income taxes payable 8,525,831 1,105,834
Long term debt 40,000,000 -
Mortgage note payable 8,190,087 8,283,884
Reinsurance payable 4,303,890 2,993,400
Commissions payable 6,175,407 2,978,140
Drafts outstanding 4,614,028 -
Other liabilities 18,922,120 9,677,267
------------------ ------------------
Total liabilities $ 669,430,204 $ 144,397,421
Shareholders' equity:
Non-voting preferred shares, $.001 par value, 2,000,000 shares
authorized, none issued - -
Common shares, $.001 par value, authorized 30,000,000 shares, issued
and outstanding 13,686,155 in 1999 and 11,495,172 in 1998 13,686 11,495
Additional paid-in capital 60,130,033 43,883,357
Retained earnings (deficit) (1,236,227) (9,154,986)
Accumulated other comprehensive (loss) income (14,723,136) 1,095,848
------------------ ------------------
Total shareholders' equity 44,184,356 35,835,714
------------------ ------------------
Total liabilities and shareholders' equity $ 713,614,560 $ 180,233,135
================== ==================
</TABLE>
-3-
<PAGE> 4
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
REVENUES:
Premiums, net
Medical $ 66,114,776 $ 36,837,507 $ 181,073,987 $ 100,933,452
Specialty and other 21,454,969 2,788,801 54,623,016 8,298,337
------------- ------------- ------------- -------------
Total premiums, net 87,569,745 39,626,308 235,697,003 109,231,789
Net investment income 5,241,153 2,114,374 16,609,025 6,147,816
Net realized investment gains 153,548 36,900 279,538 28,548
Fee and other income 3,059,325 3,634,489 12,759,914 8,365,183
Amortization of deferred reinsurance gain 1,399,800 - 4,067,800 -
------------- ------------- ------------- -------------
97,423,571 45,412,071 269,413,280 123,773,336
------------- ------------- ------------- -------------
BENEFITS, LOSSES, AND EXPENSES:
Benefits, claims, losses, and settlement expenses:
Medical 42,567,994 27,677,436 126,953,209 85,861,467
Specialty and other 17,539,366 2,404,487 43,751,497 6,152,728
------------- ------------- ------------- -------------
Total benefits, claims, losses, and
settlement expenses 60,107,360 30,081,923 170,704,706 92,014,195
Selling, general, and administrative expenses 37,717,552 14,706,726 97,347,111 35,205,351
Net amortization and change in deferral of
acquisition costs and value of business acquired (6,074,795) 10,955 (14,362,229) 21,922
Amortization of goodwill 295,145 - 795,235 -
Interest expense and financing costs 1,254,787 209,357 2,745,751 1,541,664
------------- ------------- ------------- -------------
93,300,049 45,008,961 257,230,574 128,783,132
------------- ------------- ------------- -------------
Income (loss) before federal income taxes 4,123,522 403,110 12,182,706 (5,009,796)
Federal income tax expense 1,443,233 - 4,263,947 -
------------- ------------- ------------- -------------
Net income (loss) $ 2,680,289 $ 403,110 $ 7,918,759 $ (5,009,796)
============= ============= ============= =============
Earnings (loss) per common share
Basic $ 0.20 $ 0.04 $ 0.60 $ (0.44)
Diluted $ 0.17 $ 0.03 $ 0.51 $ (0.44)
</TABLE>
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<PAGE> 5
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
OPERATING ACTIVITIES 1999 1998
--------------- ---------------
<S> <C> <C>
Net income (loss) $ 7,918,759 $ (5,009,796)
Adjustments to reconcile net income (loss) to cash
provided by operating activities:
Depreciation and amortization 2,192,364 709,453
Net realized gains losses (225,317) (28,548)
Deferred federal income taxes 2,732,723 699,101
Changes in assets and liabilities:
Restricted cash (57,336) (471,427)
Reinsurance and premiums receivable (238,286,643) (37,821,120)
Value of business acquired (1,676,391) -
Goodwill (5,227,780) -
Accrued investment income (89,914) (188,552)
Federal income taxes payable 5,794,646 -
Other assets (4,601,540) 267,386
Future policy benefits, claims and funds payable 236,252,074 23,694,554
Unearned premium 17,928,567 -
Reinsurance payable 1,310,490 -
Other liabilities (290,293) 2,821,614
Policy acquisition costs deferred (13,685,837) -
Reinsurance gain deferred (4,067,800) -
------------- -------------
Net cash provided by (used in) operating activities 5,920,772 (15,327,335)
------------- -------------
INVESTING ACTIVITIES
Purchase of fixed maturities available-for-sale (8,299,395) (22,032,733)
Proceeds from sale of fixed maturities available-for-sale 13,938,109 -
Proceeds from calls and maturities of available-for-sale 10,331,013 15,544,231
Proceeds from sales calls and maturities of held-to-maturity 3,923,138 -
Acquisition of Continental General, net of $2,212,307 cash acquired (59,787,693) -
Foreclosure on assets of United Benefit Life Insurance Company (net of $1,250,783
cash overdrafts) (7,210,620) -
Net additions to furniture and equipment (834,268) -
Net purchase of investments - short-term - (17,056,443)
Other 71,113 7,450
------------- -------------
Net cash used in investing activities (47,868,603) (23,537,495)
------------- -------------
FINANCING ACTIVITIES
Increase in annuity account balances 12,961,027 1,170,361
Decrease in annuity account balances (25,337,222) (3,920,488)
Increase in note receivable 7,367,556 (3,000,000)
Principal payments on mortgage note payable (93,797) (85,329)
Proceeds from long-term debt 40,000,000 -
Proceeds from private equity placement 15,117,415 37,674,947
Issuance of common stock to employees and Officers 1,131,452 -
Reinsurance ceding allowance, net - 23,196,842
Repayment of note payable - (20,000,000)
------------- -------------
Net cash provided by financing activities 51,146,431 35,036,333
------------- -------------
Net increase (decrease) in cash 9,198,600 (3,828,497)
Cash and cash equivalents at beginning of year 15,031,058 5,632,459
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 24,229,658 $ 1,803,962
============= =============
</TABLE>
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<PAGE> 6
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
- ----------------------------------------------------------------
Periods ended September 30, 1999 and 1998
Note 1 - Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Ceres Group, Inc., and subsidiaries (the "Company")
Annual Report on Form 10-K/A for the fiscal year ended December 31, 1998. The
condensed consolidated financial statements for September 30, 1999 include the
accounts of Provident American Life and Health Insurance Company ("Provident")
acquired on December 31, 1998, Continental General Corporation ("Continental")
acquired on February 17, 1999 and United Benefit Life Insurance Company ("United
Benefit Life") under a reinsurance arrangement effective August 1, 1998 and
acquired on July 21, 1999. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. The consolidated results for the nine months
ended September 30, 1999 are not necessarily indicative of the results to be
expected for the fiscal year ending December 31, 1999.
Note 2 - Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
Reporting Comprehensive Income, which requires that an enterprise classify items
of other comprehensive income, as defined therein, by their nature in the
financial statements and display the accumulated balance of other comprehensive
income separately from retained earnings and additional paid-in capital in the
equity section of the balance sheet. The Company adopted SFAS No. 130 in the
first quarter of 1998. The principal difference between net income as
historically reported in the consolidated statements of income and comprehensive
income is unrealized gains or losses on securities recorded in shareholders'
equity.
Comprehensive income (loss) is as follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------------- ------------------- -------------------- -------------------
<S> <C> <C> <C> <C>
Net Income (loss) $ 2,680,289 $ 403,110 $ 7,918,759 $ (5,009,796)
Unrealized (loss) gain on securities (3,175,057) 1,091,793 (16,000,684) 1,375,921
Reclassification adjustment for gains - -
(losses) included in net income 99,806 (24,354) 181,700 (18,842)
------------------- ------------------- -------------------- -------------------
Comprehensive income (loss) $ (394,962) $ 1,470,549 $ (7,900,225) $ (3,652,717)
=================== =================== ==================== ===================
</TABLE>
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<PAGE> 7
Note 3 - Reinsurance
The Company has entered into several quota-share reinsurance treaties with
Reassurance Company of Hannover ("Hannover") on various blocks of business of
its subsidiaries. Under the provisions of the treaties, the Company cedes
between 50% and 90% of the premiums for these policies and in return receives
reimbursement, for the same percentage, of the claims. In addition, the Company
receives a commission and expense allowance. In another reinsurance arrangement,
the Company also assumes certain policies, in which it paid certain commission
and expense allowances, which are classified as reinsurance expenses below. The
following table summarizes the net impact of reinsurance arrangements on
premiums and benefits, claims, losses and settlement expenses, commissions, and
other operating expenses:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Premiums
Direct $ 128,849,525 $ 64,318,066 $ 391,471,995 $ 190,946,019
Assumed 12,349,607 18,890,552 71,042,678 18,890,552
Ceded (53,629,387) (43,582,310) (226,817,670) (100,604,782)
------------- ------------- ------------- -------------
Net premiums $ 87,569,745 $ 39,626,308 $ 235,697,003 $ 109,231,789
============= ============= ============= =============
Benefits, claims, losses, and
settlement expenses $ 208,041,684 $ 74,249,012 $ 427,921,383 $ 181,187,424
Reinsurance recoveries (147,934,324) (44,167,089) (257,216,677) (89,173,229)
------------- ------------- ------------- -------------
$ 60,107,360 $ 30,081,923 $ 170,704,706 $ 92,014,195
============= ============= ============= =============
Selling, general, and administrative expenses:
Commissions $ 22,040,895 $ 9,241,042 $ 62,479,391 $ 27,584,118
Other operating expenses 25,667,106 12,151,044 66,359,134 25,818,125
Reinsurance expenses 10,957,846 5,425,599 32,358,523 5,425,599
Reinsurance allowances (20,948,295) (12,110,959) (63,849,937) (23,622,491)
------------- ------------- ------------- -------------
$ 37,717,552 $ 14,706,726 $ 97,347,111 $ 35,205,351
============= ============= ============= =============
</TABLE>
The Company has re-classified certain direct and ceded premiums in accordance
with 1999 treatment.
-7-
<PAGE> 8
Note 4 - Computation of Net Income (Loss) Per Common Share
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Basic
Average common shares
outstanding 13,642,706 11,495,172 13,196,072 11,495,172
============ ============ ============ ============
Net income (loss) $ 2,680,289 $ 403,110 $ 7,918,759 $ (5,009,796)
============ ============ ============ ============
Net income (loss) per
common share $ 0.20 $ 0.04 $ 0.60 $ (0.44)
============ ============ ============ ============
Diluted
Average common shares
outstanding 13,642,706 11,495,172 13,196,072 11,495,172
Warrants/stock options -
treasury stock method 1,767,845 1,206,667 2,171,280 -
------------ ------------ ------------ ------------
Weighted average shares 15,410,551 12,701,839 15,367,352 11,495,172
============ ============ ============ ============
Net income (loss) $ 2,680,289 $ 403,110 $ 7,918,759 $ (5,009,796)
============ ============ ============ ============
Net income (loss) per common
share $ 0.17 $ 0.03 $ 0.51 $ (0.44)
============ ============ ============ ============
</TABLE>
Net income (loss) per common share has been computed in accordance with
Statement of Financial Accounting Standards (SFAS) No. 128. In computing diluted
earnings per share, only potential common shares that are dilutive, those that
reduce earnings per share, are included. The exercise of options and warrants is
not assumed if the result would be antidilutive, such as when a loss from
continuing operations is reported.
Note 5 - Federal Income Taxes
The federal income tax returns for the Company and its subsidiaries have been
examined by the Internal Revenue Service ("IRS") for 1991 and 1992. During the
third quarter of 1994, the IRS issued a proposal for adjustments to the
Company's returns for 1991 and 1992. The proposed deficiencies were
approximately $2.4 million of which $215,000 was paid in 1994 and $590,000 was
paid in 1997. The balance of approximately $1.6 million relates to whether or
not the Company's then principal operating subsidiary, Central Reserve Life
Insurance Company ("Central"), qualified as a life company for tax purposes. The
Company vigorously protested the proposed deficiency. Based on discussions with
counsel, management believed existing law supported the Company's position. On
October 12, 1999, the United States Tax Court ruled that Central did qualify as
a life company for tax reporting purposes, and accordingly, no further amounts
are due related to the 1991 and 1992 examinations by the IRS. Since the company
had not recorded a liability for the proposed adjustment, the ruling had no
material impact on the accompanying financial statements.
-8-
<PAGE> 9
Note 6 - Acquisitions
On February 17, 1999, the Company acquired 100% of the outstanding common stock
of Continental from The Western & Southern Life Insurance Company, a mutual life
insurance company domiciled in Ohio. Continental is a holding company that
primarily conducts business through its wholly-owned subsidiary, Continental
General Insurance Company ("CGIC"), a life and accident and health insurer
domiciled in Nebraska and licensed in 49 states. Total consideration paid by the
Company for the common stock was $84.5 million. The transaction was financed
through reinsurance, debt, cash, and a private equity offering in the aggregate
amount of $62.0 million and a special dividend received from CGIC of $22.5
million. The transaction was accounted for in accordance with the purchase
method and currently the purchase price allocation is preliminary. The Company
is continuing to evaluate the purchase accounting with respect to the
Continental acquisition. The Company cannot predict the outcome of such
evaluation.
Effective on the closing, CGIC entered into a reinsurance treaty with Hannover,
whereby CGIC ceded 50% of its in force life, accident and health, and annuity
policies to Hannover, and retained the remaining risk. The treaty provides an
initial ceding allowance of $13.0 million, which was accounted for as a deferred
reinsurance gain. The treaty provides for repayment of the initial ceding
allowance plus interest out of statutory profits, if any, of the reinsured
business.
On February 17, 1999, the Company entered into a $40.0 million credit facility
with a syndicate of major commercial banks. In accordance with the terms of the
loan, the first principal payment of $3.0 million is due February 17, 2000.
Quarterly payments are due thereafter as follows: $1.0 million through February
17, 2001; $1.5 million thereafter through February 17, 2002; and $2.25 million
thereafter to February 17, 2005. The loan bears interest at a variable rate
(approximately 9.4% at September 30, 1999). The Company has pledged the common
stock of Continental and Central as security for the loan. The credit facility
prohibits the payment of dividends on the Company's common stock, except upon
compliance with certain conditions.
Effective February 17, 1999, the Company entered into a series of stock
subscription agreements with a group of investors, principally Insurance
Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P., both of which
were stockholders prior to the offering, wherein the Company issued 2,000,000
common shares at $7.50 per share for $15.0 million.
On March 18, 1999, Central announced the execution of an agreement with United
Benefit Managed Care Corporation, the parent company of United Benefit Life, to
purchase all of the outstanding shares of its subsidiary, United Benefit Life.
On June 14, 1999, Central terminated this agreement due to the increasing amount
of the reserve shortfall at United Benefit Life. United Benefit Life and its
affiliate company, Insurance Advisors of America, Inc. ("Insurance Advisors"),
were obligated to Central for the entire shortfall in reserves transferred to
Central on August 1, 1998 in connection with Central's reinsurance of all of
United Benefit Life's health insurance business in effect on August 1, 1998.
This obligation was secured, among other things, by a pledge of all of the stock
of United Benefit Life. In addition, Insurance Advisors owed Central an
additional $7 million in connection with the August 1, 1998 transaction.
Pursuant to a "true up" mechanism in the agreements among United Benefit Life,
Insurance Advisors and Central, the reserve shortfall totaled $19.4 million as
of September 30, 1999. The reserve shortfall was due in part to a fraud
committed in connection with claims administration at the United Benefit Life
facility. On July 21, 1999, due to the increasing reserve shortfall and after
-9-
<PAGE> 10
receiving approval from the Department of Insurance of the State of Indiana
authorizing Central to assume control of United Benefit Life, Central foreclosed
on the stock of United Benefit Life and the renewal commissions due Insurance
Advisors from United Benefit Life to collect the receivable arising from the
reserve shortfall.
Pursuant to Central's reinsurance agreement with Hannover, Hannover is
responsible for 80% of the amount of the reserve shortfall. As of September 30,
1999, Central has recovered approximately $14.3 million of the $19.4 million
reserve shortfall, consisting of $6.0 million from United Benefit Life, $2.9
million from withheld commissions from Insurance Advisors, and $5.4 million from
funds received from Hannover. As a result, the remaining reserve shortfall to be
recovered at September 30, 1999 totaled approximately $5.1 million. Of this
shortfall, the Company has recorded its 20% responsibility, $1.0 million, as an
expense.
The following unaudited pro forma information presents the consolidated results
of operations of the Company assuming the acquisition of Continental was
completed at the beginning of January 1998 and 1999:
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
1999 1998
------------------- ------------------
<S> <C> <C>
Revenues $279,713,848 $226,184,016
Income (loss) before federal income taxes 11,296,030 (11,251,439)
Federal income tax expense 3,953,610 455,669
Earnings (loss) 7,342,420 (11,707,108)
Per common share:
Basic $0.55 $0.87
Diluted 0.47 $0.87
</TABLE>
The pro forma results of operations are not indicative on the actual results of
operations that would have occurred had the acquisitions been made on the date
indicated, or the results that may be obtained in the future.
Note 7 - Operating Segments
In conjunction with the Company's continued growth and refinement of defined
organization structure, the Company expanded its operating segments to the
following three distinct operating segments based upon product types: medical,
specialty and other, and corporate. Products included in the medical segment
include comprehensive major medical plans. Significant products in the specialty
and other segment include Medicare supplement, long-term care, dental, life
insurance, and annuities.
The corporate segment encompasses all other activities of the Company, including
interest income and expense of the parent company. Revenues from each segment
are primarily generated from premiums charged to external policyholders and
interest earned on cash and investments, and are summarized in the following
tables:
-10-
<PAGE> 11
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
------------------- ------------------- ------------------- -------------------
<S> <C> <C> <C> <C>
Medical
Revenues
Net premiums $ 66,114,776 $ 36,837,507 $181,073,987 $ 100,933,452
Investment income 1,602,561 1,794,927 5,428,640 5,411,549
Fee and other income 3,444,691 3,634,489 15,068,003 8,365,183
------------------- ------------------- ------------------- -------------------
71,162,028 42,266,923 201,570,630 114,710,184
Expenses
Benefits and claims 42,567,994 27,677,436 126,953,209 85,861,467
Other operating expenses 26,069,979 13,360,143 67,856,221 31,984,681
------------------- ------------------- ------------------- -------------------
68,637,973 41,037,579 194,809,430 117,846,148
Segment profit (loss) before
federal income taxes $ 2,524,055 $ 1,229,344 $ 6,761,200 $ (3,135,964)
=================== =================== =================== ===================
Specialty and Other
Revenues:
Net premiums $ 21,454,969 $ 2,788,801 $ 54,623,016 $ 8,298,337
Investment income 3,745,393 130,617 11,258,347 445,106
Fee and other income 377,362 - 1,016,692 -
------------------- ------------------- ------------------- -------------------
25,577,724 2,919,418 66,898,055 8,743,443
Expenses:
Benefits and claims 17,539,366 2,404,487 43,751,497 6,152,728
Other operating expenses 4,199,072 1,131,632 12,988,803 2,652,697
------------------- ------------------- ------------------- -------------------
21,738,438 3,536,119 56,740,300 8,805,425
Segment profit (loss)
before federal income
taxes $ 3,839,286 $ (616,701) $ 10,157,755 $ (61,982)
=================== =================== =================== ===================
Corporate
Revenues:
Investment income $ 46,747 $ 225,730 $ 201,576 $ 319,709
Fee and other income 637,072 - 743,019 -
------------------- ------------------- ------------------- -------------------
683,819 225,730 944,595 319,709
Expenses:
Interest and financing
expenses 1,254,787 209,357 2,745,751 1,541,664
Other operating expenses 1,668,851 225,906 2,935,093 589,895
------------------- ------------------- ------------------- -------------------
2,923,638 435,263 5,680,844 2,131,559
Segment (loss) before
federal incomes taxes $ (2,239,819) $ (209,533) $ (4,736,249) $ (1,811,850)
=================== =================== =================== ===================
</TABLE>
The Company does not separately allocate investment or other identifiable assets
by industry segment, nor are income tax (benefits) expenses allocated by
industry segment. The Company also expanded the detail of its disclosures for
1999 and 1998, which included certain reclassifications.
-11-
<PAGE> 12
Note 8 - Subsequent Event
On October 7, 1999, Ceres Group, Inc. announced a definitive agreement to
purchase The Pyramid Life Insurance Company from United Insurance Company of
America, a subsidiary of Unitrin, Inc. of Chicago, IL. The parties also reached
an agreement in principle for the Company's subsidiaries to sell specialty
medical insurance products through the agent distribution systems of selected
Unitrin insurance subsidiaries over a three-year term. Pyramid based in Mission,
Kansas, provides health and life insurance primarily for the senior market,
including Medicare supplement, long term care, home health care, and senior life
products. At December 31, 1998, Pyramid had assets of approximately $120.0
million, statutory capital and surplus of approximately $42.0 million, and
estimated 1999 revenue of $72.0 million. Pyramid markets senior insurance
products through approximately 2,500 independent agents in 40 states.
The acquisition, subject to regulatory approvals and other customary terms and
conditions, is expected to be completed in early 2000. At completion, Pyramid
will be a wholly-owned subsidiary of the Company. The $67.5 million transaction
value will be financed through a private equity offering, exercise of the
Company's existing lines of credit with Chase Manhattan Bank and associated
banks, special dividends from Pyramid, and reinsurance funding provided by
Hannover.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
---------------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
-----------------------------------
The following discussion should be read in conjunction with our consolidated
condensed financial statements and accompanying notes and other financial
information included elsewhere.
GENERAL
The Company provides a broad spectrum of managed care, health insurance and
specialty products and services to more than 500,000 covered lives. The Company
distributes its products on a national basis through approximately 50,000
independent, licensed agents to the growing and under-served individual and
small business markets and to the senior market. Through the implementation of
cost containment programs and our underwriting and product expertise, the
Company has reduced medical costs and underwriting risks and increased fee-based
revenue. As a result, the Company's medical loss ratio for the quarter ended
September 30, 1999 declined to 64.4% from 75.1% for the same quarter of 1998.
The medical loss ratio for the nine months ended September 30, 1999 declined to
70.1% from 85.1% for the same period in 1998.
In 1996 and 1997, Central, our then-principal subsidiary, experienced
substantial losses incurred in connection with newly-issued group health
insurance policies, greater than anticipated utilization, new state and federal
mandates and reductions in profitability arising out of industry-wide pricing
competition. In June 1997, in order to address the continued decline in
Central's surplus, the Company borrowed $5.2 million from Huntington National
Bank, $5.0 million of which was contributed to the surplus of Central.
In December 1997, Central entered into a reinsurance treaty with Hannover in
which Central transferred to Hannover $24.6 million of reserve liability. In
return for Hannover's reinsurance of this liability, Central transferred $14.6
million in assets to Hannover. The reinsurance treaty, which is on a 50/50
quota-share basis, provided Central with a $10.0 million initial ceding
allowance, which increased Central's statutory surplus. The treaty provides for
repayment of the initial ceding allowance plus interest out of statutory
profits, if any, of the reinsured business. The combination of the $14.0 million
surplus note which was invested in connection with a $20.0 million bridge loan
arranged by Strategic Acquisition Partners, LLC and the $10.0 million ceding
allowance provided an additional $24.0 million to the statutory capital and
surplus of Central, increasing statutory levels in excess of regulatory
risk-based capital requirements and alleviating the regulatory concerns that
were created in 1996 and continued in 1997.
Since January 1, 1998, the Company (1) began executing a new business plan
designed to increase premium rates, reduce costs and emphasize acquisitions; (2)
underwent a change in control; (3) completed a private placement of our common
stock in July 1998 in which the Company issued and sold 7,300,000 shares of
common stock at $5.50 per share and warrants to purchase an additional 3,650,000
shares of common stock at an exercise price of $5.50 per share (the "Equity
Warrants") for an aggregate purchase price of approximately $40.2 million (the
"July Transaction"); (4) entered into an agreement with United Benefit Life as
of August 1, 1998 to reinsure 100% of the major medical policies of United
Benefit Life, covering approximately
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100,000 members with estimated annual premiums of $100.0 million; (5) acquired
Provident from Provident American Corporation on December 31, 1998 for $5.5
million in cash; (6) acquired Continental and CGIC from The Western and Southern
Life Insurance Company of Cincinnati, Ohio, on February 17, 1999 for $84.5
million in cash; (7) completed a private placement of common stock in February
1999 to provide funds for the Continental acquisition, in which 2,000,000 shares
of common stock were issued and sold at $7.50 per share; and (8) acquired United
Benefit Life in July 1999 through foreclosure (collectively, the "Restructuring
Transactions").
Because of the Restructuring Transactions and the acquisitions of Provident,
Continental and United Benefit Life, the Company has undergone significant
changes since January 1, 1998. The acquisitions of Provident and Continental had
no impact on results of operations in 1998. The financial information for the
quarter and nine months ended September 30, 1999 includes the operations of
Continental for February and March in the first quarter, its full operations in
the second and third quarters, and the financial operations of Provident for the
entire period.
RECENT EVENTS
On October 7, 1999, Ceres Group, Inc. announced a definitive agreement to
purchase The Pyramid Life Insurance Company from United Insurance Company of
America, a subsidiary of Unitrin, Inc. of Chicago, IL. The parties also reached
an agreement in principle for the Company's subsidiaries to sell specialty
medical insurance products through the agent distribution systems of selected
Unitrin insurance subsidiaries over a three-year term. Pyramid based in Mission,
Kansas provides health and life insurance primarily for the senior market,
including Medicare supplement, long term care, home health care, and senior life
products. At December 31, 1998, Pyramid had assets of approximately $120.0
million, statutory capital and surplus of approximately $42.0 million, and
estimated 1999 revenue of $72.0 million. Pyramid markets senior insurance
products through 2,500 independent agents in 40 states.
The acquisition, subject to regulatory approvals and other customary terms and
conditions, is expected to be completed in early 2000. At completion, Pyramid
will be a wholly-owned subsidiary of the Company. The $67.5 million transaction
value will be financed through a private equity offering, exercise of the
Company's existing lines of credit with Chase Manhattan Bank and associated
banks, special dividends from Pyramid, and reinsurance funding provided by
Hannover.
On August 1, 1998, Central entered into an agreement with United Benefit Life to
reinsure 100% of the major medical policies of United Benefit Life in effect
prior to August 1, 1998, covering approximately 100,000 members with estimated
annual premiums of $100.0 million. The agreement also provides that Central will
reinsure 100% of all major medical policies written by United Benefit Life from
and after August 1, 1998. Central also began administering all of United Benefit
Life's major medical policies as of August 1, 1998. In addition, Central entered
into an agreement with Insurance Advisors, to market the policies to be issued
by United Benefit Life which Central reinsured. At the same time, Central ceded
80% of the business in force on August 1, 1998 to Hannover, thereby retaining a
net risk of 20%. Additionally, Central ceded 50% of the policies to be written
by United Benefit Life from and after August 1, 1998 and reinsured by Central,
to Hannover.
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On July 31, 1998, United Benefit Life held approximately $13.5 million in
reserves. Hannover paid to Central an initial ceding allowance of $20.0 million
for its 80% portion of the reinsurance. The treaty provides for repayment of the
initial ceding allowance plus interest out of statutory profits, if any, of the
reinsured business. Central paid to United Benefit Life this ceding commission
which was applied to the known reserve shortfall. Reserves for estimated claims
of $36.5 million were assumed by Central, for which United Benefit Life
transferred assets of $33.5 million, including the $20.0 million ceding
allowance provided by Central.
Therefore, reserve liabilities assumed by Central exceeded by $3.0 million the
cash transferred to Central by United Benefit Life as reimbursement for this
assumption. This $3.0 million reserve shortfall was reflected in a note
receivable, payable to Central by United Benefit Life. Insurance Advisors joined
in United Benefit Life's $3.0 million obligation. In addition, Central entered
into an agency agreement with respect to the marketing of United Benefit Life's
policies with Insurance Advisors in exchange for a $7.0 million note receivable.
The agreements between the parties provided for a "true up" which required
United Benefit Life and Insurance Advisors to be jointly liable for the entire
shortfall in the indicated reserve of $36.5 million and the actual liabilities
as of August 1, 1998. The obligations of United Benefit Life and Insurance
Advisors to Central were secured by a pledge by the parent company of United
Benefit Life, United Benefit Managed Care Corporation, of 100% of the stock of
United Benefit Life and the pledge by Insurance Advisors of all of the
commissions due Insurance Advisors or to become due from United Benefit Life.
On March 18, 1999, Central announced the execution of an agreement with United
Benefit Managed Care Corporation to purchase all of the outstanding shares of
its subsidiary, United Benefit Life. On June 14, 1999, Central terminated this
agreement due to the increasing amount of the reserve shortfall at United
Benefit Life. Pursuant to the "true up" mechanism in the agreements among United
Benefit Life, Insurance Advisors and Central, the reserve shortfall totaled
$19.4 million as of September 30, 1999. The reserve shortfall was due in part to
a fraud committed in connection with claims administration at the United Benefit
Life facility. On July 21, 1999, due to the increasing reserve shortfall and
after receiving approval from the Department of Insurance of the State of
Indiana authorizing Central to assume control of United Benefit Life, Central
foreclosed on the stock of United Benefit Life and the renewal commissions due
Insurance Advisors from United Benefit Life to collect the receivable arising
from the reserve shortfall.
Pursuant to Central's reinsurance agreement with Hannover, Hannover is
responsible for 80% of the amount of the reserve shortfall. As of September 30,
1999, Central has recovered approximately $14.3 million of the $19.4 million
reserve shortfall, consisting of $6.0 million from United Benefit Life, $2.9
million from withheld commissions from Insurance Advisors, and $5.4 million from
funds received from Hannover. As a result, the remaining reserve shortfall to be
recovered at September 30, 1999 totaled approximately $5.1 million. Of this
shortfall, the Company has recorded its 20% responsibility, $1.0 million, as an
expense. In addition, United Benefit Life's operation adversely affected third
quarter results by approximately $1.5 million, including a $0.4 million one-time
severance cost associated with the closing of United Benefit Life's Fort Worth,
Texas facility.
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RESULTS OF OPERATIONS
QUARTER ENDED SEPTEMBER 30, 1999 COMPARED TO QUARTER ENDED SEPTEMBER 30, 1998
For the quarter ended September 30, 1999, total net premiums were $87.6 million,
an increase of 121.0%, from $39.6 million for the same quarter in 1998. Medical
premiums for the quarter ended September 30, 1999 were $66.1 million compared to
$36.8 million for the quarter ended September 30, 1998, an increase of 79.5%.
The increase in medical premiums was the result of $14.4 million attributable to
Provident and Continental, $8.9 million for reinsurance assumed and $8.6 million
from new business and rate increases for Central. Specialty and other premiums,
which includes primarily Medicare supplement, long-term care, dental, life
insurance and annuities, were $21.5 million for the quarter ended September 30,
1999 compared to $2.8 million for the quarter ended September 30, 1998, an
increase of 669.3%. The increase in specialty and other premiums was the result
of $17.8 million, or 95.2%, contributed by Continental and the remainder from
Provident.
Net investment income increased to $5.2 million for the third quarter of 1999
from $2.1 million for the third quarter of 1998, an increase of 147.9%.
Continental's portion was $3.8 million. Central's investment income was down
approximately $1.0 million for the quarter due to lower invested assets and the
elimination of the interest on the $10.0 million note receivable due Central
from Insurance Advisors following the foreclosure.
Fee and other income decreased to $3.1 million for the quarter ended September
30, 1999 compared to $3.6 million for the same quarter of 1998, a decrease of
15.8%. This decrease was primarily attributed to additional fees ceded pursuant
to reinsurance.
The amortization of deferred reinsurance gain of $1.4 million for the quarter
ended September 30, 1999 represents the recognition of the ceding commission
allowances received under the Company's reinsurance agreements. The unamortized
amount of $22.3 million for the quarter ended September 30, 1999 is accounted
for as a deferred reinsurance gain on the consolidated condensed balance sheet.
Total benefits, claims and settlement expenses increased to $60.1 million for
the quarter ended September 30, 1999 compared to $30.1 million for the same
quarter in 1998, an increase of 99.8%. Approximately $23.0 million of the $30.0
million total increase was attributable to Provident and Continental. The
remaining approximately $7.0 million was attributable to an increase of claims
at Central and United Benefit Life and the Company's portion of the increase in
the reserve shortfall at United Benefit Life. Medical benefits, claims, losses
and settlement expenses were $42.6 million for the quarter ended September 30,
1999 compared to $27.7 million for the same quarter in 1998, an increase of
53.8%. The medical loss ratio was 64.4%, for the quarter ended September 30,
1999 compared to 75.1% for the same quarter of 1998. Cost reduction and benefit
programs modifications implemented in 1998, such as rate increases, underwriting
changes, claim procedures, and additional managed care programs, led to the
reduction in the medical loss ratio. Specialty and other benefits, claims,
losses and settlement expenses were $17.5 million for the quarter ended
September 30, 1999 compared to $2.4 million for the same quarter of 1998, an
increase of 629.4%. The specialty benefit ratio was 81.7% for
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<PAGE> 17
the third quarter of 1999 compared to 86.2% for the third quarter of 1998. The
increase in the specialty and other benefits, claims, losses, and settlement
expenses, is primarily due to the inclusion of Continental's Medicare supplement
business and interest sensitive life insurance and annuity benefits and
reserves.
Selling, general and administrative expenses increased to $37.7 million in the
third quarter of 1999 compared to $14.7 million in the third quarter of 1998, an
increase of 156.5%. Of this amount, commissions paid (due) to agents in the
quarter ended September 30, 1999 were $22.0 million compared to $9.2 million in
the same quarter of 1998. Included in the 1999 commissions are $11.7 million for
Provident and Continental. The remaining increase of $10.3 million represents
the increase in commissions for Central. This increase was due to the
combination of higher commission rates and an increase in new business sold in
1999. Other operating expenses, consisting of employee salaries and benefits and
other administrative expenses, increased to $25.7 million for the quarter ended
September 30, 1999 compared to $12.1 million in the third quarter of 1998.
Provident, Continental and United Benefit Life accounted for $8.8 million of the
$13.6 million increase, including a $0.4 million one-time severance cost
associated with the closing of United Benefit Life's Fort Worth, Texas facility.
As a percentage of revenues, selling, general and administrative expenses
increased to 38.7% in the third quarter of 1999 compared to 32.4% in the third
quarter of 1998, primarily as a result of higher commission rates, outsourcing
of computer operations, increase in employee costs, United Benefit Life
severance costs, consulting support, acquisitions and product development to
help support our increased growth.
The net amortization and change in deferral of acquisition costs and value of
business acquired resulted in a net deferral of $6.1 million for the third
quarter of 1999 compared to a net amortization of $10,955 for the third quarter
of 1998. Continental and Provident account for $3.7 million of the deferral. The
deferral of first year excess commissions associated with the significant
increase in sales of new products written by Central, Provident and United
Benefit Life, as well as the resulting increase in excess first year expenses,
accounted for the remaining balance.
Amortization of goodwill of $0.3 million relates to the February 1999
acquisition of Continental. The goodwill asset of $23.1 million as of September
30, 1999 will be amortized over 25 years.
Interest expense and financing costs increased to $1.3 million in the third
quarter of 1999 compared to $0.2 million in the third quarter of 1998 as a
result of the interest expense on the $40.0 million loan under the credit
facility which began to accrue on February 17, 1999, the closing date of the
purchase of Continental.
A provision for federal income taxes of $1.4 million, or 35.0% of income before
federal taxes of $4.1 million, was established for the third quarter of 1999.
Net income for the third quarter of 1999 was $2.7 million, or $0.20 basic
earnings per share and $0.17 diluted earnings per share, compared to a net
income of $403,110, or $0.04 basic earnings per share and $0.03 diluted earnings
per share, for the third quarter of 1998. The change in results was primarily
due to a significant increase in revenues resulting from acquisitions and
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increased gross premium writings and decreased benefit, claim and settlement
expenses as a percentage of premiums resulting from rate increases, underwriting
changes, claim procedures and additional managed care programs.
NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1998
For the nine months ended September 30, 1999, total net premiums were $235.7
million, an increase of 115.8%, from $109.2 million for the same period in 1998.
Medical premiums for the nine months ended September 30, 1999 were $181.1
million compared to $100.9 million for the nine months ended September 30, 1998,
an increase of 79.4%. The increase in medical premiums was the result of $34.5
million attributable to Provident and Continental, $24.8 million reinsurance
assumed, and $20.9 million for rate increases and new business at Central.
Specialty and other premiums were $54.6 million for the nine months ended
September 30, 1999 compared to $8.3 million for the nine months ended September
30, 1998, an increase of 558.2%. The increase in specialty and other premiums
was the result of $45.5 million attributable to Continental and Provident.
Net investment income increased to $16.6 million for the nine months ended
September 30, 1999 from $6.1 million for the same period of 1998, an increase of
170.2%. Continental's portion was $11.0 million. Central's net investment income
decreased approximately $1.2 million during the period from the same period in
1998. The decrease was directly related to the decrease in invested assets from
$106.8 at September 30, 1998, to $65.4 million at September 30, 1999. Invested
assets were used to acquire Continental and Provident, and support the cash flow
for the payment of claims for the United Benefit Life reinsurance agreement.
Fee and other income increased to $12.8 million for the nine months ended
September 30, 1999 compared to $8.4 million for the same period of 1998, an
increase of 52.5%. This increase was primarily attributed to $3.5 million in
administrative fees for business reinsured through Provident and United Benefit
Life. The balance represents a defalcation recovery. The amortization of
deferred reinsurance gain of $4.1 million for the nine months ended September
30, 1999 represents the recognition of the ceding commission allowances received
on the Company's reinsurance agreements. The unamortized amount of $22.3 million
at September 30, 1999 is accounted for as a deferred reinsurance gain on the
consolidated condensed balance sheet.
Total benefits, claims and settlement expenses increased to $170.7 million for
the nine months ended September 30, 1999 compared to $92.0 million for the same
period in 1998, an increase of 85.5%. Provident and Continental accounted for
$59.6 million of the total increase of $78.7 million. The remaining $19.1
million is attributable to Central and the Company's portion of the increase in
reserve shortfall at United Benefit Life. Medical benefits, claims, losses and
settlement expenses were $127.0 million for the nine months ended September 30,
1999 compared to $85.9 million for the same period in 1998, an increase of
47.9%. The medical loss ratio was 70.1% for the nine months ended September 30,
1999 compared to 85.1% for the same period in 1998. Cost reduction and benefit
program modifications implemented beginning in 1998, such as rate increases,
underwriting changes, claim procedures, and additional managed care, led to the
reduction in the medical loss ratio. Specialty and other benefits, claims,
losses
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and settlement expenses were $43.8 million for the nine months ended September
30, 1999 compared to $6.2 million for the same period in 1998, an increase of
611.1%. The specialty benefit ratio was 80.1% for the nine months ended
September 30, 1999 compared to 74.1% for the same period in 1998. The increase
is primarily attributable to the inclusion of Continental's Medicare supplement
business and interest sensitive life and annuity benefits and reserves.
Selling, general and administrative expenses increased to $97.3 million in the
nine months ended September 30, 1999 compared to $35.2 million in the same
period in 1998, an increase of 176.5%. Of this amount, commissions paid (due) to
agents in the nine months ended September 30, 1999 were $62.5 million compared
to $27.6 million in the same period in 1998. Included in the 1999 commissions is
$32.5 million for Provident and Continental. The remaining increase represents
the increase in commissions for Central. This increase was due to the
combination of higher commission rates and an increase in new business sold in
1999. Other operating expenses, consisting of employee salaries and benefits and
other administrative expenses, increased to $66.4 million for the nine months
ended September 30, 1999 compared to $25.8 million in the same period in 1998.
Continental accounted for $19.9 million of the $40.6 million increase. We also
incurred costs of $5.8 million for the operations of Provident in the nine
months ended September 30, 1999.
As a percentage of revenues, selling, general and administrative expenses
increased to 36.1% in the nine months ended September 30, 1999 compared to 28.4%
for the same period of 1998, primarily as a result of higher commission rates,
outsourcing of computer operations, hiring additional employees, consulting
support, acquisitions, and product development to help support our increased
growth.
The net amortization and change in deferral of acquisition costs and value of
business acquired resulted in a net deferral of $14.4 million for the nine
months ended September 30, 1999 compared to a net amortization of $21,922 for
the same period in 1998. Continental and Provident account for $10.1 million of
the deferral. The deferral of first year excess expenses associated with the
significant increase in sales of new products written by Central and United
Benefit Life accounted for the remaining balance.
Amortization of goodwill of $0.8 million relates to the February 1999
acquisition of Continental. The goodwill asset of $23.1 million as of September
30, 1999 will be amortized over 25 years.
Interest expense and financing costs increased to $2.7 million in the nine
months ended September 30, 1999 compared to $1.5 million for the same period in
1998 as a result of the interest expense on the $40.0 million loan under our
credit facility, which began to accrue on February 17, 1999, the closing date of
the purchase of Continental.
A provision for federal income taxes of $4.3 million, or 35.0% of income before
federal taxes of $12.2 million was established for the nine months ended
September 30, 1999.
Net income for the nine months ended September 30, 1999 was $7.9 million, or
$0.60 basic earnings per share and $0.51 diluted earnings per share, compared to
a net loss of $5.0 million, or $0.44 loss per share on both a basic and diluted
basis, for the same period in 1998.
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The change in results was primarily due to a significant increase in revenues
resulting from acquisitions and increased gross premium writings and decreased
benefit, claim and settlement expenses as a percentage of premiums resulting
from rate increases, underwriting changes, claim procedures and added managed
care programs.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is the ability of the Company to generate adequate amounts of cash to
meet its financial commitments. The major needs for cash are to enable the
Company's insurance subsidiaries to pay claims and expenses as they come due.
The primary sources of cash are premiums and investment income. Payments consist
of current claim payments to insureds, managed care expenses, operating expenses
such as salaries, employee benefits, commissions, taxes and interests on debts.
The Company has, in the past, relied on the dividend from Central to enable it
to pay dividends to stockholders. We discontinued paying dividends on our common
stock at the end of 1996. By statute, the state regulatory authorities set
minimum liquidity standards to protect both policyholders and stockholders and
limit the dividends payable by our insurance subsidiaries to the Company.
The majority of our assets are in investments, which were $304.9 million, or
42.7% of the total assets, at September 30, 1999 and $89.8 million or 49.8% of
the total assets, at December 31, 1998. Fixed maturities are our primary
investment and were $301.0 million, or 98.7% of total investments, at September
30, 1999, and $89.7 million, or 99.9% of total investments, at December 31,
1998. Other investments consist of policy loans and mortgage loans.
We are carrying fixed maturities of $301.0 million at estimated fair value
(available for sale) at September 30, 1999 and at December 31, 1998 we carried
fixed maturities of $8.9 million at amortized cost (held to maturity) and $80.8
million at estimated fair value (available for sale).
The Company holds few high-yield type securities, with nearly 100% of our bonds
being investment grade quality. In addition to the fixed maturities, we also had
$24.2 million in cash and cash equivalents, and a $10.0 million line of credit
with a major bank (as described below) at September 30, 1999 and $15.0 million
in cash and cash equivalents and a $15.0 million line of credit with a major
bank (which was replaced with the $10.0 million line of credit) equivalents at
December 31, 1998. There was no amount outstanding on the line of credit at
September 30, 1999.
Assets increased 295.9% to $713.6 million at September 30, 1999 from $180.2
million at December 31, 1998. The increase in the nine months ended September
30, 1999 was primarily due to the acquisition of Continental, which had assets
of $512.4 million at September 30, 1999, with the remaining increase
attributable to the acquisition of Provident and United Benefit Life. These
increases were, in part, offset by a related increase in liabilities of $525.0
million during the period to $669.4 million. Continental's liabilities were
$457.9 million and Provident's and United Benefit Life's were $33.9 million at
September 30, 1999. The two major items of our total assets continue to be
investments (42.7%) and reinsurable receivable (39.1%).
The total policy liabilities and accruals ("reserves") were 80.8% of the total
liabilities at September 30, 1999, compared to 67.3% at December 31, 1998.
Continental accounted for 77.3% of the reserves at September 30, 1999.
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To provide funds for the acquisition of Continental, the Company incurred a debt
of $40.0 million under a credit agreement. Under the terms of the credit
agreement, dated as of February 17, 1999, among the Company, various lending
institutions and The Chase Manhattan Bank, as Administrative Agent, the first
principal payment of $3.0 million is due February 17, 2000. Quarterly payments
are due thereafter starting with $1.0 million through February 17, 2001; $1.5
million thereafter through February 17, 2002; and $2.25 million thereafter to
February 17, 2005. Interest on the outstanding balance will be determined based
on whether we select a "Base Rate Loan" or a "Eurodollar Loan". Under the Base
Rate Loan, the interest rate will be 2.5% per annum plus the funds rate and (y)
Chase's prime rate as in effect from time to time. Under the Eurodollar Loan,
the interest rate will be 3.5% per annum plus a Eurodollar rate, which is the
arithmetic average of the offered quotation to first-class banks in the
interbank Eurodollar market by Chase, adjusted for certain reserve requirements.
At September 30, 1999, the interest rate was 9.41%. The credit agreement also
provides for a $10.0 million line of credit which bears interest at the same
rate as the $40.0 million loan. There is currently no amount outstanding under
the line of credit.
The credit agreement contains financial and other covenants with respect to the
Company that, among other matters: (1) prohibit the payment of cash dividends on
our shares of common stock, except upon compliance with certain conditions; (2)
restrict the creation of liens and sales of assets; and (3) require that we at a
minimum maintain (a) a leverage ratio (consolidated debt to consolidated total
capital) of 0.50 to 1.00 through December 31, 1999, 0.45 to 1.00 thereafter
through December 31, 2000, 0.40 to 1.00 thereafter through December 31, 2001,
and 0.35 to 1.00 thereafter, (b) an interest coverage ratio (consolidated EBITDA
to consolidated interest expense) of 2.0 to 1 through December 31, 1999, 2.5 to
1 through December 31, 2000, and 3.0 to 1 thereafter, (c) a risk-based capital
ratio for any regulated insurance company subsidiary of the Company of not less
than 125.0%, and (d) consolidated net worth of $35.0 million through December
31,1999, $40.0 million thereafter through December 31, 2000, $50.0 million
thereafter through December 31, 2001, $60.0 million thereafter through December
31, 2002, and $70.0 million thereafter. In addition, the Company pledged the
common stock of Continental, Central, Provident and other insignificant
subsidiaries as security for the credit agreement. At September 30, 1999, we
were in compliance with the covenants contained in the credit agreement.
The Company believes that cash flow from operating activities will be sufficient
to meet its currently anticipated operating and capital expenditure
requirements. The Company is seeking to raise $18.9 million in a private
placement to finance, in part, the acquisition of Pyramid, and will also borrow
additional funds under available lines with Chase. If additional funds are
required for long-term growth, the Company believes that these funds could be
obtained through equity or debt offerings as market conditions permit or
dictate. There is no assurance that the Company will be able to obtain such
financing on terms that are favorable to it.
OPERATING SEGMENT INFORMATION
The Company has identified three distinct operating segments based upon product
types, as follows: medical, specialty and other, and corporate and other.
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Products included in the medical segment include comprehensive major medical
insurance plans.
Products included in the specialty and other segment include Medicare
supplement, long-term care, dental, life insurance, and annuities.
The corporate and other segment encompasses all our other activities, including
our interest income and expense.
The medical segment had net revenues of $71.2 million in the third quarter of
1999 compared to $42.3 million in 1998. The major reasons for the increase were
due to the addition of approximately $11.7 million from Continental and $8.8
million of net assumed premiums from Provident and United Benefit Life in 1999.
The remaining increase was for premium increases in Central and the collection
of fees for administrating the reinsured business assumed.
Total benefits, claims, losses and settlement expenses for the medical segment
were $42.6 million in the third quarter of 1999 compared to $27.7 million in the
third quarter of 1998. The increase included approximately $4.1 million of
benefits, claims, and expenses for Continental. The remaining increase of $11.0
million was primarily due to claims and expenses related to the United Benefit
Life business assumed in August 1998.
The specialty and other segment had revenues of $25.6 million for the third
quarter in 1999 compared to $2.9 million in 1998. The increase was primarily
attributable to the Continental business acquired in February 1999. Benefits,
claims, losses, and settlement expenses for the specialty and other segment were
$17.5 million in the third quarter of 1999 compared to $2.4 million in the third
quarter of 1998. Again, the increase was primarily attributable to Continental.
Total corporate and other revenues were $0.7 million for the third quarter of
1999 compared to $0.2 million for the third quarter of 1998. The increase was
primarily due to a reclassification of association fees from Central to the
Company.
MARKET RISK AND MANAGEMENT POLICIES
The following is a description of certain risks facing health, life and accident
insurers and how the Company mitigates those risks:
Legal/Regulatory Risk is the risk that changes in the legal or regulatory
environment in which an insurer operates will create additional expenses not
anticipated by the insurer in pricing its products. That is, regulatory
initiatives designed to reduce insurer profits or otherwise affecting the
industry in which the insurer operates, new legal theories or insurance company
insolvencies through guaranty fund assessments, may create costs for the insurer
beyond those recorded in the financial statements. The Company attempts to
mitigate this risk by offering a wide range of products and by operating in many
states, thus reducing its exposure to any single product of non-Federal
jurisdiction, and also by employing underwriting practices which identify and
minimize the adverse impact of this risk.
-22-
<PAGE> 23
Inadequate Pricing Risk is the risk that the premium charged for insurance and
insurance related products is insufficient to cover the costs associated with
the distribution of such products which include: benefits, claims and losses,
settlement expenses, acquisition expenses and other corporate expenses. The
Company utilizes a variety of actuarial and/or qualitative methods to set such
pricing levels.
Credit Risk is the risk that issuers of securities owned by us will default or
that other parties, including reinsurers that have obligations to us, will not
pay or perform. The Company attempts to minimize this risk by adhering to a
conservative investment strategy and by maintaining sound reinsurance and credit
and collection policies.
Interest Rate Risk is the risk that interests rates will change and cause a
decrease in the value of an insurer's investments. This change in rates may
cause certain interest-sensitive products to become uncompetitive or may cause
disintermediation if the Company attempts to mitigate this risk by charging fees
for non-conformance with certain policy provisions and/or by attempting to match
the maturity schedule of its assets with the expected payouts of its
liabilities. To the extent that liabilities come due more quickly than assets
mature, an insurer would have to sell assets prior to maturity and recognize a
gain or loss.
IMPACT OF INFLATION
Inflation rates impact the Company's financial condition and operating results
in several areas. Changes in inflation rates impact the market value of the
investment portfolio and yields on new investments.
Inflation has had an impact on claim costs and overall operating costs and
although it has been, lower in the last few years, hospital and medical costs
have still increased at a higher rate than general inflation, especially
prescription drug costs. New, more-expensive and wider use of pharmaceuticals is
inflating healthcare costs. The Office of Personnel Management reported the
costs of prescription drugs increased by 22.0% in 1998.
While to a certain extent these increased costs are offset by interest rates
(investment income), the rate of income from investments has not increased
proportionately with the increased hospital and medical costs. The Company will
continue to establish premium rates in accordance with trends in hospital and
medical costs along with concentrating on various cost containment programs.
However, there can be no assurance that these efforts will fully offset the
impact of inflation or that premiums will equal or exceed increasing healthcare
costs.
YEAR 2000 UPDATE
General - A comprehensive assessment of the Year 2000 ("Y2K") was completed in
1998 by the Company and its wholly-owned subsidiaries. The Company established a
plan for compliance of all information technology ("IT") systems and "non-IT"
systems, such as operating and control systems that rely on embedded computer
chips, to ensure accurate processing of date data for Y2K and beyond. The plan
also included the identification of key vendors and business partners and
obtaining assurances that their key systems are Y2K compliant. Total cost of the
project was estimated at $5.5 million. At the end of the third quarter of 1999,
incurred costs were $5.3 million. The estimated additional costs are currently
expected to be approximately $200,000.
-23-
<PAGE> 24
Status - The Company continues to execute its plan to ensure that all systems
are Y2K compliant and completed the IT systems in July 1999, and the non-IT
systems in the third quarter of 1999. This review includes Continental, which
the Company believes had all its operating systems and applications Y2K
compliant as of December 31, 1998.
Ongoing Activity - The Company continues to follow-up with key vendors and
business partners on compliance assurances. Contingency planning continues for
the Company's and its subsidiaries systems regarding additional back-up
protection.
Risks - Management of the Company believes it has an effective program in place
to resolve the Y2K issue in a timely manner. As noted above, the Company
continues to work with its key vendors and business partners and finalize its
contingency. In the event that the Company does not complete any of this
additional planning or the present system were to fail, the Company may be
unable to continue important operations, such as billing and collection, payroll
operations and daily administration of policyholder claims. In addition, there
may be disruptions in the economy generally resulting from Y2K problems,
including computer systems failure and equipment shutdown or failure to properly
date business records, all of which may be subject to litigation. The amount of
potential liability and lost revenue cannot be reasonably estimated at this
time, but it is possible that such liability or lost revenue may be material.
Any such event or occurrence could have a material adverse effect on the
Company's business, results of operations and financial condition.
Summary - At this time, the Company is aware of no Y2K compliance issues that
will negatively impact the key business processes of the Company or its
subsidiaries.
FORWARD-LOOKING STATEMENTS
This report contains both historical and forward-looking statements.
Forward-looking statements are statements other than historical information or
statements of current condition. The forward-looking statements relate to the
plans and objectives of the Company for future operations. In addition to
statements which are forward-looking by reason of context, the words "believe,"
"expect," "anticipate," "intend," "designed," "goal," "objective," "optimistic,"
"will" and other similar expressions identify forward-looking statements. In
light of the risks and uncertainties inherent in all future projections, the
inclusion of the forward-looking statements should not be regarded as a
representation by the Company or any other person that the objectives or plans
of the Company will be achieved.
Many factors could cause the Company's actual results to differ materially and
adversely from those in the forward-looking statements, including the following:
- the failure to successfully integrate the businesses of
Continental, Provident, United Benefit Life into the Company,
including the failure to achieve cost savings;
- the failure to complete the acquisition of Pyramid or if the
acquisition is completed, the failure to successfully integrate
the operations of Pyramid into those of the Company; including the
failure to achieve cost savings;
- any shortfall in the assets or reserves of United Benefit Life, or
the commissions due to the Insurance Advisors, which were
foreclosed upon on July 21, 1999;
- rising healthcare costs;
- business conditions and competition in the healthcare industry;
- developments in healthcare reform and other regulatory issues;
-24-
<PAGE> 25
- changes in laws and regulations affecting the Company's business;
- adverse changes in interest rates;
- unforeseen losses with respect to loss and settlement expense
reserves for unreported and reported claims;
- the Company's ability to develop, distribute, and administer
competitive products and services in a timely cost-effective
manner;
- the Company's visibility in the marketplace and its financial and
claims paying ratings;
- the costs of defending litigation and the risk of unanticipated
material adverse outcomes in such litigation;
- the performance of others on whom the Company relies for
reinsurance;
- the risk that issuers of securities owned by the Company will
default or that other parties will not pay or perform;
- changes in accounting and reporting practices;
- the failure to complete the Y2K conversion, including the success
of the outside vendors in being Y2K compliant;
- the effect of any future acquisitions;
- the failure to comply with financial and other covenants in the
Company's loan agreements and;
- the ability of the Company to obtain additional debt or equity
financing on terms favorable to the Company to facilitate
long-term growth.
The foregoing review of important factors should not be construed as exhaustive
and should be read in conjunction with other cautionary statements that are
included in this report, including the risks detailed under "Market Risk and
Management Policies." The Company undertakes no obligation to update
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
--------------------------------------------------------------
The information called for by this item is provided under the caption "Market
Risk and Management Policies" under Item 2 -- Management's Discussion and
Analysis of Financial Condition and Results of Operations.
PART II - OTHER INFORMATION
---------------------------
All items of Part II other than Item 1, Item 2 and Item 6 are either
inapplicable to Registrant, would not require a response, or have been
previously reported.
ITEM 1. LEGAL PROCEEDINGS
-------------------------
The federal income tax returns for the Company and its subsidiaries have been
examined by the Internal Revenue Service ("IRS") for 1991 and 1992. During the
third quarter of 1994, the IRS issued a proposal for adjustments to the
Company's returns for 1991 and 1992. The proposed deficiencies were
approximately $2.4 million of which $215,000 was paid in 1994 and $590,000
-25-
<PAGE> 26
was paid in 1997. The balance of approximately $1.6 million relates to whether
or not the Company's then principal operating subsidiary, Central Reserve Life
Insurance Company ("Central"), qualified as a life company for tax purposes. The
Company vigorously protested the proposed deficiency. Based on discussions with
counsel, management believed existing law supported the Company's position. On
October 12, 1999, in CENTRAL RESERVE LIFE CORPORATION AND ITS SUBSIDIARIES VS.
COMMISSIONER OF INTERNAL REVENUE, Docket No. 12390-96, the United States Tax
Court ruled that Central did qualify as a life company for tax reporting
purposes, and accordingly, no further amounts are due related to the 1991 and
1992 examinations by the IRS.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
-------------------------------------------------
Pursuant to the stock award provision of Peter W. Nauert's, the Company's
Chairman of the Board, President and Chief Executive Officer, employment
agreement, as amended, the Company issued 108,108 common shares to Mr. Nauert in
the third quarter of 1999. This issuance was exempt from registration in
accordance with Section 4(2) of the Securities Act of 1933, as amended, and
exemptions available under applicable state securities laws.
On September 22, 1999, the Company issued 16,667 common shares to Val Rajic
pursuant to his Settlement and Consulting Agreement, dated as of August 10,
1999. This issuance was exempt from registration in accordance with Section 4(2)
of the Securities Act of 1933, as amended, and exemptions available under
applicable state securities laws.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
----------------------------------------
a) Exhibits.
(27) Financial Data Schedule
b) Reports on Form 8-K.
The Company did not file any reports on Form 8-K during the three
months ended September 30, 1999.
-26-
<PAGE> 27
SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CERES GROUP, INC.
Date: November 15, 1999 By: /s/ Charles E. Miller, Jr.
----------------------- -----------------------------------------
Charles E. Miller, Jr.
Executive Vice President and Chief
Financial Officer (Principal Financial
Officer and Chief Accounting Officer)
-27-
<PAGE> 28
EXHIBITS
--------
(27) Financial Data Schedule
-28-
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CERES
GROUP, INC. CONSOLIDATED CONDENSED FINANCIAL STATEMENTS AS OF SEPTEMBER 30, 1999
AND FILED IN FORM 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0000215403
<NAME> CERES GROUP, INC.
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
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