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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-KSB
|X|ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
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 0-20148
CITIZENS FINANCIAL CORPORATION
(Name of small business issuer in its charter)
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Kentucky 61-1187135
(State of Incorporation) (I.R.S. Employer Identification No.)
The Marketplace, Suite 300, 12910 Shelbyville Road, Louisville, Kentucky 40243
(Address of principal executive offices) (Zip Code)
Issuers's telephone number, including area code: (502) 244-2420
Securities registered under Section 12(b) of the Act: None
Securities registered under Section 12(g) of the Act: Class A Stock, No Par
Value
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months and (2) has
been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Check if there is no disclosure of delinquent filers pursuant to Item 405
of Regulation S-B contained in this form and no disclosure will be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [X]
State issuer's revenues for its most recent fiscal year: $23,701,843.
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates computed by reference to the average bid and ask prices
of such stock within the past 60 days: $3,235,000; based on a $7.25 per share
average price on March 24, 1998.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: 1,075,615 shares of Class A
Stock as of March 24, 1998.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the issuer's Board of Director's Proxy Statement for the Annual
Meeting of Shareholders now scheduled for May 21, 1998 are incorporated into
Part III of this Form 10-KSB. This Report consists of 51 consecutively numbered
pages. An index to the Exhibits to this Report appears on page 47. The date of
this Report is March 31, 1998.
Traditional Small Business Disclosure Format (check one): Yes [ ] No [X]
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CONTENTS
PART I
Page
ITEM 1. DESCRIPTION OF BUSINESS ...................................... 3
ITEM 2. DESCRIPTION OF PROPERTY ........................................ 9
ITEM 3. LEGAL PROCEEDINGS ............................................. 10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS .............................................. 10
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS .......................... 10
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR
PLAN OF OPERATIONS .................................. 12
ITEM 7. FINANCIAL STATEMENTS ......................................... 23
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE ................. 44
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS,
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT ... 44
ITEM 10. EXECUTIVE COMPENSATION ....................................... 44
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT ............................... 44
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS ........................................ 44
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K ............................. 45
SIGNATURES ............................................................. 46
EXHIBIT INDEX .......................................................... 47
EXHIBITS................................................................ 49
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
Citizens Financial Corporation (herein, the "Company" or the "Registrant")
was incorporated in Kentucky in 1990 at the direction of the Board of Directors
of Citizens Security Life Insurance Company ("Citizens Security") for the
ultimate purpose of becoming an insurance holding company. Pursuant to a merger
completed in 1991, Citizens Security became a wholly-owned subsidiary of the
Company. The Company is now a holding company that engages in the business of
life insurance, annuities, and accident and health insurance through Citizens
Security.
Citizens Security was incorporated in Kentucky and commenced business in
1965. In 1971, Citizens Security acquired Central Investors Life Insurance
Company by merger. In 1987, it purchased the stock of Old South Life Insurance
Company ("Old South"). In 1992, Old South merged into Citizens Security.
Effective August 31, 1995, the Company and Citizens Security purchased
substantially all of the stock of Integrity National Life Insurance Company
("Integrity"). See Item 6. "Management's Discussion and Analysis or Plan of
Operations" and Note 2 of the Notes to Consolidated Financial Statements for
descriptions of this acquisition and related transactions. On December 31, 1995,
Integrity merged into Citizens Security. Citizens Security is currently licensed
to transact the business of life insurance, annuities, and accident and health
insurance in 19 states and the District of Columbia.
In this Form 10-KSB, the term "Insurance Subsidiaries" is a collective
reference to Citizens Security and Old South prior to their 1992 merger and to
Citizens Security and Integrity from September, 1995 through their December,
1995 merger. It is otherwise a reference to Citizens Security. References to the
business of Integrity are to those elements of Integrity's business continued by
the Company after the acquisition and therefore excludes other elements that
were disposed of in connection with the acquisition.
Insurance Operations
The Company, through Citizens Security, operates in two segments -- 1).
life insurance and annuities and 2). accident and health insurance. Both
segments include individual and group insurance. The following table presents
information concerning the revenues and income or loss from operations before
federal income taxes for each segment for each of the last three fiscal years
and the identifiable assets of the two segments as of the end of such years.
Additional information regarding these segments is contained in Note 11 of the
Notes to Consolidated Financial Statements, in Item 7. "Management's Discussion
and Analysis or Plan of Operations."
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<TABLE>
Year Ended December 31 1997 1996 1995
<CAPTION>
- - --------------------------------- -------------------- -------------------- -------------------
Revenues:
Life insurance and annuities:
<S> <C> <C> <C>
Traditional life $12,168,844 $11,041,474 $ 6,523,554
Universal life 1,089,728 1,749,935 1,116,724
Group life 603,462 685,968 827,348
Annuity and other 1,055,053 918,773 1,242,045
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Total life insurance and annuities 14,914,088 14,396,150 9,709,671
Accident and health insurance 8,784,755 8,654,035 6,576,906
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Total revenues $23,701,843 $23,050,185 $16,286,577
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Income (loss) from operations before federal income taxes:
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Life insurance and annuities $ 2,019,390 $ 1,051,618 $ 417,888
Accident and health insurance 451,322 284,008 323,343
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Total income (loss) $ 2,470,712 $ 1,335,626 $ 741,231
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Assets at end of period:
Life insurance and annuities $81,178,706 $76,384,118 $77,504,054
Accident and health insurance 3,571,135 3,878,590 6,751,207
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Total assets at end of period $84,749,841 $80,262,708 $84,255,261
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</TABLE>
Life Insurance and Annuities. The individual life insurance products
presently offered by Citizens Security consist of traditional whole life
insurance, which provides policyholders with permanent life insurance and fixed,
guaranteed rates of return on the cash value element of policy premiums, and
universal life insurance, which provides policyholders with permanent life
insurance and adjustable rates of return on the cash value element of policy
premiums, based upon current interest rates. The substantial majority of
individual life insurance products currently sold by Citizens Security are
traditional whole life policies. Citizens Security also issues individual term
life insurance products although sales in recent years have been minimal.
Approximately 86% of 1997 individual life insurance sales were made through
the Company's home service agency force. These agents sell primarily traditional
whole life policies of small face value (typically from $1,000 to $10,000).
These policies are subject to normal underwriting procedures with the extent of
such procedures determined by the amount of insurance, age of applicant and
other pertinent factors. The remaining traditional whole life sales are
primarily attributable to the Company's graded death benefit product. The graded
death benefit policy returns premium plus interest compounded at an annual rate
of 10% if the insured dies of natural causes during the first three years the
policy is in force. After three years, and during the first three years if the
insured dies of an accidental cause, the benefit payable is the face amount of
the policy. Prior to the second quarter of 1997, the Company issued graded death
benefit policies with a two year return-of-premium period. During the third
quarter of 1997, the Company introduced a simplified issue product that is more
extensively underwritten and carries lower premium rates than the graded death
benefit product. The Company believes these products will permit significant
additional penetration into the "final expense market".
Generally, traditional whole life insurance products are more profitable
than universal life policies, in part because investment margins are normally
greater for traditional whole life products than for universal life policies.
Overall profitability on universal life policies may decline as a result of
downward interest crediting rate adjustments to the extent that policyholders
withdraw funds to invest in higher-yielding financial products. The majority of
Citizens Security's currently outstanding universal life products are subject to
surrender charges. The Company believes that this factor protects it to a great
extent from a decline in profitability due to increased withdrawals over the
next few years. The
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profitability of traditional whole life products and universal life
policies is also dependent upon the ultimate underwriting experience and the
realization of anticipated unit administrative costs. The Company believes that
the historical claims experience for the traditional whole life and universal
life products issued by the Insurance Subsidiaries has been within expected
ranges, in relation to the mortality assumptions used to price the products.
Citizens Security also sells group life, accidental death and
dismemberment, and dependent life insurance. Most policies are written for a one
year term and competitive bids are often sought by the contract holder prior to
renewal.
The following table provides information concerning the Insurance
Subsidiaries' volume of life insurance coverage in force excluding participation
in group underwriting pools for federal employees (FEGLI) and service personnel
(SGLI) for each of the last three fiscal years.
<TABLE>
Year Ended December 31
(Dollars in Thousands) 1997 1996 1995
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<CAPTION>
<S> <C> <C> <C>
In force at beginning of period1 $712,581 $769,471 $423,814
Acquired business of Integrity --- --- 355,077
New business issued during period:
Individual 61,519 51,477 31,166
Group 3,755 6,787 14,091
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Total $ 65,274 $ 58,264 $ 45,257
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Terminations during period $ 97,191 $115,154 $ 54,677
Termination rate2 13.64% 14.97% 10.03%
In force at end of period1:
Individual 507,381 515,163 555,377
Group 173,283 197,418 214,094
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Total $680,664 $712,581 $769,471
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Net reinsurance ceded at end of period $115,218 $129,287 $131,516
</TABLE>
1Before deduction of reinsurance ceded.
2Represents the percentage of individual policies terminated during the
indicated period by lapse, surrender, conversion, maturity, or otherwise.
For 1995, terminations by Integrity policyholders have been annualized to
compute amounts.
Substantially all annuity considerations are attributable to sales of
flexible premium deferred annuities, life policy annuity riders, and single
premium deferred annuities. Generally, a flexible premium deferred annuity or a
life policy annuity rider permits premium payments in such amounts as the
policyholder deems appropriate, while a single premium deferred annuity requires
a one-time lump sum payment.
Accident and Health Insurance. Citizens Security markets individual
accident and health insurance products providing coverage for monthly income
during periods of hospitalization, scheduled reimbursement for specific hospital
and surgical expenses and cancer treatments, and lump sum payments for
accidental death or dismemberment. Citizens Security also markets group health
plans providing coverage for short and long-term disability, income protection,
and dental procedures. The dental products are indemnity policies sold on a pure
group and voluntary group basis. Voluntary dental groups must meet prescribed
participation limits. All dental products have annual limits on all covered
procedures and lifetime limits on orthodontia procedures. In addition,
orthodontia and major restorative procedures are not covered for the first six
months to one year, depending upon the plan, unless a no-loss-no-gain provision
is attached to the policy. Group dental policy premiums have grown substantially
in recent years, making it Citizens Security's largest product based upon
premiums (in 1997, 41% of total premiums and 84% of accident and health
insurance segment premiums).
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Marketing. Citizens Security is currently licensed to sell products in the
District of Columbia and in 19 states as follows:
Alabama Indiana Missouri South Carolina
Arkansas Kentucky New Jersey Tennessee
Delaware Louisiana North Carolina Virginia
Florida Maryland Ohio West Virginia
Georgia Mississippi Pennsylvania
Citizens Security markets its portfolio of products through the personal
producing general agent distribution system. It presently has approximately
1,700 sales representatives, all of whom are independent agents and all or
substantially all of whom also represent other insurers. Approximately 300 of
these agents are former agents of Integrity who specialize in the home service
market. That market consists primarily of low-income families and individuals
who desire whole life policies with policy limits typically below $10,000.
Agents usually collect premiums directly at monthly intervals. The home service
market has higher than average policy lapse rates.
Citizens Security furnishes rate material, brochures, applications, and
other pertinent sales material, at no expense to the agents. The agents are
responsible for complying with state licensing laws and any related appointment
fees. Agents are compensated by commissions. Citizens Security has agent
commission arrangements that are generally intended to provide competitive
incentives for agents to increase their production of new insurance and to
promote continued renewals of in-force insurance. Historically, these incentives
have frequently involved awards, overrides, and compensation scales that
escalate according to achievement levels for newly-issued business and that
provide additional payments for renewal business.
Underwriting. Citizens Security follows underwriting procedures designed to
assess and quantify insurance risks before issuing life and health insurance
policies to individuals and members of groups. Such procedures require medical
examinations (including blood tests, where permitted) of applicants for certain
policies of health insurance and for policies of life insurance in excess of
certain policy limits. These requirements are graduated according to the
applicant's age and vary by policy type. Citizens Security also relies upon
medical records and upon each applicant's written application for insurance,
which is generally prepared under the supervision of a trained agent. In issuing
health insurance, information from the application and, in some cases,
inspection reports, physician statements, or medical examinations are used to
determine whether a policy should be issued as applied for, issued with reduced
coverage under a health rider, or rejected.
Acquired Immunodeficiency Syndrome ("AIDS") claims identified to date, as a
percentage of total claims, have not been significant for the Insurance
Subsidiaries. Evaluating the impact of future AIDS claims under health and life
insurance policies issued is extremely difficult, in part due to the
insufficiency and conflicting data regarding the number of persons now infected
with the AIDS virus, uncertainty as to the speed at which the AIDS virus has and
may spread through the general population, and advancements in medical treatment
options. Citizens Security has implemented, where legally permitted,
underwriting procedures designed to assist in the detection of the AIDS virus in
applicants.
Investments. The Company derives a substantial portion of its income from
investments. Citizens Security maintains a diversified investment portfolio that
is held primarily to fund future policyholder obligations. State insurance laws
impose certain restrictions on the nature and extent of investments by insurance
companies and, in some states, require divestiture of assets contravening these
restrictions. Within the framework of such laws, Citizens Security follows a
general strategy to maximize total return (current income plus appreciation)
without subjecting itself to undue risk. Where deemed appropriate, Citizens
Security will hold selected non-investment grade bonds that provide higher
yields or are convertible to common stock. The Company considers a bond
non-investment grade if it is unrated or rated less than BBB by Standard &
Poor's Rating Group ("S&P") or BAA by Moody's Investors Service ("Moody's").
Citizens Security's non-investment grade bonds, based on reported fair values,
represented 8.8% of its cash and invested assets as of December 31, 1997.
Citizens Security follows the practice of maintaining substantial investments in
equity securities in order to achieve higher investment earnings than can
usually be achieved through portfolio bonds but at a greater comparative risk.
Mortgage loans, federally-insured mortgage-backed securities, collateralized
mortgage obligations and real estate investments, apart from the investment in
the office building described in Item 2. "Description of Property," represented
approximately 11.4% of cash and invested assets as of December 31, 1997.
Citizens Security
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owned no collateralized mortgage-backed securities as of December 31, 1997
that would be included in the high risk accounting classification.
The Company also maintains an investment portfolio of equity securities
separate from that of Citizens Security. A portion of the portfolio is financed
by a collateral loan from Citizens Security under terms that limit the Company's
investment discretion, primarily by requiring that the Company's investments,
when aggregated with those of Citizens Security, shall not exceed any
categorical or issuer-diversification limitations imposed upon investments by
the Kentucky Insurance Code.
For additional information concerning investment results, see Item 6,
"Management's Discussion and Analysis or Plan of Operations."
Reinsurance. In keeping with industry practice, Citizens Security
reinsures, with unaffiliated insurance companies, portions of the life and
health insurance risks which it underwrites. Citizens Security retains no more
than $40,000 of individual life insurance risk and $15,000 of group life
insurance risk for any single life. Graded death benefit coverages above $4,000
are generally 50% reinsured, with Citizens Security maintaining a maximum
$10,000 risk on any one life. Individual and group accidental death coverage is
100% reinsured. At December 31, 1997, approximately $115,218,000 or 17% of life
insurance in force was reinsured under arrangements described in Note 12 to the
Consolidated Financial Statements. Under most such reinsurance arrangements, new
insurance is reinsured automatically rather than on a basis that would require
the reinsurer's prior approval. Generally, Citizens Security enters into
indemnity reinsurance arrangements to assist in diversifying its risks and to
limit its maximum loss on large or unusually hazardous risks. Indemnity
reinsurance does not discharge the ceding insurer's liability to meet policy
claims on the reinsured business. Accordingly, Citizens Security remains
responsible for policy claims on the reinsured business to the extent a
reinsurer should fail to pay such claims.
Competition. The insurance industry is highly competitive, with over 1,700
life and health insurance companies in the United States. Many insurers and
insurance holding company systems have substantially greater capital and
surplus, larger and more diversified portfolios of life and health insurance
policies, and larger agency sales operations than those of Citizens Security.
Financial and claims paying ratings assigned to insurers by A.M. Best Company
("Best's") and by nationally-recognized statistical rating organizations have
become more important to policyholders. Citizens Security's rating was last
changed by Best's in May, 1996, when it was moved to B- (Good) in financial size
Class IV from C++ (Fair) in the same size Class. According to Best's, a B-
rating is assigned to companies that, in its opinion, have achieved good overall
performance when compared to the standards established by Best's. Also according
to Best's, B- companies generally have an adequate ability to meet their
policyholder and other contractual obligations, but their financial strength may
be susceptible to unfavorable changes in underwriting or economic conditions.
There are seven Best's rating categories above the B- category from B to A++.
Citizens Security will continue to pursue upward revisions in its Best's rating.
S&P assigns claims-paying ability ratings to certain U.S. insurers.
Generally, such a rating is S&P's opinion of an insurer's financial capacity to
meet the obligations of its insurance policies in accordance with their terms.
In the case of companies like Citizens Security that have not requested ratings,
S&P's methodology uses statistical tests based on statutory financial data as
filed with the National Association of Insurance Commissioners ("NAIC"). The
rating process does not involve contact between S&P analysts and the insurer's
management. Citizens Security's rating was last changed to BBq effective June,
1997, from BBBq. (The "q" subscript indicates the quantitative method of
rating.) According to S&P, BB companies may have adequate financial security but
their capacity to meet policyholder obligations is vulnerable to adverse
economic and underwriting conditions. The BB rating is the highest of five
ratings in the vulnerable range of ratings. The Company was not informed of
particular reasons for the latest change in its rating. A rating is not a
recommendation to buy, sell or hold securities and is subject to revision or
withdrawal by the assigning rating organization. Each rating should be evaluated
independently of any other rating.
Citizens Security competes primarily on the basis of the experience, size,
accessibility and claims response of its customer service representatives,
product design, service and pricing. The Company believes that Citizens Security
is generally competitive in the markets in which it is engaged based upon
premium rates and services, has good relationships with its agents, and has an
adequate variety of insurance and annuity products approved for issuance.
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State Insurance Regulation. Citizens Security, in common with other
insurers, is subject to comprehensive regulation in the states in which it is
authorized to conduct business. The laws of such states establish supervisory
agencies with broad administrative powers, among other things, to grant and
revoke licenses for transacting business, to regulate the form and content of
policies, reserve requirements, and the type and amount of investments, and to
review premium rates for fairness and adequacy. Citizens Security files detailed
annual convention statements with all states in which it is licensed to transact
business. The Kentucky Department of Insurance also periodically examines the
business and accounts of Citizens Security.
Citizens Security also can be required, under the solvency or guaranty laws
of most states in which it does business, to pay assessments (up to prescribed
limits) to fund policyholder losses or liabilities of other insurance companies
that become insolvent. These assessments may be deferred or foregone under most
guaranty laws if they would threaten an insurer's financial strength and, in
certain instances, may be offset against future premium or intangible property
taxes. Gross assessments for Citizens Security, before offsets for future
premium or intangible property taxes, were $ 15,325, $20,308, and $65,182 in
1997, 1996 and 1995, respectively. The amount of any future assessments under
these laws cannot be reasonably estimated.
Kentucky, in common with substantially all states, regulates transactions
between or affecting insurance holding companies and their insurance company
subsidiaries, including the Company and Citizens Security. Generally, under
Kentucky insurance holding company statutes, the Kentucky Department of
Insurance must approve in advance the direct or indirect acquisition of 15% or
more of the voting securities of an insurance company organized under the laws
of Kentucky. Such statutes also regulate certain transactions among affiliates,
including the payment of dividends by an insurance company to its holding
company parent. Under the Kentucky statutes, Citizens Security may not during
any year pay dividends on its common and preferred stock to the Company in
excess of the lesser of the net gain from operations for the preceding year or
10% of Citizens Security's surplus at the end of the preceding year, without the
consent of the Kentucky Commissioner of Insurance. For 1998, the maximum amount
of dividends that could be paid without the Commissioner's approval is $762,000.
It is presently anticipated that the Company will derive substantially all of
its liquidity from income and capital gains earned on its investment portfolio,
management service fees and dividends paid by Citizens Security, and Citizens
Security's repurchase of its preferred stock owed by the Company.
During the past few years, the National Association of Insurance
Commissioners (NAIC) has taken several steps to address public concerns
regarding insurer solvency. These steps included implementing a state
certification program designed to promote uniformity among the insurance laws of
the various states and developing insurer reporting requirements that focus on
asset quality, capital adequacy, profitability, asset/liability matching, and
liquidity. These requirements include establishment of asset valuation reserves
("AVR") and interest maintenance reserves ("IMR"); risk- based capital ("RBC")
rules to assess the capital adequacy of an insurer; and a revision to the
Standard Valuation Law ("SVL") that specifies minimum reserve levels and
requires cash flow testing in which projected cash inflows from assets are
compared to cash outflows for liabilities to determine reserve adequacy.
Citizens Security's AVR, as of December 31, 1997, 1996 and 1995, is shown
in Item 6. "Management's Discussion and Analysis or Plan of Operations," where
cash flow testing and the results of such testing as applied to Citizens
Security are also described and discussed.
RBC provides a means of establishing the capital standards for insurance
companies to support their overall business operations in light of their size
and risk profile. The four categories of major risk involved in the formula are
[i] asset risk -- the risk with respect to the insurer's assets; [ii]insurance
risk -- the risk of adverse insurance experience with respect to the insurer's
liabilities and obligations; [iii] interest rate risk -- the interest risk with
respect to the insurer's business; and [iv] business risk -- all other business
risks. A company's RBC is calculated by applying factors to various asset,
premium and reserve items, with higher factors for those items with greater
underlying risk and lower for less risky items. RBC standards are used by
regulators to set in motion appropriate regulatory actions relating to insurers
that show signs of weak or deteriorating conditions. They also provide an
additional standard for minimum capital, below which companies would be placed
in conservatorship. Based on Citizens Security's RBC computation as of December
31, 1997, its adjusted capital exceeds the point at which regulatory inquiries
would normally begin by approximately 210%.
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Action taken by the NAIC in these and other areas may have a significant
impact on the regulation of insurance companies during the next several years.
Given its comparatively small size, it may be expected that Citizens Security
would be affected by more stringent regulatory policy, both under existing laws
and any new regulatory initiatives. Such effects could include curtailment or
discontinuance of insurance underwriting in one or more states, mandated
increases in capital and surplus, and/or other effects.
Federal Income Taxation. Citizens Security is taxed under the life
insurance company provisions of the Internal Revenue Code of 1986, as amended
(the "Code"). Under the Code, a life insurance company's taxable income
incorporates all income, including life and health premiums, investment income,
and certain decreases in reserves. The Code currently establishes a maximum
corporate tax rate of 35% and imposes a corporate alternative minimum tax rate
of 20%. See Item 6. "Management's Discussion and Analysis or Plan of Operations"
and Note 9 of the Notes to Consolidated Financial Statements.
The Code currently requires capitalization and amortization over a five to
ten year period of certain policy acquisition costs incurred in connection with
the sale of certain insurance products. Prior tax laws permitted these costs to
be deducted as incurred. These provisions apply to life, health, and annuity
business. Certain proposals to make additional changes in the federal income tax
laws, including increasing marginal tax rates, and regulations affecting
insurance companies or insurance products, continue to be considered at various
times in the United States Congress and by the Internal Revenue Service. The
Company currently cannot predict whether any additional changes will be adopted
in the foreseeable future or, if adopted, whether such measures will have a
material effect on its operations.
Reserves. In accordance with applicable insurance laws, Citizens Security
has established and carries as liabilities actuarial reserves to meet its policy
obligations. Life insurance reserves, when added to interest thereon at certain
assumed rates and premiums to be received on outstanding policies, are required
to be sufficient to meet policy obligations. The actuarial factors used in
determining reserves in the statutory basis financial statements are based upon
statutorily-prescribed mortality and interest rates. Reserves maintained for
health insurance include the unearned premiums under each policy, reserves for
claims that have been reported but not yet paid, and reserves for claims that
have been incurred but have not been reported. Furthermore, for all health
policies under which renewability is guaranteed, additional reserves are
maintained in recognition of the actuarially-calculated probability that the
frequency and amount of claims will increase as policies persist. Citizens
Security does not continue accumulating reserves on reinsured business after it
is ceded. Citizens Security is required to maintain reserves on reinsured
business assumed on a basis essentially comparable to direct insurance reserves.
Reinsurance business assumed is presently insignificant in amount.
The reserves carried in the financial statements included elsewhere in this
Form 10-KSB are calculated on the basis of generally accepted accounting
principles and differ from the reserves specified by the laws of the various
statutes and carried in the financial statements of Citizens Security prepared
on the basis of statutory accounting principles. These differences arise from
the use of different mortality and morbidity tables and interest assumptions,
the introduction of lapse assumptions into the reserve calculation, and the use
of the level premium reserve method on all insurance business. See Note 1 of the
Notes to Consolidated Financial Statements for certain additional information
regarding reserve assumptions under generally accepted accounting principles.
Employees. The total number of persons employed by the Company and its
subsidiaries on March 16, 1998, exclusive of agents, was 56 of whom 54 were full
time. As of that date, the Company had approximately 1,520 independent agents
licensed to sell its products.
ITEM 2. DESCRIPTION OF PROPERTY
The Company owns, through Citizens Security, a three-story, 63,000 square
foot office building in suburban Louisville, Kentucky completed in 1988. The
Company and Citizens Security occupy about 13,200 square feet in the building
for their headquarters and home offices. Another 49,600 square feet of the
remaining space are leased to unaffiliated tenants under leases of various
duration. Market conditions for this property are favorable and, in management's
opinion, the property is adequately covered by insurance. Currently, the
Company's policy is not to invest in additional real estate or real estate
mortgages, although a change in such policy would not require a vote of security
holders. Citizens Security
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is constrained by state statues from investing more than ten percent of its
assets in any one item, including real estate. Citizens Security's maximum such
investment at December 31, 1997 would be $7,160,370. In addition, the Company's
current bank lending agreement precludes investment in additional real estate
and in mortgages with a loan-to-appraised- value ratio of more than 75%.
ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings pending against the Company or its
subsidiaries or of which any of their property is the subject other than routine
litigation incidental to the business of the Company and its subsidiaries. There
are no material proceedings in which any director, officer, affiliate or
shareholder of the Company, or any of their associates, is a party adverse to
the Company or any of its subsidiaries or has a material interest adverse to the
Company or any of its subsidiaries.
ITEM 4. SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of the fiscal year
covered by this Form 10KSB to a vote of the Company's security holders, through
the solicitation of proxies or otherwise.
PART II
ITEM 5. MARKET FOR COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS
As of March 30, 1998, there were approximately 2,930 holders of record of
the Company's Class A Stock, its only class of common equity.
The Class A Stock is currently eligible for quotation on the National
Association of Securities Dealers, Inc.'s Small-Cap Market ("NASDAQ") under the
trading symbol CNFL. Trading activity has been limited. NASDAQ has taken the
position that the Company does not meet the newly-adopted requirement for the
number of shares owned by non- affiliates. The Company is presently contesting
this position and is seeking an exemption or extension for compliance. In the
event that NASDAQ does not provide relief, the Company would be required to take
steps (e.g. a stock dividend) to increase the number of shares owned by
non-affiliates in order to maintain the Class A stock's eligibility for
quotation.
10
<PAGE>
The following table summarizes quarterly high and low bid quotations for
the Class A Stock in 1997 and 1996 as reported by NASDAQ. Such quotations
represent prices between dealers and do not include retail markup, markdown, or
commission, and may not necessarily represent actual transactions.
Bid Quotations for Class A Stock
---------------------------------------
Quarter Ended High Bid Low Bid
- - --------------------------- ------------------- -------------------
December 31, 1997 $ 7 3/4 $ 5 5/8
September 30, 1997 $ 6 1/8 $ 4 3/4
June 30, 1997 $ 5 3/4 $ 4 3/4
March 31, 1997 $ 6 $ 5
December 31, 1996 $ 6 $ 4 3/4
September 30, 1996 $ 6 $ 5 1/4
June 30, 1996 $ 6 1/2 $ 5 1/4
March 31, 1996 $ 6 $ 5
The Company has not paid a dividend on the Class A Stock since its
organization in 1991, and no dividend had been paid by its predecessor, Citizens
Security, from 1988 through the date it became a subsidiary of the Company. The
Board of Directors of the Company has not adopted a dividend payment policy;
however, dividends must necessarily depend upon the Company's earnings and
financial condition, applicable legal restrictions, and other factors relevant
at the time the Board of Directors considers a dividend policy. The Company is
subject to a loan agreement covenant that prevents it from paying dividends on
the Class A Stock without the consent of the lender except to the extent it can
meet certain requirements relating to the ratio of its income before interest
and tax expense plus dividends, to its interest expense and dividend payments
for five (5) consecutive quarters and provided that there is no default or
potential default under the loan agreement. As of January, 1998, the Company
could pay dividends in the maximum amount of approximately $625,000 without
violating the loan agreement covenant. Cash available for dividends to
shareholders of the Company must initially come from income and capital gains
earned on its investment portfolio, management service fees and dividends paid
by Citizens Security, and Citizens Security's repurchase of its preferred stock
owned by the Company. Provisions of the Kentucky Insurance Code relating to
insurance holding companies subject transactions between the Company and
Citizens Security, including dividends paid to the Company, to certain standards
generally intended to prevent such transactions from adversely affecting the
adequacy of Citizens Security's surplus as regards policyholders. See Item
1."Description of Business -- State Insurance Regulation." In addition, under
the Kentucky Business Corporation Act, the Company may not pay dividends if,
after giving effect to a dividend, it would not be able to pay its debts as they
become due in the usual course of business or if its total liabilities would
exceed its total assets.
11
<PAGE>
ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS
OR PLAN OF OPERATIONS
During 1997 the Company achieved record earnings, with net income
applicable to common shares up 123% from the prior year, net income per share
(diluted) up 77%, and book value per share up 27% (excluding the effect of
unrealized gains and losses on fixed maturity securities - fair value accounting
standard SFAS 115). Much of this growth was attributable to successful
management of the investment portfolio. As detailed below, during the past three
years the Company has maintained an equity portfolio averaging approximately
$8,100,000 (cost basis) which yielded an average annual pretax total return in
excess of 30%. Overall pretax income from insurance operations, excluding
realized investment gains, is about $143,000 below last year. However, after
adjusting for the decline in investment income attributable to transferring
additional funds to equity positions, insurance operating income is roughly
equivalent to the prior year. Significant progress was achieved during 1997 in
several aspects of insurance operations. Particularly, after expanding the
dental premium volume during the past few years, a number of steps were taken in
1997 to increase profits on this additional volume, as evidenced by a 4.6
percentage point improvement in the dental claim ratio. During 1997, the Company
lengthened the return-of-premium period on its graded death benefit product from
two to three years and began selling this revised product along with a newly
developed simplified issue product. The lengthened return-of-premium period
significantly increases protection of profit margins on the graded death benefit
product. Initial sales of these new products have exceeded management's
expectations. Home service, individual life volume was down moderately in 1997;
however, we believe this situation will improve in 1998 as a result of the
Company's recent licensing in New Jersey, enhancement of the life and disability
product portfolio, and a number of agent recruiting and incentive initiatives.
Home service mortality increased during 1997; however we believe this situation
will gradually improve as a result of the more structured underwriting practices
implemented after this business was acquired in late 1995.
ACQUISITIONS
United Liberty Life Insurance Company
Effective December 12, 1997, the Company agreed to acquire 100% of the
common stock of United Liberty Life Insurance Company ("United Liberty") from
Chaswil United Corporation, a privately-held Cincinnati-based insurance holding
company. Initially, the terms called for a cash price of $7.8 million, subject
to satisfactory completion of business and legal reviews and closing
adjustments. Effective March 2, 1998, the purchase price was revised to $6.4
million and Chaswil agreed to retain approximately $2.0 million of United
Liberty mortgage and real estate related assets as payment towards the purchase
price. This transaction is subject to receipt of all necessary state and federal
regulatory approvals. At December 31, 1997, United Liberty had statutory
admitted assets of approximately $40 million and statutory capital and surplus
of approximately $3.7 million (including approximately $328,000 of Asset
Valuation Reserves). United Liberty's primary business is traditional life
insurance, including a presence in the pre-need funeral funding niche.
Integrity National Life Insurance Company
In September, 1995, the Company and Citizens Security Life Insurance
Company ("Citizens Security") acquired 98.85% of the common stock of Integrity
National Life Insurance Company (the "Integrity acquisition") from Southwestern
Life Corporation, which has since been renamed ICH Corporation ("ICH"). The
Integrity acquisition was accounted for as a purchase and the results of
Integrity's operations have been included in the consolidated financial
statements of the Company since the date of acquisition. Citizens Security
acquired the remaining 1.15% of Integrity's common stock in conjunction with the
merger of Integrity into Citizens Security as of December 31, 1995.
The aggregate purchase price for the Integrity acquisition, as finally
adjusted, was $9,419,000 (including $437,000
12
<PAGE>
of net transaction costs associated with the purchase and, the purchase of
minority shareholders' stock as part of the merger discussed above).
Prior to the closing, Integrity entered into a coinsurance and assumption
reinsurance agreement with Union Bankers Insurance Company ("Union Bankers"),
another affiliate of ICH, covering Integrity's 14,500 individual long-term care
and Medicare Supplement insurance policies with annualized premiums of
approximately $14,800,000, leaving the remaining life and accident and health
insurance business with Integrity. In conjunction with this reinsurance
transaction, Integrity transferred approximately $9,200,000 of reserves to Union
Bankers. Completion of these transactions was a condition to the Company's
obligations in the Integrity Acquisition because the reinsured business did not
fit into the Company's business plans. Union Bankers directly assumed the
liability for these policies.
The Integrity Acquisition was financed with working capital of Citizens
Security and approximately $6,100,000 of the $6,400,000 proceeds under a Term
Loan Agreement with a commercial bank (the "Term Loan Agreement"). Borrowings
under the Term Loan Agreement are evidenced by a $4,400,000 note that originally
matured on October 1, 2002; however, due to prepayments, it now matures on
October 1, 2001 (the "2001 Note") and a $2,000,000 note that matures on October
1, 2003 (the "2003 Note"). See Note 6 to the Consolidated Financial Statements.
In order to obtain required approvals from insurance regulatory authorities
of Pennsylvania, the Company issued $1,727,000 of preferred stock in December
1995 and applied $1,500,000 of the proceeds to prepay the first installment of
the 2001 Note. In addition, in January 1996, the Company sold an additional
$2,343,000 of preferred stock. See Notes 7 and 16 to the Consolidated Financial
Statements. Giving effect to payments and prepayments, the principal balances of
the 2001 Note and the 2003 Note were $1,900,000 and $1,610,000, respectively, as
of December 31, 1997.
FINANCIAL POSITION
Assets. At December 31, 1997, the Company's available-for-sale fixed
maturities had a fair value of $43,030,000 and amortized cost of $41,841,000.
The available-for-sale portfolio consists of fixed maturities and equity
securities that the Company, given the proper market condition, would sell prior
to maturity. This portfolio is reported at fair value with unrealized gains and
losses, net of applicable deferred taxes and adjustments to deferred policy
acquisition costs, reflected as a separate component in shareholders' equity.
Effective December 31, 1995, the Company transferred all of its
"held-to-maturity" fixed maturities to the "available-for-sale" fixed maturities
portfolio. The Company's fixed maturities portfolio decreased approximately 11%
in 1997 and increased 4% in 1996, on an amortized cost basis. The 1997 decrease
resulted primarily from increasing its positions in the favorable equities
market and somewhat higher year-end cash balances, while the 1996 increase
resulted from a moderately lower year end cash position. Shown below is a
distribution by rating category of the Company's fixed maturities portfolio as
of December 31, 1997.
13
<PAGE>
Standard & Poor's Corporation Rating Amortized Cost1 Fair Value 2
- - -------------------------------- ---------------------- -------------
Investment grade:
AAA to A- $32,931,490 $33,642,109
000
BBB+ to BBB- 2,990,651 3,041,000
- - -------------------------------- ---------------------- -------------
Total investment grade 35,922,141 36,683,109
Non-investment grade:
BB+ to BB- 3,856,945 4,306,000
B+ to B- 1,700,907 1,601,000
CCC+ to C 268,243 347,500
CI to not rated 92,416 92,000
- - -------------------------------- ---------------------- -------------
Total non-investment grade 5,918,511 6,346,500
- - -------------------------------- ---------------------- -------------
Total fixed maturities $41,840,652 $43,029,609
- - -------------------------------- ---------------------- -------------
1 Net of write-downs on bonds whose decline in value is believed to be
other-than-temporary
2 Fair values as of December 31, 1997 were obtained from the Company's
investment advisor's portfolio review, which used market prices from Shaw Data
Services.
The Company believes it has a well diversified portfolio and has no
definitive plans to decrease its non-investment grade portfolio significantly
below its current level, unless necessary to satisfy requirements of state
regulators or rating agencies. The Company purchases non-investment grade bonds
to obtain higher yields or convertible features and attempts to reduce credit
risk by portfolio diversification. However, publicized failures of significant
insurers, attributed partially or principally to non-investment grade bonds, led
the Company to decrease such bond holdings in most years since 1990.
Shown below are the Company's four largest holdings in non-investment grade
bonds by a single issuer as of December 31, 1997.
Non-Investment Grade
December 31, 1997 Book Value Fair Value
- - --------------------------- -------------- ----------------
Largest $504,920 $816,000
Second largest 553,337 660,000
Third largest 635,907 570,000
Fourth largest 500,000 550,000
- - --------------------------- -------------- ----------------
Total $2,194,164 $2,596,000
- - --------------------------- -------------- ----------------
The Company had no guarantee or other type of investment associated with
the issuers represented above.
The Company's investment in equity securities increased $4,929,000 and
$6,979,000 during 1997 on a cost (net of write-downs) and fair value basis,
respectively, after increasing $2,822,000 and $2,221,000 on the same basis in
1996. As of December 31, 1997, there were $2,929,000 of net unrealized gains in
equity securities, as compared with $878,000 and $1,480,000 at December 31, 1996
and December 31, 1995, respectively. One security represented $372,000 of such
gains at December 31, 1997.
The Company reviews its marketable investments each quarter to determine if
there have been declines in their value that in management's opinion are
other-than-temporary. These reviews resulted in the recognition of impairment
losses on equity securities totaling $233,000 during 1997 ($91,000 and $142,000
for the first and fourth quarters, respectively). In addition, $75,000 of
impairment losses were recognized on fixed maturities in the fourth quarter of
1997. During 1997, equity securities were sold which contained impairment
writedowns of $505,000.
14
<PAGE>
As more extensively discussed under Consolidated Results and Analysis,
below, the Company realized significant net capital gains from its marketable
investments over the three-year period ended December 31, 1997. Management
believes these net gains, which total $4,397,000, [$2,193,000, $915,000, and
$1,289,000 for 1997, 1996 and 1995, respectively], are greater than would have
been obtained from a more conservative investment strategy involving only
investment grade bonds. The Company's strategy has in some years subjected it to
fluctuations in income and shareholders' equity of a magnitude significantly
larger than would be anticipated under a more conservative investment strategy.
Net capital gains or losses for a given period are not necessarily indicative of
those for future periods.
Citizens Security owns the building in which the Company and Citizens
Security maintain their home offices. Approximately 79% of the building is
leased to third-party tenants. An appraisal obtained during 1996 indicates that
the current market value of the property is approximately $1,700,000 higher than
its carrying value.
The Company has maintained relatively high balances in cash and short-term
securities over the past several years, principally due to the uncertainty as to
future interest rates and in anticipation of potential surrenders and
withdrawals. The increase in the December 31, 1997 balance to $6,181,000 is
primarily a coincidental result of active management investment decisions. It is
anticipated that such balance will average less than $3,000,000 during 1998.
At December 31, 1997, the Company holds a $156,000 mortgage loan from a
real estate limited partnership in which the Company also has a 20% equity
interest. The mortgage loan, maturing March 31, 1998, permits revolving credit
advances, not to exceed at any time, the lesser of $750,000 or 80% of the
collateral fair value. Stockholders of the partnership's general partner
personally guarantee 80% of the loan.
Liabilities. A comparison as of December 31, 1997, 1996 and 1995 of
contract reserves for future policy benefits is shown below.
<TABLE>
Year Ended December 31 1997 1996 1995
- - ---------------------------------- ---------------- ---------------- ----------------
<CAPTION>
<S> <C> <C> <C>
Ordinary Life $40,681,920 $39,566,891 $39,515,527
Accident and Health 1,547,599 1,934,980 1,913,638
- - ---------------------------------- ---------------- ---------------- ----------------
Total $42,229,519 $41,501,871 $41,429,165
- - ---------------------------------- ---------------- ---------------- ----------------
</TABLE>
The 1997 increase in ordinary life reserves reflects normal interest and
net sales growth. The 1996 ordinary life reserve change reflects a $780,000
reduction associated with refinement of purchase GAAP accounting. The December
31, 1997 decline in accident and health reserves is primarily attributable to
reduced group disability volume, most of which is reinsured, along with improved
group dental loss experience and reductions in individual accident and health
volumes.
Shown below is a progression of the Company's policyholder deposit activity
for the year ended December 31, 1997.
<TABLE>
Year Ended December 31, 1997 Total Annuity Universal Life Other
- - ----------------------------- -------------- ------------- -------------- -------------
<CAPTION>
<S> <C> <C> <C> <C>
Beginning Balance $15,930,271 $9,490,085 $5,276,623 $1,163,563
Deposits 787,910 326,696 442,235 18,979
Withdrawals (2,093,351) (1,195,521) (771,540) (126,290)
Interest credited 914,061 560,498 298,710 54,853
- - ----------------------------- -------------- ------------- -------------- -------------
Ending Balance $15,538,891 $9,181,758 $5,246,028 $1,111,105
- - ----------------------------- -------------- ------------- -------------- -------------
</TABLE>
Annuity balances decreased $308,000 in 1997 after increasing by $32,000 in
1996. This decrease is partially attributable to a reduction in annuity interest
crediting rates during 1997. The 1997 changes in Universal Life and Other
policyholder deposit balances were very similar to the 1996 changes.
15
<PAGE>
CONSOLIDATED RESULTS AND ANALYSIS
Premiums and Other Considerations. The following table presents premiums
and other considerations received during the past three fiscal years.
Year Ended December 31 1997 1996 1995
- - ------------------------ ----------------- ----------------- -----------------
Traditional life $8,009,550 $ 8,256,967 $ 4,420,143
Universal life 544,603 571,831 518,710
Group life 550,791 636,689 758,578
Annuity 22,851 24,864 29,339
- - ------------------------ ----------------- ----------------- -----------------
Total life and annuity 9,127,795 9,490,351 5,726,770
Accident and health 8,563,082 8,457,272 6,345,199
- - ------------------------ ----------------- ----------------- -----------------
Total accident and health $17,690,877 $17,947,623 $12,071,969
- - ------------------------ ----------------- ----------------- -----------------
The Company's life and annuity premium decreased approximately 3.8% in
1997, approximately half of which was attributable to home service (former
Integrity business), one-quarter attributable to group life, and the remaining
one- quarter to broker-sold traditional life and Universal life. The 66% life
and annuity premium increase in 1996 was essentially all attributable to the
Integrity acquisition.
The 1997 home service premium decline is partially attributable to the loss
of Integrity's licenses in New Jersey and Delaware at the merger date and some
agent concern with more structured underwriting practices. Prior to the merger,
New Jersey accounted for more that 14% of Integrity's individual life insurance
premium. Citizens Security successfully obtained licenses to transact business
in Delaware in early 1997 and in New Jersey during late 1997. However, New
Jersey did not approve marketing of Citizens Security's insurance products until
early 1998. The Company is planning a reintroduction of its individual life
products and newly developed disability products to the New Jersey agents in the
second quarter and third quarter of 1998, respectively. Additionally, the
Company has developed a number of product enhancements, agent referral programs
and sales incentives during 1997 which management believes will result in
favorable home service growth trends during 1998.
The Company experienced some decline in the sale of its graded death
benefit products during 1997. The graded death benefit product, which is sold
primarily through the broker market, returns premiums paid, plus interest
compounded at an annual rate of 10% if the insured dies of natural causes during
the first three years the policy is in force. After three years, and during the
first three years if the insured dies of an accidental cause, the benefit
payable is the face amount of the policy. This three-year return of premium
product replaced Citizens Security's more liberal two-year return of product
during mid-1997. As expected, sales were initially dampened by the lengthened
return- of-premium period, along with the addition of an "at work" question on
the policy application. However, during the fourth quarter of 1997, a simplified
issue product was added, as a companion to the graded death benefit product. The
companion products were very favorably received by the broker market. Their
introduction allows the agent to offer a more extensively underwritten policy to
their qualifying customers at a lower premium rate, while preserving the
availability of insurance for other customers through the more conservative
benefit structure of the three-year graded death benefit product. The Company
believes these products will permit significant additional penetration into
the "final expense market."
Accident and health premiums increased approximately 1.3% during 1997. This
change includes a 3.4% increase in dental premium, partially offset by a decline
in individual accident and health and group disability premium. During 1996,
accident and health premiums increased 33.3%. Approximately three-quarters of
the 1996 increase related to the dental business, while the remaining portion
was primarily attributable to the acquired Integrity individual accident and
health business. From 1994 through 1996, the Company significantly expanded
sales of dental insurance to public education groups. During 1997, the Company
improved its claim ratios by issuing significant
16
<PAGE>
rate increases to many of the new groups; however, as expected, some of
these groups elected to cancel their coverage.
Investments. The Company monitors its available-for-sale fixed maturities
and equity securities to assure they are strategically positioned within the
current interest rate environment. This practice has historically resulted in
equity securities comprising 10% to 20% of the Company's cash and invested
assets, which tends to dampen current income yields in favor of an overall total
return focus.
Investment income yields were 5.4%, 5.9%, and 6.7% for 1997, 1996, and
1995, respectively. The investment income yield declines in 1997 and 1996
resulted primarily from higher equity security balances, recognition of gains on
fixed maturity securities, and somewhat higher than average cash and short-term
balances.
As noted above, although increased equity security balances have dampened
investment income yields and segment operating income results, total return
performance for the past three years has been very favorable. As illustrated
below, during the past three years the Company's equity securities have
generated approximately $5,800,000 of additional pre-tax return, above a
hypothetical 6.5% fixed-maturity return. After direct expenses, the Company's
equity security portfolio has averaged a pretax total return of 30.5% for each
of the past three years.
<TABLE>
Equity Portfolio - Pretax Total Return
- - --------------------------------------------------------------------------------------------
Year Ended December Total/Average 1997 1996 1995
31
- - --------------------- ---------------- ----------------- ----------------- ----------------
<S> <C> <C> <C> <C>
Average Equities Cost $8,119,247 $11,585,228 $7,125,001 $5,647,512
- - --------------------- ---------------- ----------------- ----------------- ----------------
Realized Gains1 $4,723,984 $2,773,809 $792,009 $1,158,166
Change in Unrealized
Gains (Losses) 2,800,687 2,050,241 (601,195) 1,351,641
Dividends 718,520 317,699 152,025 248,796
- - --------------------- ---------------- ----------------- ----------------- ----------------
Gross Return 8,243,191 5,141,749 342,839 2,758,603
Direct Expenses (819,216) (581,930) (51,875) (185,411)
- - --------------------- ---------------- ----------------- ----------------- ----------------
Net Return 7,423,975 4,559,819 290,964 2,573,192
6.5% Base Return (1,583,253) (753,040) (463,125) (367,088)
- - --------------------- ---------------- ----------------- ----------------- ----------------
Excess Return $5,840,722 $3,806,779 $ (172,161) $2,206,104
- - --------------------- ---------------- ----------------- ----------------- ----------------
Total Return - Gross 33.84% 44.38% 4.81% 48.85%
Total Return - Net 30.48% 39.36% 4.08% 45.56%
</TABLE>
1 Excludes adjustments for incentive and guaranty fees incurred by the
Company for investment management services.
Net realized gains on equity securities were $2,132,000, $697,000, and
$973,000 for 1997, 1996, and 1995, respectively. These amounts reflect the
direct expenses shown above, as well as reductions for amortization of deferred
policy acquisition costs of $59,904 and $43,260 in 1997 and 1996, respectively.
Also included in gross realized losses during 1997, 1996 and 1995 are
adjustments to the carrying value of available-for-sale equity securities of
$232,544, $666,871, and $561,135, respectively, relating to declines in value
which were considered by management to be other than temporary. The equity
portfolio had $2,929,000 of net after-tax unrealized gains as of December 31,
1997 compared to net after-tax unrealized gains of $878,000 and $1,480,000 at
December 31, 1996 and 1995, respectively.
17
<PAGE>
Segment Earnings. 1997 income before federal income tax increased by
$1,135,000 [85%], to $2,471,000, while 1996 income before federal income tax
increased by $594,000 [80%], to $1,336,000. The 1997 increase resulted from a
$1,278,000 increase in net realized capital gains and a $143,000 decrease in
operating income. The 1997 decrease in operating income resulted primarily from
somewhat less favorable home service mortality and persistency and the increased
equity positions noted above. The 1996 increase resulted from a $374,000
decrease in net realized capital gains and a $968,000 increase in gain from
operations. The $968,000 increase in operating income resulted primarily from
successful completion of the Integrity acquisition.
Shown below is segment operating income (loss) before realized gains on
investment securities and federal income taxes for 1997, 1996, and 1995.
Year Ended December 31 1997 1996 1995
- - --------------------------- ------------ ------------- ---------------
Life and Annuity $ (92,879) $170,886 $(803,376)
Accident and Health 370,443 249,678 256,071
- - --------------------------- ------------ ------------- ---------------
Total $ 277,564 $420,564 $(547,305)
- - --------------------------- ------------ ------------- ---------------
The 1997 decrease of $264,000 in Life and Annuity segment operating income
was principally attributable to less favorable home service mortality and
persistency, partially offset by mortality improvement in broker-sold business.
The 1996 increase of $974,000 in Life and Annuity segment operating income was
principally attributable to successfully completing the integration of
Integrity's operations in 1996 and certain nonrecurring costs in 1995.
The 1997 increase of $121,000 in Accident and Health segment operating
income was principally attributable to improvement in the group dental claims
ratio, partially offset with lower margins on group disability and individual
accident and health business. The 1996 decrease of $6,000 in Accident and Health
segment operating income was principally attributable to inclusion of
Integrity's individual accident and health business and improvement in the loss
ratios for the Company's individual cancer products, substantially offset by
higher claim ratios and expense volumes on group dental products.
Shown below is a comparison of the contribution of the Company's primary
group accident and health products toward profit and overhead (direct premium
minus: claims, change in reserves and commissions) and loss ratios for the years
ended December 31, 1997, 1996 and 1995.
<TABLE>
Contribution Margin Loss Ratio
------------------------------------- ---------------------------------
Year Ended December 31 1997 1996 1995 1997 1996 1995
31
<CAPTION>
- - ------------------------- ----------- ------------ ------------ ---- ----------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Group Dental $1,150,921 $ 741,525 $ 939,857 71.0% 75.6 % 68.6%
Group Disability $ 61,653 $ 116,167 $ 61,788 10.8% (3.4)% 42.7%
Individual $ 485,648 $ 569,824 $ 347,585 45.4% 42.8 % 43.7%
</TABLE>
The 1997 improvement in dental's contribution is the result of a 3.4%
increase in premium and a 4.6% decline in the loss ratio. The 1997 increase in
premium is principally attributable moderate growth in new cases and premium
increases for a number of groups with excessive claim rations, partially offset
by termination of groups with unacceptable claim ratios. The 4.6% improvement in
the loss ratio resulted from a number of initiatives, including reconfiguring
products to provide additional margins for certain more costly dental
procedures, engaging a company to provide expert assistance with the ongoing
adjudication of judgmental claims, and implementing a program of aggressive
renewal underwriting and rerating. Dental's 1996 contribution margin decline
resulted primarily from a 7.0% increase in the loss ratio offset by a 29%
increase in premium. These results were primarily driven by aggressively pricing
products in order to attract new cases, principally in the public education
sector.
The 1997 group disability contribution margin of $61,653 was generated from
only $104,000 of net premium. The 1997 contribution margin decline resulted from
a 30% reduction in premium and the loss ratio increase noted above.
18
<PAGE>
The 1996 group disability contribution margin increase resulted from a
significant reduction in reported claims, as indicated by the above loss ratios.
The 1997 individual accident and health margin decline resulted primarily
from a 10% reduction in premium and the modest loss ratio increase noted above.
The 1996 margin improvement resulted from approximately $100,000 of additional
margins from the acquired Integrity business and $50,000 of additional margins
from the cancer product's performance.
Federal Income Taxes. The Company has a relatively low effective federal
income tax rate, which can fluctuate significantly due to the application of
Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for
Income Taxes." The most significant provision under SFAS No. 109 affecting the
Company is the disallowance of the small life insurance company deduction when
computing deferred taxes. The small life insurance deduction allows Citizens
Security to reduce its taxable income by 60% before computing its current
provision for regular or alternative minimum tax. By disallowing this deduction
in the computation of deferred taxes, SFAS No. 109 significantly increases the
deferred taxes on Citizens Security's temporary differences. Thus, when a
significant increase or decrease occurs in the Company's net temporary
differences, the related deferred tax is computed using the 34% federal tax
rate, whereas tax will actually be paid on these net liabilities (when realized)
at a 17% rate (the alternative minimum tax rate after application of the
allowable small life insurance company deduction). The Company's gross deferred
federal income tax liabilities and assets are more fully discussed in Note 8 to
the Consolidated Financial Statements. All operating deferred tax assets of the
Company are realizable by offset against existing deferred tax liabilities.
Capital deferred tax assets of Citizens Security can be realized through the
carry back of such assets to recapture prior years' taxes paid on capital
assets. Capital deferred tax assets of the Company must be offset against future
capital gains. The Company believes such gains will materialize and the deferred
tax assets will be realized. The deferred tax assets are offset, to some extent,
by valuation allowances related to the Company and to Citizens Security. Due to
the impact of the small life insurance company deduction, Citizens Security
records a valuation allowance to reduce deferred tax assets (associated with
temporary differences) to their expected benefit rate of 17%, rather than 34%.
The Company's valuation allowance is designed to reduce deferred tax assets to
their estimated ultimate realization value.
Statutory Insurance Information. For insurance regulatory and rating
purposes, Citizens Security reports on the basis of statutory accounting
principles ("SAP"). During 1996, A.M. Best Company upgraded Citizens Security's
rating to B- from C++, based upon information through December 31, 1995. To
provide a more detailed understanding of Citizens Security's operations, shown
below are SAP basis net income, net operating income, statutory capital and
surplus, asset reserves, and capital ratios for Citizens Security for the five
years ended December 31, 1997.
<TABLE>
Net Statutory Asset
Year Ended Net Operating Capital and Valuation Capital
December 31 Income Income Surplus Reserves1 Ratio2
- - ------------------ ---------- ------------- ------------- -------------- -----------
<CAPTION>
<S> <C> <C> <C> <C> <C>
1997 $1,708,884 $762,357 $9,627,479 $2,753,064 18.22%
1996 $3,062,421 $871,089 $9,145,830 $1,426,918 16.05%
1995 3 $ 883,003 $494,588 $8,406,313 $1,087,020 14.63%
1994 $ 591,998 $296,809 $5,651,136 $ 768,664 18.46%
1993 $1,381,537 $126,887 $5,690,048 $1,648,343 20.08%
</TABLE>
1 Asset Valuation Reserves are statutory liabilities that act as
contingency reserves in the event of extraordinary losses on invested assets and
as a buffer for policyholders' surplus to reduce the impact of realized and
unrealized investment losses. 2 Represents Statutory Capital and Surplus plus
Asset Valuation Reserves divided by invested assets plus cash. 3 Statutory
Capital and Surplus amounts and Asset Valuation Reserve amounts include
Integrity beginning in 1995, while Income amounts include Integrity beginning in
1996.
During 1997, statutory capital and surplus and asset reserves increased by
approximately $1,808,000. This increase resulted primarily from $1,709,000 of
statutory net income and $1,130,000 of unrealized investment gains, partially
offset by a $1,050,000 redemption of Citizens Security's preferred capital
stock.
19
<PAGE>
During 1996, capital and surplus and asset reserves increased by
approximately $1,079,000. This increase resulted primarily from statutory net
income of $3,062,000 and unrealized investment losses of $904,000, partially
offset by a $1,000,000 redemption of Citizens Security's preferred capital
stock. Net income earned in 1996 includes an approximate $1,200,000 net gain
from an investment transaction between Citizens Security and an affiliate.
The merger of Integrity into Citizens Security resulted in $1,832,000 of
the increase in statutory capital and surplus in 1995. The remaining $924,000
increase was the result of operating income and unrealized investment gains
partially offset by $945,000 of dividends paid to the Company.
The decrease in statutory capital and surplus and asset reserves in 1994
was due to unrealized losses in the equity portfolio offset to an extent by
increased operating income.
Statutory capital and surplus, specifically the component called surplus,
is used to fund the expansion of an insurance company's first year individual
life and accident and health sales. The first year commission and underwriting
expenses on such sales will normally consume a very high percentage of, if not
exceed, first year premiums. Accordingly, a statutory loss often occurs on these
sales the first year of the policy. Citizens Security's first year sales of
these type of products have not been of a magnitude to have a significant impact
on statutory surplus.
Impact of Year 2000. Some of the Company's older computer programs were
written using two digits rather than four to define the applicable year. As a
result, those computer programs have time-sensitive software that recognize a
date using "00" as the year 1900 rather than the year 2000. This could cause a
system failure or miscalculations causing disruptions of operations, including,
among other things, a temporary inability to process transactions, send premium
notices, or engage in similar normal business activities.
The Company has completed an assessment and will have to modify or replace
portions of its software so that its computer systems will function properly
with respect to dates in the year 2000 and thereafter. The total Year 2000
project cost is estimated at approximately $100,000, which includes $25,000 for
the purchase of new software that will be capitalized and $75,000 of
non-incremental, internal costs that will be expensed as incurred. The direct
cost of modifying the Company's two primary insurance administrative systems
(individual and group) is included in annual maintenance fees which total
approximately $25,000 per year. To date, the Company has incurred and expensed
approximately $25,000 ($7,000 capitalized), primarily for modifying peripheral
programs associated with its individual life insurance administrative system and
purchase of a general leger software package upgrade.
The project is estimated to be completed not later than December 31, 1998,
which is prior to any anticipated impact on its operating systems. The Company
believes that with modifications to existing software and conversions to new
software, the Year 2000 Issue will not pose significant operational problems for
its computer systems. However, if such modifications and conversions are not
made, or are not completed timely, the Year 2000 Issue could have a material
impact on the operations of the Company. Notwithstanding the Company's efforts,
its ability to function unaffected to and through the year 2000 may be adversely
affected by actions (or failure to act) of third parties.
The costs of the project and the date on which the Company believes it will
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events, including
the continued availability of certain resources and other factors. However,
there can be no guarantee that these estimates will be achieved and actual
results could differ materially from those anticipated. Specific factors that
might cause such material differences include, but are not limited to, the
availability and cost of personnel trained in this area, the ability to locate
and correct all relevant computer codes, and similar uncertainties.
CASH FLOW AND LIQUIDITY
During 1997, the Company generated $2,191,000 of positive cash flow from
operations compared to $1,570,000 in 1996 and $2,664,000 in 1995. The 1997
increase of $621,000 resulted from a significant improvement in group dental
claim ratios and growth in other liabilities at December 31, 1997. The 1996
decrease of $1,094,000 resulted
20
<PAGE>
from a significant reduction in accrued expenses that were outstanding at
December 31, 1995 related to the Integrity acquisition, partially offset by
additional Integrity operating margins.
At December 31, 1997, the Company generated $518,394 of funds from
brokerage account advances. 1997 cash payments on bank notes include $140,000 of
prepayments and exclude a $75,000 scheduled installment that was prepaid in late
1996. In order to enhance net investment spreads, during late 1996 the Company
elected to repay an outstanding $4,202,000, 8% mortgage loan, the majority of
which was due in 1998. In addition, during 1996, $825,000 of bank note
prepayments were made, including the $75,000 installment noted above.
As indicated above, the Company expects to complete the acquisition of
United Liberty Life Insurance Company during 1998 at a purchase price of $6.4
million. It is anticipated that approximately half of the purchase price will be
financed with additional bank borrowings while the remaining half will be funded
with cash from Citizens Security's investment portfolio.
The NAIC promulgated Standard Valuation Law ("SVL") specifies minimum
reserve levels and prescribes methods for determining them, with the intent of
enhancing solvency. Some of the states in which Citizens Security is licensed
have enacted this law. The primary method required by the SVL for verifying
reserve adequacy is cash flow testing, in which projected cash inflows from
assets are matched with cash outflows for liabilities. Various future economic
and yield curve scenarios are assumed. This is a dynamic process, whereby the
performance of the assets and liabilities is directly related to the scenario
assumptions. (An example would involve the credited interest rate on annuity
products and how such rates vary depending upon projected earnings rates, which
are based upon asset performance under a particular economic scenario.)
In addition to the SVL, the Actuarial Standards Board of the American
Academy of Actuaries has produced a Standard of Practice that prescribes cash
flow testing as a basis for the actuarial opinion on the adequacy of the
reserves required as part of the annual statutory reporting process of insurance
companies.
Citizens Security's most recent testing process, which was completed in
March, 1998, involved a review of two basic measures. The first was the value of
free market surplus, which is defined as the difference between the projected
market value of assets and liabilities at the end of the analysis period
(typically 10-20 years). Deficits could indicate the need for corrective action
depending upon the severity and the number of scenarios in which a deficit
appeared. A second measure involved distributable earnings. Negative earnings
for extended durations might impair the ability of Citizens Security to continue
without exhausting surplus. Again, depending upon severity and frequency,
corrective measures might be needed. Based on results of the testing completed
in March of 1998, no corrective measures were indicated at the current time.
However, such testing is ongoing and dynamic in nature and future events in the
interest and equity markets or a significant change in the composition of
Citizens Security's business could negatively impact testing results and require
the initiation of corrective measures.
Any necessary corrective measures could take one or more forms. The
duration of existing assets might not match well with those of the liabilities.
Certain liabilities, such as those associated with indemnity accident and
health, short-term disability and group dental products, are short-term in
nature and are best matched with cash and short- term investments. By contrast,
whole life insurance, which involves lifetime obligations, is usually best
matched by longer duration maturities. In the event there are insufficient
assets of these types, a repositioning of the investment portfolio might be
undertaken.
Initially balanced durations do not guarantee positive future results.
Asset type, quality, and yield will vary depending upon the economic scenario
tested. Liabilities will be similarly affected. Projected reinvestment yields
may cause overall yields to fall below those required to support projected
liabilities. In that event, portfolio realignment might involve the type,
quality and yield of investments rather than duration. Alternatively, additional
reserve amounts could be allocated to cover any future shortfalls.
The above discussion centers around asset management. Other possible
corrective measures might involve liability realignment. The Company's marketing
plan could be modified to emphasize certain product types and reduce
21
<PAGE>
others. New business levels could be varied in order to find the optimum
level. Management believes that the Company's current liquidity, current bond
portfolio maturity distribution and positive cash flow from operations give it
substantial resources to administer its existing business and fund growth
generated by direct sales. The Company will service debt, dividends, redemption
of preferred stock, and other expenses by:
-Management fees charged to Citizens Security.
-Dividends from Citizens Security, which are limited by law to the lesser
of prior year net operating income or 10% of prior year-end capital and surplus
unless specifically approved by the Kentucky Department of Insurance.
-Redemption of Citizens Security preferred stock as necessary, with such
redemption also requiring approval by the Kentucky Department of Insurance.
FORWARD-LOOKING INFORMATION
The Company makes forward-looking statements from time to time and desires
to take advantage of the "safe harbor" which is afforded such statements under
the Private Securities Litigation Reform Act of 1995 when they are accompanied
by meaningful cautionary statements identifying important factors that could
cause actual results to differ materially from those in the forward-looking
statements.
The statements contained in this "Management's Discussion and Analysis or
Plan of Operations," and statements contained in future filings with the
Securities and Exchange Commission and publicly-disseminated press releases, and
statements which may be made from time to time in the future by management of
the Company in presentations to shareholders, prospective investors, and others
interested in the business and financial affairs of the Company, which are not
historical facts, are forward-looking statements that involve risks and
uncertainties that could cause actual results to differ materially from those
set forth in the forward-looking statements. Any projections of financial
performance or statements concerning expectations as to future developments
should not be construed in any manner as a guarantee such results or
developments will, in fact, occur. There can be no assurance that any
forward-looking statement will be realized or actual results will not be
significantly different from that set forth in such forward- looking statement.
In addition to the risks and uncertainties of ordinary business operations, the
forward-looking statements of the Company referred to above are also subject to
risks and uncertainties.
The Company operates in a highly competitive business environment, and its
operations could be negatively affected by matters discussed under Item 1.
"Description of Business -- Competition".
22
<PAGE>
ITEM 7. FINANCIAL STATEMENTS
INDEX TO FINANCIAL STATEMENTS
CITIZENS FINANCIAL CORPORATION AND SUBSIDIARIES
Financial Statements For Full Fiscal Years Page
Report of Independent Auditors.................................... 24
Consolidated Statements of Operations for the
years ended December 31, 1997, 1996 and 1995 ..................... 25
Consolidated Statements of Financial Condition at
December 31, 1997 and 1996........................................ 26
Consolidated Statements of Shareholders' Equity
for the years ended December 31, 1997, 1996 and 1995.............. 28
Consolidated Statements of Cash Flows for the
years ended December 31, 1997, 1996 and 1995...................... 29
Notes to Consolidated Financial Statements........................ 30
23
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Shareholders and Board of Directors
Citizens Financial Corporation
We have audited the consolidated financial statements of Citizens Financial
Corporation and subsidiaries listed in the accompanying index to financial
statements at Item 7. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Citizens Financial Corporation and subsidiaries at December 31, 1997 and 1996,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
/s/ Ernst & Young LLP
Louisville, Kentucky
March 24, 1998
24
<PAGE>
<TABLE>
Consolidated Statements of Operations
Citizens Financial Corporation and Subsidiaries
Year Ended December 31 1997 1996 1995
- - ---------------------------------------------------- ------------- -------------- ---------------
<CAPTION>
Revenues:
<S> <C> <C> <C>
Premiums and other considerations $18,790,483 $18,941,875 $12,925,088
Premiums ceded (1,099,606) (994,252) (853,119)
- - ---------------------------------------------------- ------------- -------------- ---------------
Net premiums earned 17,690,877 17,947,623 12,071,969
Net investment income 3,808,938 4,158,282 2,852,884
Net realized investment gains 2,193,148 915,062 1,288,536
Other income 8,880 29,218 73,188
- - ---------------------------------------------------- ------------- -------------- ---------------
Total Revenues 23,701,843 23,050,185 16,286,577
Benefits and Expenses:
Policyholder benefits 11,736,457 11,845,025 7,685,979
Policyholder benefits ceded (834,426) (734,082) (649,116)
- - ---------------------------------------------------- ------------- -------------- ---------------
Net benefits 10,902,031 11,110,943 7,036,863
Increase in net benefit reserves 789,135 680,263 405,035
Interest credited on policyholder deposits 914,061 916,494 896,247
Commissions 3,762,482 3,956,075 2,887,398
General expenses 3,902,603 3,899,708 3,342,096
Interest expense 341,275 784,325 470,894
Policy acquisition costs deferred (982,333) (1,189,993) (932,746)
Amortization expense:
Deferred policy acquisition costs 736,633 911,543 790,140
Value of insurance acquired 584,993 390,688 419,516
Goodwill 20,962 20,962 20,962
Depreciation expense 259,289 233,551 208,941
- - ---------------------------------------------------- ------------- -------------- ---------------
Total Benefits and Expenses 21,231,131 21,714,559 15,545,346
Income before Federal Income Tax 2,470,712 1,335,626 741,231
Federal Income Tax (Expense) (482,500) (226,303) (9,000)
- - ---------------------------------------------------- ------------- -------------- ---------------
Net Income 1,988,212 1,109,323 732,231
Dividends on Redeemable Convertible Preferred Stock (407,000) (402,214) ---
- - ---------------------------------------------------- ------------- -------------- ---------------
Net Income Applicable to Common Stock $ 1,581,212 $ 707,109 $ 732,231
- - ---------------------------------------------------- ------------- -------------- ---------------
Net Income Per Common Share:
Basic $ 1.47 $ 0.66 $ 0.68
Diluted $ 1.10 $ 0.62 $ 0.67
- - ---------------------------------------------------- ------------- -------------- ---------------
</TABLE>
See Notes to Consolidated Financial Statements.
25
<PAGE>
Consolidated Statements of Financial Condition
<TABLE>
December 31 1997 1996
- - ------------------------------------------------------------------------ ---------------- ----------------
<CAPTION>
ASSETS
Investments:
Securities available for sale, at fair value:
Fixed maturities (amortized cost of $41,840,652
<S> <C> <C>
and $47,238,559 in 1997 and 1996, respectively) $43,029,609 $47,040,591
Equity securities (cost of $12,014,105
and $7,085,104 in 1997 and 1996, respectively) 14,942,792 7,963,550
Investment real estate 3,890,961 3,938,806
Mortgage loans on real estate 170,536 176,636
Policy loans 2,943,148 2,852,670
Short-term investments 572,492 893,410
- - ------------------------------------------------------------------------ ---------------- ----------------
Total Investments 65,549,538 62,865,663
Cash and cash equivalents 6,180,576 2,805,717
Accrued investment income 710,673 772,689
Reinsurance recoverable:
Paid benefits and losses 82,702 231,648
Unpaid benefits, losses and IBNR 1,537,270 1,579,926
Premiums receivable 442,846 491,330
Property and equipment 1,295,917 1,265,948
Deferred policy acquisition costs 3,819,678 3,791,939
Value of insurance acquired 4,496,872 5,081,865
Goodwill 104,814 125,766
Other assets 528,956 502,204
Deferred federal income tax --- 748,013
- - ------------------------------------------------------------------------ ---------------- ----------------
Total Assets $84,749,842 $80,262,708
- - ------------------------------------------------------------------------ ---------------- ----------------
</TABLE>
See Notes to Consolidated Financial Statements.
26
<PAGE>
Citizens Financial Corporation and Subsidiaries
<TABLE>
December 31 1997 1996
- - ------------------------------------------------------------------------ -------------- ----------------
LIABILITIES AND SHAREHOLDERS' EQUITY
<CAPTION>
Liabilities
Policy liabilities:
<S> <C> <C>
Future policy benefits $42,229,519 $41,501,871
Policyholder deposits 15,538,891 15,930,271
Policy and contract claims 1,220,023 1,210,393
Unearned premiums 160,107 183,613
Other 190,243 214,305
- - ------------------------------------------------------------------------ -------------- ----------------
Total Policy Liabilities 59,338,783 59,040,453
Notes payable 3,510,000 4,095,869
Accrued expenses and other liabilities 2,763,849 1,982,024
Federal income tax payable 263,500 527,000
Deferred federal income tax 508,918 ---
- - ------------------------------------------------------------------------ -------------- ----------------
Total Liabilities 66,385,050 65,645,346
Commitments and Contingencies
Redeemable Convertible Preferred Stock (370 shares issued and
outstanding) 4,043,907 4,043,907
Shareholders' Equity:
Common stock, 6,000,000 shares authorized; 1,275,724 shares issued
and outstanding 1,275,724 1,275,724
Additional paid-in capital 5,198,250 5,198,250
Unrealized appreciation of investments 2,594,998 428,780
Retained earnings 5,814,215 4,233,003
Common stock held in treasury - at cost (200,109 shares) (562,302) (562,302)
- - ------------------------------------------------------------------------ -------------- ----------------
Total Shareholders' Equity 14,320,885 10,573,455
- - ------------------------------------------------------------------------ -------------- ----------------
Total Liabilities and Shareholders' Equity $84,749,842 $80,262,708
- - ------------------------------------------------------------------------ -------------- ----------------
</TABLE>
See Notes to Consolidated Financial Statements.
27
<PAGE>
<TABLE>
Consolidated Statements of Shareholders' Equity
Citizens Financial Corporation and Subsidiaries
Net Unrealized
Appreciation Common Stock
Additional (Depreciation) Owned by
Common Paid-in of Available-for- Retained Wholly-owned
Stock Capital Sale Securities Earnings Subsidiary
<S> <C> <C> <C> <C> <C>
Balance at January 1, 1995 $1,275,724 $5,198,250 $(157,800) $2,793,663 $(562,302)
Net income --- --- --- 732,231
Net unrealized appreciation of
available-for-sale securities --- --- 2,029,452 --- ---
Balance at December 31, 1995 1,275,724 5,198,250 1,871,652 3,525,894 (562,302)
Net income --- --- --- 1,109,323 ---
Net unrealized depreciation of
available-for-sale securities --- --- (1,442,872) --- ---
Preferred stock dividends --- --- --- (402,214) ---
Balance at December 31, 1996 1,275,724 5,198,250 428,780 4,233,003 (562,302)
Net income --- --- 1,988,212 ---
Net unrealized appreciation of
available-for-sale securities --- --- 2,166,218 --- ---
Preferred stock dividends --- --- (407,000) ---
Balance at December 31, 1997 $1,275,724 $5,198,250 $2,594,998 $5,814,215 $(562,302)
- - ----------------------------------- ------------- ------------ ----------------- ------------ -----------------
</TABLE>
See Notes to Consolidated Financial Statements.
28
<PAGE>
<TABLE>
Consolidated Statements of Cash Flows
Citizens Financial Corporation and Subsidiaries
Year Ended December 31 1997 1996 1995
<CAPTION>
Cash Flows from Operations:
<S> <C> <C> <C>
Net income $1,988,212 $1,109,323 $ 732,231
Adjustments to reconcile net income to net cash flows from operations:
Increase in benefit reserves 704,142 791,089 706,719
Increase in claims liabilities 9,630 70,616 179,910
(Increase) decrease in reinsurance recoverable:
Paid benefits 148,946 (139,875) 63,896
Unpaid benefits 42,656 (111,513) (238,738)
Interest credited on policyholder deposits 914,061 916,494 896,247
Provision for amortization and depreciation, net of deferrals 619,544 366,751 506,813
Amortization of premium and accretion of discount on securities
purchased, net (7,438) (16,822) (51,785)
Net realized investment gains (2,193,148) (915,062) (1,288,536)
Decrease (increase) in accrued investment income 62,016 (135,931) 192,806
Change in other assets and other liabilities 24,919 (598,883) 1,095,030
Deferred federal income taxes 141,000 (273,175) (151,000)
Federal income taxes payable (263,500) 506,837 20,163
Net Cash Flows Provided by Operations 2,191,040 1,569,849 2,663,756
Cash Flows from Investment Activities:
Securities available-for-sale:
Purchases - fixed maturities (3,011,750) (24,651,316) (6,663,541)
Sales - fixed maturities 8,492,083 23,033,577 2,018,858
Purchases - equity securities (24,800,144) (20,301,373) (12,431,696)
Sales - equity securities 22,570,580 18,316,750 15,480,434
Securities held-to-maturity:
Purchases --- --- (1,228,594)
Maturities --- --- 4,731,524
Short-term investments sold (acquired), net 320,918 (72,139) 2,670,671
Repayments of mortgage loans 6,100 7,299 286,038
Additions to real estate (77,983) (24,396) (65,583)
Additions to property and equipment, net (163,430) (185,501) (110,998)
Investment management and brokerage account fees (249,841) (297,453) ---
Increase in net broker receivable (95,000) (154,269) (44,775)
Other investing activities, net (27,798) (132,274) 56,280
Purchase price of Integrity National Life Insurance Company
in excess of cash and cash equivalents acquired --- --- (3,679,184)
Net Cash Provided by (Used In) Investment Activities 2,963,735 (4,461,095) 1,019,434
Cash Flows from Financing Activities:
Policyholder deposits 787,910 818,849 931,477
Policyholder withdrawals (2,093,351) (1,730,273) (2,242,256)
Net proceeds from brokerage account loans 518,394 --- ---
(Payments) proceeds on notes payable - guarantor (220,869) 15,543 205,326
Payments on notes payable - bank (365,000) (5,226,656) (1,571,480)
Dividends on nonredeemable convertible preferred stock (407,000) (300,464) ---
Issuance of redeemable convertible preferred stock --- 2,343,000 1,700,907
Proceeds from bank borrowing --- --- 6,400,000
Other --- --- (251,485)
Net Cash Flows Provided by (Used In) Financing Activities (1,779,916) (4,080,001) 5,172,489
Net Increase (Decrease) in Cash and Cash Equivalents 3,374,859 (6,971,247) 8,855,679
Cash and Cash Equivalents at Beginning of Year 2,805,717 9,776,964 921,285
Cash and Cash Equivalents at End of Year $6,180,576 $2,805,717 $ 9,776,964
- - ----------------------------------------------------------------------------------------------------------
</TABLE>
See Notes to Consolidated Financial Statements.
29
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1--NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations. Citizens Financial Corporation is a holding company
that engages in the business of life insurance, annuities and accident and
health insurance through its wholly-owned subsidiary, Citizens Security Life
Insurance Company ("Citizens Security"). Citizens Security offers life,
fixed-rate annuity and accident and health insurance products to individuals and
groups through independent agents.
The individual life insurance products currently offered by Citizens
Security consist of traditional whole life insurance and universal life
insurance policies. Citizens Security also sells group life and accidental death
and dismemberment policies. The fixed-rate annuity products offered by Citizens
Security consist of flexible premium deferred annuities, life policy annuity
riders, and single premium deferred annuities. Citizens Security's individual
accident and health insurance products provide coverage for monthly income
during periods of hospitalization, scheduled reimbursement for specific hospital
and surgical expenses and cancer treatments, and lump sum payments for
accidental death or dismemberment, while the group accident and health products
provide coverage for short and long-term disability, income protection and
dental procedures.
Citizens Security is licensed to sell products in the District of Columbia
and 19 states primarily located in the south and southeast. Citizens Security
markets its portfolio of products through the personal producing general agent
distribution system and presently has approximately 1,700 sales representatives,
all of whom are independent agents and all, or substantially all, of whom also
represent other insurers. Approximately 300 of these agents are former agents of
Integrity Life Insurance Company ("Integrity") who specialize in the home
service market. That market consists primarily of individuals who desire whole
life policies with policy limits typically below $10,000.
Principles of Consolidation and Presentation. The accompanying consolidated
financial statements include the accounts of Citizens Financial Corporation, its
wholly-owned subsidiaries, Citizens Financial Properties, Inc., Citizens
Security, and Integrity since the date of its acquisition, September 22, 1995
(see Note 2), and a wholly-owned partnership, Marketplace I Limited Partnership
(collectively hereinafter referred to as the "Company"). Effective December 31,
1995, Integrity was merged into Citizens Security. All significant intercompany
accounts and transactions are eliminated in consolidation. Certain balances in
prior years have been reclassified to conform to current year classifications.
Use of Estimates. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Investments. The Company classifies fixed maturities and equity securities
as "available-for-sale". Available-for-sale securities are carried at fair
value, with unrealized gains and losses included in shareholders' equity, net of
applicable deferred taxes and adjustments to related deferred policy acquisition
costs. Prior to December 31, 1995, the Company classified fixed maturities as
"held-to-maturity" when the Company had the positive intent and ability to hold
the securities to maturity. Held-to-maturity securities were carried at cost
adjusted for amortization of premium or accretion of discount. Effective
December 31, 1995, the Company adopted the Financial Accounting Standards
Board's Implementation Guide on Statement of Financial Accounting Standards (
SFAS) No. 115 ("Implementation Guide"). In accordance with the Implementation
Guide, the Company reassessed the classification of its fixed maturities and
equity securities and, accordingly, transferred all of its "held-to-maturity"
fixed maturities to "available-for-sale." The fair value and amortized cost of
the fixed maturities transferred on December 31, 1995, were $13,085,928 and
$12,524,060, respectively. The effect of this transfer was to increase
shareholders' equity by $370,833, net of deferred taxes of $191,035, at December
31, 1995. There was no effect on net income. In addition, upon acquisition of
Integrity, the Company classified all of Integrity's fixed maturities and equity
securities as "available-for-sale." Prior to the Company's acquisition of
Integrity, Integrity did not prepare its financial statements in accordance with
generally accepted accounting principals ("GAAP").
Fixed maturities and equity securities having a decline in value considered
by management to be other than temporary are adjusted to an amount which, in
management's judgment, reflects such declines. Such amounts are included in net
realized investment gains and losses. For purposes of computing realized gains
and losses on fixed maturities and equity securities sold, the carrying value is
determined using the specific-identification method. Mortgage loans and policy
loans are carried at unpaid
30
<PAGE>
Note 1--NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
balances. Investment real estate is carried at depreciated cost. Short-term
investments, which consist of certificates of deposit and treasury bills, are
carried at cost which approximates fair value. Cash and cash equivalents consist
of highly liquid investments with maturities of three months or less at the date
of purchase and are also carried at cost which approximates fair value.
Deferred Policy Acquisition Costs. Commissions and other policy acquisition
costs which vary with, and are primarily related to, the production of new
insurance contracts are deferred, to the extent recoverable from future policy
revenues and gross profits, and amortized over the life of the related
contracts. See Premiums, Benefits and Expenses regarding amortization methods.
Property and Equipment. Property and equipment, including the home office
building, are carried at cost less accumulated depreciation, using principally
the straight-line method of depreciation. Accumulated depreciation at December
31, 1997, was $1,376,653 ($1,117,364 at December 31, 1996).
Goodwill and Value of Insurance Acquired. Goodwill represents the excess of
the purchase price of a former wholly-owned subsidiary, which was merged into
Citizens Security effective September 30, 1992, over amounts assigned (based on
estimated fair values at the date of acquisition) to the identifiable net assets
acquired. Goodwill is amortized over 15 years using the straight-line method. At
December 31, 1997, accumulated amortization was $151,178 ($130,216 at December
31, 1996).
Value of insurance acquired is recorded for the estimated value assigned to
the insurance in force of the purchased subsidiaries at the dates of
acquisition. The assigned value is amortized over the expected remaining life of
the insurance in force using methods consistent with that used for amortization
of policy acquisition costs (as described under Premiums, Benefits and
Expenses). At December 31, 1997, accumulated amortization was $2,109,180
($1,524,187 at December 31, 1996).
Benefit Reserves and Policyholder Deposits. Traditional life and accident
and health insurance products include those contracts with fixed and guaranteed
premiums and benefits and consist principally of whole-life and term insurance
policies, limited-payment life insurance policies and certain annuities with
life contingencies. Reserves on such policies are based on assumed investment
yields which range from 6% to 7%. Reserves on traditional life and accident and
health insurance products are determined using the net level premium method
based on future investment yields, mortality, withdrawals and other assumptions,
including dividends on participating policies. Such assumptions are based on
past experience and include provisions for possible unfavorable deviation.
Benefit reserves and policyholder contract deposits on universal life,
other interest-sensitive life products and investment-type products are
determined using the retrospective deposit method and consist of policy account
balances, before deducting surrender charges, which accrue to the benefit of the
policyholder.
Participating insurance business at December 31, 1997, 1996 and 1995,
constituted approximately 1% of ordinary life insurance in force and less than
1% of annualized ordinary life premium inforce. Participating dividends are
determined at the discretion of the Board of Directors.
Reserves on insurance policies acquired by purchase are based on
assumptions considered appropriate as of the date of purchase. Assumed
investment yields for such acquired policies range from 6.6% to 9.0%.
Premiums, Benefits and Expenses. Premiums for traditional individual life
and accident and health policies are reported as earned when due. Benefit claims
(including an estimated provision for claims incurred but not reported), benefit
reserve changes and expenses (except those deferred) are charged to expense as
incurred. Deferred policy acquisition costs related to traditional life and
accident and health policies are charged to expense over the life of the policy
using methods and assumptions consistent with those used in estimating
liabilities for future policy benefits. In determining whether a premium
deficiency exists on short-duration policies, management does not give
consideration to investment income.
Revenues for universal life and investment-type products consist of
investment income and policy charges for the cost of insurance, policy
initiation, administrative surrender fees and investment income. Expenses
include interest credited to policy account balances, incurred administrative
expenses and benefit payments in excess of policy account balances.
31
<PAGE>
Note 1--NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
Deferred policy acquisition costs related to universal life and
investment-type products are amortized in relation to the incidence of expected
gross profits over the life of the policies. Expected gross profits are reviewed
at each reporting period, and to the extent actual experience varies from that
previously assumed, the effects of such variances are recorded in the current
period.
Liabilities for Policy Claims. Policy claim liabilities are based on known
liabilities plus estimated future liabilities developed from trends of
historical data applied to current exposures. These liabilities are closely
monitored and adjustments for changes in experience are made in the period
identified.
Federal Income Taxes. The Company uses the liability method of accounting
for income taxes. Deferred income taxes are provided for cumulative temporary
differences between balances of assets and liabilities determined under
generally accepted accounting principles and balances determined for tax
reporting purposes.
Earnings Per Share. In 1997, the Financial Accounting Standards Board
issued SFAS No. 128, Earnings per Share. SFAS 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted earnings per
share. Unlike primary earnings per share, basic earnings pers share excludes any
dilutive effects of options, warrants, and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented to conform to the SFAS 128 requirements.
Basic earnings per share amounts are based on the weighted average number
of common shares outstanding during the year (1,075,615 in 1997, 1996 and 1995).
Diluted earnings per share amounts assume conversion of all outstanding Class B
Convertible Preferred Stock at a conversion price of $5.50 per share (see notes
7 and 8). The weighted average number of common shares outstanding, on a diluted
basis is 1,815,615; 1,793,148; and 1,089,379; in 1997, 1996, and 1995,
respectively.
Note 2--ACQUISITIONS
United Liberty Life Insurance Company
Effective December 12, 1997, the Company agreed to acquire 100% of the
common stock of United Liberty Life Insurance Company (United Liberty) from
Chaswil United Corporation, a privately-held Cincinnati-based insurance holding
company. Initially, the terms called for a cash price of $7.8 million, subject
to satisfactory completion of business and legal reviews and closing
adjustments. Effective March 2, 1998, the purchase price was revised to $6.4
million and Chaswil agreed to retain approximately $2.0 million of United
Liberty mortgage and real estate related assets as payment towards the purchase
price. This transaction is subject to receipt of all necessary state and federal
regulatory approvals. At December 31, 1997, United Liberty had statutory
admitted assets of approximately $40 million and statutory capital and surplus
of approximately $3.7 million (including approximately $328,000 of Asset
Valuation Reserves). Historically, United Liberty's financial statements have
not been prepared on a GAAP basis of accounting and are not currently available
on that basis.
Integrity National Life Insurance Company
On September 22, 1995, the Company acquired 98.85% of the common stock of
Integrity from Southwestern Life Corporation ("Southwestern"), a Dallas-based
insurance holding company (the "Integrity acquisition"). The Integrity
acquisition was accounted for as a purchase with the results of Integrity's
operations being included in the consolidated statements since the date of
acquisition. Citizens Security acquired the remaining 1.15% of the common stock
of Integrity in conjunction with the merger of Integrity into Citizens Security
on December 31, 1995.
The aggregate purchase price for the Integrity acquisition, was $9,419,000
(including net cost associated with the purchase of $437,000 and the purchase of
minority shareholders stock as part of the merger discussed above). No goodwill
was recorded relating to the acquisition.
Prior to the closing, Integrity entered into a coinsurance and assumption
reinsurance agreement with Union Bankers Insurance Company ("Union Bankers"),
another affiliate of Southwestern, covering Integrity's 14,500 individual
long-term care and Medicare supplement insurance policies with annualized
premiums of approximately $14,800,000, leaving the remaining life and
32
<PAGE>
Note 2--ACQUISITIONS (Continued)
accident and health insurance business with Integrity. In conjunction with
this reinsurance transaction, Integrity transferred approximately $9,200,000 in
reserves to Union Bankers. Completion of these transactions was a condition to
the Company's obligations under the Stock Purchase Agreement with Southwestern
because the reinsured business did not fit into the Company's current business
plans. Under the agreement, Union Bankers directly assumed the liability for
these policies.
The Integrity acquisition was financed with the working capital of Citizens
Security and with approximately $6,100,000 of the $6,400,000 of proceeds under a
Term Loan Agreement dated as of September 22, 1995 between the Company and a
commercial bank (the "Term Loan Agreement"). The Term Loan Agreement provides
for a $4,400,000 note payable that originally matured on October 1, 2002;
however, due to prepayments, it now matures on October 1, 2001 (the "2001 Note")
and a $2,000,000 note payable that matures on October 1, 2003 (the "2003 Note")
(see Note 6). In order to obtain required approvals from insurance regulatory
authorities of the state of Pennsylvania, [i] the Company agreed to authorize a
private placement of preferred stock to accredited investors, [ii] the Principal
Shareholder of the Company provided a personal guarantee that at least
$1,500,000 of the aforementioned preferred stock would be sold, and [iii] the
Company agreed that at least $1,500,000 of the proceeds of such sale would be
used to pay down the principal amount of the 2001 Note. The Company sold
$1,727,000 of the preferred stock on December 15, 1995, and applied $1,500,000
of the proceeds to prepay the first installment of the 2001 Note (see Notes 6
and 7).
Note 3--INVESTMENTS
The cost and fair value of investments in fixed maturities and equity
securities are shown below. The cost amounts are adjusted for amortization of
premium and accretion of discount on fixed maturities and for write-downs of
securities whose decline in value is believed to be other than temporary.
Treasury bills having a carrying value of $342,219 as of December 31, 1996, are
included below but reported as short-term investments and cash equivalents in
the accompanying financial statements. There were no such investments as of
December 31, 1997.
<TABLE>
Amortized Gross Unrealized Fair Value Losses
December 31, 1997 Cost Gains Losses (Carrying Value) Losses
- - -------------------------------- ---------------- ------------------------------------- -------------------
<CAPTION>
Fixed Maturities:
<S> <C> <C> <C> <C>
U. S. government obligations $ 8,039,775 $ 178,570 $ 4,845 $ 8,213,500
Corporate securities 26,007,059 961,956 165,515 26,803,500
Mortgage-backed securities 7,793,818 246,559 27,768 8,012,609
- - -------------------------------- ---------------- ------------------- ----------------- -------------------
Total $ 41,840,652 $ 1,387,085 $ 198,128 $43,029,609
- - -------------------------------- ---------------- ------------------- ----------------- -------------------
Equity securities $ 12,014,105 $ 3,245,854 $ 317,167 $14,942,792
- - -------------------------------- ---------------- ------------------- ----------------- -------------------
December 31, 1996
- - -------------------------------- -------------- ------------------- ----------------- -------------------
Fixed Maturities:
U. S. government obligations $10,132,155 $ 35,502 $ 210,194 $ 9,957,463
Corporate securities 25,663,794 308,374 312,780 25,659,388
Mortgage-backed securities 11,784,829 120,605 139,475 11,765,959
- - -------------------------------- -------------- ------------------- ----------------- -------------------
Total $47,580,778 $ 464,481 $ 662,449 $47,382,810
- - -------------------------------- -------------- ------------------- ----------------- -------------------
Equity securities $ 7,085,104 $1,291,042 $ 412,596 $ 7,963,550
- - -------------------------------- -------------- ------------------- ----------------- -------------------
</TABLE>
The fair values for investments in fixed maturities and equity securities
are based on quoted market prices, where available. For investments in fixed
maturities and equity securities not actively traded, fair values are estimated
using values obtained from independent pricing services.
33
<PAGE>
Note 3--INVESTMENTS (Continued)
The annual change in net unrealized investment appreciation or
depreciation, at December 31, 1997, 1996 and 1995, and the amount of net
realized investment gain or loss included in net income for the respective years
then ended are as follows:
<TABLE>
Year Ended December 31 1997 1996 1995
- - --------------------------------------------------------- ---------------- --------------- --------------
<CAPTION>
Fixed Maturities:
Available-For-Sale:
<S> <C> <C> <C>
Change in net unrealized appreciation (depreciation) $ 1,386,925 $ (1,745,362) $1,930,776
Net realized gain $ 61,173 $ 218,188 $ 300,777
Held-To-Maturity:
Change in net unrealized appreciation $ --- $ --- $ 612,060
Net realized gain $ --- $ --- $ 15,004
Equity Securities:
Change in net unrealized appreciation (depreciation) $ 2,050,241 $ (601,195) $1,351,641
Net realized gain $ 2,131,975 $ 696,874 $ 972,755
</TABLE>
The amortized cost and fair value of investments in fixed maturities at
December 31, 1997, by contractual maturity are shown below. Expected maturities
for investments in fixed maturities will differ from contractual maturities
because borrowers may have the right to call or prepay obligations, sometimes
without prepayment penalties.
December 31, 1997 Amortized Cost Fair Value
- - ------------------------------------ --------------- ---------------
Due in one year or less $ 2,883,520 $ 2,891,000
Due after one year through five years 13,456,173 14,042,500
Due after five years through ten years 14,243,515 14,545,500
Due after ten years 3,463,626 3,538,000
- - ------------------------------------ --------------- ---------------
Subtotal 34,046,834 35,017,000
Mortgage-backed securities 7,793,818 8,012,609
- - ------------------------------------ --------------- ---------------
Total $41,840,652 $43,029,609
- - ------------------------------------ --------------- ---------------
Gross gains of $171,062, $551,881, and $376,889 and gross losses of
$96,073, $317,685, and $18,892 were realized on the sale of available-for-sale
fixed maturities during 1997, 1996 and 1995, respectively. Included in gross
realized losses during 1997 is a net adjustment to the carrying value of
available-for-sale fixed maturities of $75,000, relating to declines in value
which were considered by management to be other than temporary. Net realized
gains from the sale of fixed maturities have been reduced by $3,039 and $16,008
in 1997 and 1996 respectively, due to amortization of deferred policy
acquisition costs. In addition, net realized gains from the sale of fixed
maturities have been reduced by $10,777 and $60,167 in 1997 and 1995,
respectively, for incentive fees earned by the portfolio manager.
Gross gains of $3,520,589, $2,481,688, and $2,372,076 and gross losses of
$746,780, $1,689,679, and $1,213,910 were realized on the sale of
available-for-sale equity securities during 1997, 1996 and 1995. Included in
gross realized losses during 1997, 1996 and 1995 are adjustments to the carrying
value of available-for-sale equity securities of $232,544; $666,871; and
$561,135, respectively, relating to declines in value which were considered by
management to be other than temporary. Net realized gains from the sale of
equity securities have been reduced by $59,904 and $43,260 in 1997 and 1996
respectively, due to amortization of deferred policy acquisition costs. In
addition, net realized gains from the sale of available-for-sale equity
securities have been reduced by $581,930, $51,875, and $185,411 in 1997, 1996,
and 1995, respectively, for incentive and guaranty fees earned by the portfolio
manager and costs associated with operating a brokerage margin account. Under
terms of this brokerage margin account, Morgan Stanley & Company, Inc. permits
50% of the value of securities held in the account to be purchased on margin, at
a 6.625% interest rate. At December 31, 1997, $518,394 of margin advances were
outstanding in this account and are included in the financial statements with
accrued expenses and other liabilities.
34
<PAGE>
Note 3--INVESTMENTS (Continued)
Net unrealized appreciation (depreciation) of available-for-sale securities
is summarized as follows:
December 31 1997 1996
- - ----------------------------------------------- --------------- ---------------
Net appreciation (depreciation) on available-for-sale:
Fixed maturities $1,188,957 $(197,968)
Equity securities 2,928,687 878,446
Adjustment of deferred policy acquisition costs (185,829) (30,811)
Deferred income taxes (1,336,817) (220,887)
- - ----------------------------------------------- --------------- ---------------
Net Unrealized Appreciation $2,594,998 $ 428,780
- - ----------------------------------------------- --------------- ---------------
Investment management services are provided by a firm affiliated with
certain board members and shareholders of the Company. Related fees for these
services were $506,330, $30,000, and $275,578 in 1997, 1996 and 1995,
respectively.
Major categories of investment income are summarized as follows:
Year Ended December 31 1997 1996 1995
- - -------------------------------- --------------- --------------- ---------------
Fixed maturities $3,033,320 $3,361,210 $2,088,980
Equity securities 317,699 152,025 248,796
Mortgage loans on real estate 16,321 18,298 18,975
Policy loans 174,647 154,845 114,191
Investment real estate 334,044 323,498 288,259
Short-term investments and other 148,421 367,324 206,596
- - -------------------------------- --------------- -------------- ---------------
Subtotal $4,024,452 $4,377,200 $2,965,797
Investment expenses (215,514) (218,918) (358,491)
- - -------------------------------- --------------- --------------- ---------------
Net Investment Income $3,808,938 $4,158,282 $2,607,306
- - -------------------------------- --------------- --------------- ---------------
The Company limits credit risk by diversifying its investment portfolio
among government and corporate fixed maturities and common and preferred equity
securities. It further diversifies these investment portfolios within industry
sectors. As a result, management believes that significant concentrations of
credit risk do not exist. At December 31, 1997 and 1996, the Company's largest
investment in any entity (other than the U.S. Government) was $1,525,000 and
$1,494,350, respectively, of Walt Disney Company fixed maturity securities. At
December 31, 1997, the Company had no investments which had not been income
producing for a period of at least twelve months prior to year end.
Pursuant to requirements of certain state insurance departments, the
Company has investments with a carrying value of $27,360,220, at December 31,
1997, placed on deposit at various financial institutions which are restricted
from withdrawal without prior regulatory approval.
The Company owns the building and land in which it currently resides and
occupies approximately 21% of the building with the majority of the remaining
space being leased to tenants. The accompanying financial statements reflect 21%
of the building and its operating expense as property and equipment and general
expense, respectively, with the remaining 79% as investment real estate and as a
reduction of investment income, respectively. Accumulated depreciation at
December 31, 1997 and 1996 on the investment real estate portion of the building
was $699,603 and $588,097, respectively.
The Company leases office space to third party tenants under noncancellable
lease agreements. Future minimum rental income is $668,606, $178,941, and $7,400
for years 1998 through 2000, respectively.
35
<PAGE>
Note 4--VALUE OF INSURANCE ACQUIRED
The value of insurance acquired is an asset which represents the present
value of future profits on business acquired, using interest rates of 6.6% to
9%. An analysis of the value of insurance acquired for the years ended December
31, 1997, 1996 and 1995 is as follows:
Year ended December 31 1997 1996 1995
- - --------------------------- ---------------- -------------- ---------------
Balance at beginning of year $5,081,865 $6,059,095 $ 442,046
Purchase of Integrity --- (586,542) 6,036,565
Accretion of interest 321,166 354,312 394,337
Amortization (906,159) (745,000) (813,853)
- - --------------------------- ---------------- -------------- ---------------
Balance at end of year $4,496,872 $5,081,865 $6,059,095
- - --------------------------- ---------------- -------------- ---------------
During the first twelve months after the September 22, 1995 acquisition of
Integrity, the assumptions used to establish the value of insurance acquired
were reconfirmed. Based on this review, the value of net assets acquired was
increased by $586,542. This revision relates primarily to a reduction in the
amount of assumed future policy benefits associated with certain individual life
insurance policies that cover multiple family members, partially offset by an
increase in direct costs required to complete the acquisition.
Amortization of the value of insurance acquired (net of interest accretion)
in each of the following five years will be approximately: 1998 - $428,000; 1999
- - - $361,000; 2000 - $364,000; 2001 - $364,000; and 2002 - $344,000.
Note 5--LIABILITY FOR ACCIDENT AND HEALTH UNPAID CLAIMS AND INCURRED, BUT
NOT REPORTED CLAIMS PORTION OF RESERVES
Activity in the accident and health liability portion of policy and
contract claims ($384,162 and $425,095 at December 31, 1997 and 1996,
respectively) and the incurred but not reported portion of accident and health
reserves ($789,612 and $1,195,361 at December 31, 1997 and 1996, respectively)
are summarized as follows:
Year Ended December 31 1997 1996
- - ------------------------------------------ ---------------- -----------------
Balance at January 1 $1,620,456 $1,663,701
Less reinsurance recoverable 576,015 735,100
- - ------------------------------------------ ---------------- -----------------
Net balance at January 1 1,044,441 928,601
Incurred related to:
Current year 5,694,456 5,848,067
Prior years --- ---
- - ------------------------------------------ ---------------- -----------------
Total incurred 5,694,456 5,848,067
Paid related to:
Current year 5,353,405 5,243,068
Prior years 504,045 489,159
- - ------------------------------------------ ---------------- -----------------
Total paid 5,857,450 5,732,227
Net balance at December 31 881,447 1,044,441
Plus reinsurance recoverable 292,327 576,015
- - ------------------------------------------ ---------------- -----------------
Balance at December 31 $1,173,774 $1,620,456
- - ------------------------------------------ ---------------- -----------------
36
<PAGE>
Note 6--DEBT
Long term debt consists of the following:
December 31 1997 1996
- - ------------------------------------------ ---------------- -----------------
Commercial bank note, prime plus 1/2%, due 2001 $1,900,000 $2,125,000
Commercial bank note, prime, due 2003 1,610,000 1,750,000
Subordinated guaranty note, prime, due 2003 --- 220,869
- - ------------------------------------------ ---------------- -----------------
Total 3,510,000 4,095,869
Less: Current Portion (400,000) (225,000)
- - ------------------------------------------ ---------------- -----------------
Long Term Portion $3,110,000 $3,870,869
- - ------------------------------------------ ---------------- -----------------
The two commercial bank notes were issued in 1995, to finance the Integrity
acquisition. The notes were both originally issued at the bank's prime lending
rate plus 1%, with interest payable quarterly. The 2001 Note and the 2003 Note
had original note amounts of $4,400,000 and $2,000,000, respectively, and have
outstanding balances at December 31, 1997 of $1,900,000 and $1,610,000,
respectively. Remaining principal installments due on the 2001 Note total
$400,000 in 1998, and $500,000 each year thereafter through the year of
maturity, 2001. Originally, this note also called for $500,000 of scheduled
payments during 2002, however these installments were prepaid during 1996. The
2003 Note is to be repaid in three (3) consecutive quarterly installments of
$500,000 each beginning on January 1, 2003, and a the final installment of
$110,000 due on October 1, 2003. During 1996, the interest rate on the 2001 Note
was reduced by 1/2% to prime plus 1/2%, while the interest rate on the 2003 Note
was reduced by 1% to prime. No prepayments are permitted on the 2003 Note until
the 2001 Note has been paid in full, except from proceeds of equity security
offerings or other subordinated indebtedness. During 1997, the Company received
approval to prepay $140,000 of principal on the 2003 Note. Additionally,
$225,000 of scheduled installments on the 2001 note were paid in 1997, while the
January 1, 1997 scheduled installment of $75,000 was paid in late 1996. The
Company has pledged all of the issued and outstanding common and preferred stock
of Citizens Security as collateral for the commercial bank notes. In addition,
the Company's principal shareholder (the "Principal Shareholder"), who is also
its Chairman and President, has personally guaranteed the 2003 Note.
In consideration of the personal guarantee noted above, the Company entered
into a Guarantor's Compensation Agreement (the "Guarantor's Compensation
Agreement"), dated September 22, 1995, with its Principal Shareholder whereby
the Company will pay an annual guaranty fee based on an applicable percentage of
the outstanding principal balance of the 2003 Note on its date of issuance and
each anniversary thereof. The applicable percentage ranged from 10% in the first
two years and thereafter decreased in stages to 0.5% on the last anniversary
before maturity, for an average of 4.21% over the term of the 2003 Note.
However, the Guarantor's Compensation Agreement was amended as of September 22,
1996, to replace the annual guaranty fee with an Interim Fee equal to 15% of the
net realized and unrealized investment gains and losses earned on the parent
company's (nonconsolidated) investment portfolio during each of the twelve month
periods ending September 30, 1998 and 1997. This 15% fee is reduced in
proportion to average principal repayments on the 2003 Note. Accordingly, the
applicable reduced rate was 12.075% for the three month period ended December
31, 1997, and 12.80% for the twelve months ended September 30, 1997. A guaranty
fee of $36,119 has been accrued as of December 31, 1997 for the three month
period then ended, and a guaranty fee of $133,464 was paid during 1997 for the
twelve month period ended September 30, 1997.
Annual guaranty fees will be paid in the form of non-negotiable promissory
notes of the Company (the "Guaranty Notes"), except that the Interim Fees noted
above are payable in cash 45 days after the period earned, unless the Company is
unable to obtain any required consent from the holder of the commercial bank
notes. The Guaranty Notes bear interest at the prime rate charged by a
commercial bank, they are subordinated to the commercial bank notes, and they
are payable at maturity of the 2003 Note. The Guarantor's Compensation Agreement
also provides that the Company and the Principal Shareholder may agree to
exchange the Guaranty Notes for securities of the Company on terms to be
determined by a majority of the members of the Company's Board of Directors who
are not affiliated with the Principal Shareholder. Effective September 22, 1995,
the Company issued a Guaranty Note in the amount of $200,000 to the Principal
Shareholder. Upon receiving consent from the holder of the commercial bank
notes, the $200,000 Guaranty Note plus accrued interest of $29,743 was paid to
the Guarantor on April 7, 1997.
37
<PAGE>
Note 6--DEBT (Continued)
Cash paid for interest on debt was $367,539, $835,426, and $517,855 during
1997, 1996, and 1995, respectively; including $103,227 and $51,875 in 1997 and
1996, respectively, related to brokerage account borrowings.
Note 7--REDEEMABLE CONVERTIBLE PREFERRED STOCK
On January 19, 1996 and December 15, 1995, the Company issued 213 and 157
shares, respectively of 1995 Class B redeemable convertible preferred stock
("Preferred Stock"), for cash in the amount of $11,000 per share ($4,070,000 in
the aggregate). Holders of the Preferred Stock are entitled to cumulative
quarterly dividends, currently at the rate of $275 per share ($1,100 per annum).
The Preferred Stock currently has a liquidation preference of $4,070,000 in the
aggregate. The Preferred Stock is mandatorily redeemable in 12 equal quarterly
installments beginning January 1, 2003. At the option of any holder, the Company
must redeem any or all of such holder's Preferred Stock not later than January
1, 2002. The Company may call any or all of the Preferred Stock for redemption,
at any time after January 1, 1999. It may also call any or all of the Preferred
Stock for redemption at any time after January 1, 1998, if the market price for
the Company's Class A Stock exceeds $8.25 per share for at least 20 out of 30
consecutive trading days. In each case, the redemption price is currently
$11,000 per share. Until five (5) days prior to any redemption date, each share
of the Preferred Stock is convertible into a specified number of shares of the
Company's Class A Stock (currently 2,000). Holders of the Preferred Stock have
the right to elect two (2) members of the Company's Board of Directors at any
time that, and for as long as, the Company has failed to complete a required
redemption or to pay dividends on the Preferred Stock for six (6) quarterly
periods. The dividend rate, redemption price and conversion ratio are all
subject to adjustment for any stock dividends, combinations, splits or similar
changes affecting the Preferred Stock in the future.
Note 8--EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share. See Note 7 above for additional disclosures regarding the
outstanding preferred stock.
<TABLE>
Year Ended December 31 1997 1996 1995
- - ----------------------------------------------------------------- ------------- --------------- --------------
<CAPTION>
Numerator:
<S> <C> <C> <C>
Diluted: Net income $1,988,212 $1,109,323 $ 732,231
Less: Preferred stock dividends 407,000 402,214 ---
- - ----------------------------------------------------------------- ------------- --------------- --------------
Basic: Net income applicable to common stock $1,581,212 $ 707,109 $ 732,231
707,109
- - ----------------------------------------------------------------- ------------- --------------- --------------
Denominator:
Basic: Weighted average common shares 1,075,615 1,075,615 1,075,615
Plus: Assumed conversion of preferred stock 740,000 717,533 13,764
- - ----------------------------------------------------------------- ------------- --------------- --------------
Diluted: Weighted average shares assuming preferred conversions 1,815,615 1,793,148 1,089,379
- - ------------------------------------------------------------------ ------------- --------------- --------------
Basic earnings per share $ 1.47 $ 0.66 $ 0.68
Diluted earnings per share $ 1.10 $ 0.62 $ 0.67
</TABLE>
Options to purchase 5,000 shares of the Company's common stock at $9 per
share were outstanding during 1997 but were not included in the computation of
diluted earnings per share because the options' exercise price was greater than
the average market price of the common shares and, therefore, the effect would
be antidilutive.
38
<PAGE>
Note 9--FEDERAL INCOME TAXES
Federal income taxes consist of the following:
<TABLE>
Year Ended December 31 1997 1996 1995
- - --------------------------------- ---------------- -------------- -------------
<CAPTION>
<S> <C> <C> <C>
Current tax expense $ (341,500) $ (479,033) $(160,000)
Deferred tax benefit (expense) (141,000) 252,730 151,000
- - --------------------------------- ---------------- -------------- -------------
Federal income tax expense $(482,500) $ (226,303) $ (9,000)
- - --------------------------------- ---------------- -------------- -------------
</TABLE>
Deferred income taxes are provided for cumulative temporary differences
between balances of assets and liabilities determined under generally accepted
accounting principles and balances determined for tax reporting purposes.
Significant components of the Company's deferred tax liabilities and assets as
of December 31, 1997 and 1996 are as follows:
<TABLE>
December 31 1997 1996
- - ------------------------------------------------- --------------- ----------------
<CAPTION>
Deferred Tax Liabilities:
<S> <C> <C>
Value of insurance acquired $1,528,936 $1,727,834
Net unrealized gains on available-for-sale securities 1,336,817 220,887
Other 156,121 179,543
- - ------------------------------------------------- --------------- ----------------
Total deferred tax liabilities 3,021,874 2,128,264
Deferred Tax Assets:
Policy and contract reserves 1,783,158 1,808,358
Deferred policy acquisition costs 285,193 438,105
Fixed maturities and equity securities 169,552 192,075
Real estate 548,668 531,709
Alternative minimum tax credit carry forwards 474,757 317,165
Net operating loss carry forwards 235,666 464,146
Other 212,272 118,170
- - ------------------------------------------------- --------------- ----------------
Total deferred tax assets 3,709,266 3,869,728
Valuation allowance for deferred tax assets (1,196,310) (993,451)
- - ------------------------------------------------- --------------- ----------------
Net deferred tax assets 2,512,956 2,876,277
- - ------------------------------------------------- --------------- ----------------
Net Deferred Tax Liabilities (Assets) $ 508,918 $ (748,013)
- - ------------------------------------------------- --------------- ----------------
</TABLE>
The following is a reconciliation of the federal statutory income tax rate
to the Company's effective income tax rate:
Year Ended December 31 1997 1996 1995
- - ---------------------------------- -------------- --------------- -------------
Statutory rate of income tax 34.00 % 34.00 % 34.00 %
Dividend exclusion (1.71)% (1.65)% (3.70)%
Alternative minimum tax 5.28 % 9.00 % --- %
Small life insurance deduction (18.32)% (39.48)% (23.10)%
Surtax exemption and other (3.76)% 1.17 % 3.30 %
Increase in valuation allowance 4.04 % 13.96 % 15.80 %
Deferred benefit from merger --- % --- % (26.20)%
- - ----------------------------------- -------------- --------------- -------------
Effective rate of income tax 19.53% 17.00% 0.10%
- - ----------------------------------- -------------- --------------- -------------
39
<PAGE>
Note 9--FEDERAL INCOME TAXES (Continued)
Federal income taxes paid in 1997, 1996, and 1995 were $610,000, $91,766,
and $55,000, respectively. The Company utilized $310,616 and $1,180,000 of net
operating loss carry forwards in 1997 and 1996, respectively. The Company has
$666,003 of net operating loss carry forwards which will expire between 2008 and
2012.
Under the tax law in effect prior to 1984, a portion of income of Citizens
Security was not taxed when earned. It was accumulated in a tax account known as
policyholders' surplus. Under the provisions of the Deficit Reduction Act of
1984, policyholders' surplus accounts were frozen at their December 31, 1983,
balance of $859,000 for Citizens Security on a merged basis. Distributions from
the policyholders' surplus would be subject to income tax. At December 31, 1997,
Citizens Security could have paid additional dividends of approximately
$7,875,000 before paying tax on any part of its policyholders' surplus accounts.
Since the Company believes that tax will not be paid on any part of the
policyholders' surplus accounts in the foreseeable future, no provision has been
made for the related deferred income taxes which total $292,000, based on
current tax rates.
Note 10--STATUTORY ACCOUNTING PRACTICES AND SHAREHOLDERS' EQUITY
Citizens Security is domiciled in Kentucky and prepares its statutory-basis
financial statements in accordance with statutory accounting practices ("SAP")
prescribed or permitted by the Kentucky Department of Insurance ("KDI"). Net
income and capital and surplus for the Company's insurance operations as
reported in accordance with SAP for the three years ended December 31, 1997 are
shown below.
Year Ended December 31 1997 1996 1995
- - --------------------------------- -------------- --------------- --------------
Net Income $1,708,884 $3,062,421 $883,003
Capital and Surplus $9,627,479 $9,145,830 $8,406,313
Principal differences between SAP and GAAP include: a) costs of acquiring
new policies are deferred and amortized for GAAP; b) value of insurance inforce
acquired is established as an asset for GAAP; c) benefit reserves are calculated
using more realistic investment, mortality and withdrawal assumptions for GAAP;
d) deferred income taxes are provided for GAAP; e) assets and liabilities of
acquired companies are adjusted to their fair values at acquisition with the
excess purchase price over such fair values recorded as goodwill under GAAP; f)
available-for-sale fixed maturity investments are reported at fair value with
unrealized gain and losses reported as a separate component of shareholders'
equity for GAAP; and g) statutory asset valuation reserves and interest
maintenance reserves are not required for GAAP.
"Prescribed" statutory accounting practices include state insurance laws,
regulations, and general administrative rules, as well as a variety of
publications of the National Association of Insurance Commissioners ("NAIC").
"Permitted" statutory accounting practices encompass all accounting practices
that are not prescribed; such practices may differ from state to state, may
differ from company to company within a state, and may change in the future. The
NAIC is in the process of codifying statutory accounting practices
("Codification"). Codification will likely change, to some extent, prescribed
statutory accounting practices that Citizens Security uses to prepare its
statutory-basis financial statements. Codification, which is expected to be
approved by the NAIC in 1998, will require adoption by the various states before
it becomes the prescribed statutory basis of accounting for insurance companies
domesticated within those states. Accordingly, before Codification becomes
effective for Citizens Security, the KDI must adopt Codification as the
prescribed basis of accounting on which domestic insurers must report their
statutory- basis results to the KDI. At this time it is unclear whether the KDI
will adopt Codification. However, based on current draft guidance, management
believes that the impact of Codification will not be material to Citizens
Security's statutory-basis financial statements.
Statutory restrictions limit the amount of dividends which may be paid by
Citizens Security to the Company. Generally, dividends during any year may not
be paid, without prior regulatory approval, in excess of the lesser of (a) 10%
of statutory shareholder's surplus as of the preceding December 31, or (b)
statutory net operating income for the preceding year. During 1997 and 1996,
with appropriate prior regulatory approval, Citizens Security redeemed
$1,050,000 and $1,000,000, respectively, of its outstanding preferred stock. In
addition, during 1996 and 1995, with appropriate regulatory approval, Citizens
Security paid extraordinary dividends of $750,000 and $650,000, respectively, to
the Company. Citizens Security must maintain the minimum capital and surplus,
$1,250,000, required for life insurance companies domiciled in Kentucky.
40
<PAGE>
Note 10--STATUTORY ACCOUNTING PRACTICES AND SHAREHOLDERS' EQUITY (Continued)
The KDI imposes minimum risk-based capital ("RBC") requirements on
insurance enterprises that were developed by the NAIC. The formulas for
determining the amount of RBC specify various weighting factors that are applied
to financial balances and various levels of activity based on the perceived
degree of risk. Regulatory compliance is determined by a ratio (the "Ratio") of
the enterprise's regulatory total adjusted capital, as defined by the NAIC, to
its authorized control level RBC, as defined by the NAIC. Enterprises below
specific trigger points or ratios are classified within certain levels, each of
which requires specified corrective action. Citizens Security has a Ratio that
is at least 400% of the minimum RBC requirements; accordingly, Citizens Security
meets the RBC requirements.
Under a prior year stock option agreement, 5,000 options on the Company's
common stock have been granted to an officer and were outstanding at the
beginning and end of 1997. The stock options vested as of June 16, 1995, at an
exercise price of $9 per share, and expire on June 16, 1998. The Company
accounts for its stock option grants in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees." No compensation expense has been
recognized for these stock options since the exercise price exceeds market
value. No options were exercised during 1997, 1996 or 1995. The effect of
applying the fair value method of accounting for the Company's stock based
awards (as described in SFAS 123, "Accounting and Disclosure of Stock-Based
Compensation") results in net income and earnings per share that are not
materially different from amounts reported.
Note 11--SEGMENT INFORMATION
The Company essentially operates in two segments as shown in the following
tables. Both segments include individual and group insurance. Identifiable
revenues, expenses and assets are assigned directly to the applicable segment.
Net investment income and invested assets are allocated to the operating
segments generally in proportion to policy liabilities.
Segment information as of December 31, 1997, 1996 and 1995, and for the
years then ended is as follows:
<TABLE>
Year Ended December 31 1997 1996 1995
- - ------------------------------------- --------------- ---------------- ---------------
<CAPTION>
Revenues:
<S> <C> <C> <C>
Life and Annuities $14,917,088 $14,396,150 $ 9,709,671
Accident and Health 8,784,755 8,654,035 6,576,906
- - ------------------------------------- --------------- ---------------- ---------------
Total $23,701,843 $23,050,185 $16,286,577
Income from operations before federal income taxes:
Life and Annuities $2,019,390 $ 1,051,618 $ 417,888
Accident and Health 451,322 284,008 323,343
- - ------------------------------------- --------------- ---------------- ---------------
Total $2,470,712 $ 1,335,626 $ 741,231
Assets:
Life and Annuities $81,178,707 $76,384,118 $77,504,054
Accident and Health 3,571,135 3,878,590 6,751,207
- - ------------------------------------- --------------- ---------------- ---------------
Total $84,749,842 $80,262,708 $84,255,261
Depreciation and amortization expense:
Life and Annuities $1,492,176 $ 1,462,051 $ 1,315,897
Accident and Health 109,701 94,693 123,662
- - ------------------------------------- --------------- ---------------- ---------------
Total $1,601,877 $ 1,556,744 $ 1,439,559
</TABLE>
41
<PAGE>
Note 11--SEGMENT INFORMATION (Continued)
The increase in income from operations before federal income taxes for Life
and Annuities from $1,051,618 in 1996 to $2,019,390 in 1997 results from an
approximate $264,000 decrease in segment earnings before realized capital gains
and an increase of approximately $1,232,000 in realized capital gains. The
$264,000 segment earnings decline resulted primarily from increased mortality on
home service policies. The increase in income from operations before federal
income taxes for Life and Annuities from $417,888 in 1995 to $1,051,618 in 1996
resulted primarily from the initial full year of earnings from the Integrity
acquisition in 1996 and non-recurring merger costs incurred recognized in 1995.
The increase in income from operations before federal income taxes for
Accident and Health from $284,008 in 1996 to $451,322 in 1997 resulted primarily
from various profit improvement initiatives taken in the group dental product
line. The decrease in income from operations before federal income taxes for
Accident and Health from $323,343 in 1995 to $284,008 in 1996 resulted
principally from a decrease in realized gains allocated to the segment and
increased dental claim levels.
Note 12--REINSURANCE
The Company currently follows the general practice of reinsuring that
portion of risk on the life of any individual which is in excess of $40,000 for
individual policies (under yearly renewable term and coinsurance agreements) and
$15,000 for group policies (under a group yearly renewable term agreement).
Graded death benefit coverages above $4,000 are generally 50% reinsured, with
Citizens Security maintaining a maximum $10,000 risk on any one policyholder.
Individual and group accidental death coverage is 100% reinsured. To the extent
that reinsuring companies are unable to meet obligations under reinsurance
agreements, the Company would remain liable.
As discussed in Note 2, on September 22, 1995, Integrity entered into a
coinsurance and assumption reinsurance agreement with Union Bankers covering
Integrity's long term care and Medicare supplement business. Under the
agreement, Union Bankers directly assumed these liabilities.
Note 13--CONTINGENCIES
In the normal course of business, the Company is party to a number of
lawsuits. Management believes recorded claims liabilities are adequate to ensure
these suits will be resolved without material financial impact to the Company.
Note 14--LEASE COMMITMENTS
Future minimum rental payments required under various equipment leases
total $50,477 in 1998 and $29,311 in 1999. The Company incurred rental expense
of $79,598, $59,783, and $105,922 in 1997, 1996 and 1995, respectively.
Note 15--FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair values of financial instruments, and the methods and assumptions
used in estimating their fair values, are as follows:
Fixed Maturities: The fair values for fixed maturities are based on quoted
market prices, where available. For those fixed maturities which are not
actively traded, fair values are estimated using values obtained from
independent pricing services. Available-for-sale fixed maturities are carried at
fair value in the accompanying statements of financial condition. At December
31, 1997 and 1996, the fair value of available-for-sale fixed maturities was
$43,029,609, and $47,040,591, respectively.
Equity Securities: The fair values for equity securities are based on
quoted market prices. Equity securities are carried at fair value in the
accompanying statements of financial condition. At December 31, 1997 and 1996,
the fair value of equity securities was $14,942,792 and $7,963,550,
respectively.
Short-Term Investments: The carrying amount of short-term investments
approximates their fair value. At December 31, 1997 and 1996, the fair value of
short-term investments was $572,492 and $893,410, respectively.
Cash and Cash Equivalents: The carrying amount of cash and cash equivalents
approximates their fair value. At December 31, 1997 and 1996, the fair value of
cash and cash equivalents was $6,180,576 and $2,805,717, respectively.
42
<PAGE>
Note 15--FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)
Mortgage Loans: The carrying amount of mortgage loans approximates their
fair value. At December 31, 1997 and 1996, the fair value of mortgage loans was
$170,536 and $176,636, respectively.
Policy Loans: The carrying amount of policy loans approximates their fair
value. At December 31, 1997 and 1996, the fair value of policy loans was
$2,943,148 and $2,852,670, respectively.
Investment Contracts: The carrying amount of investment-type fixed annuity
contracts approximates their fair value. At December 31, 1997 and 1996, the fair
value of investment-type fixed annuity contracts was $9,181,758 and $9,490,085,
respectively.
Notes Payable: The carrying amounts of notes payable approximate their fair
values. At December 31, 1997 and 1996, the fair value of notes payable was
$4,064,513 and $4,095,869, respectively.
Brokerage Account Loans: The carrying amounts of brokerage account loans
approximate their fair values. At December 31, 1997 the fair value of brokerage
account loans was $518,394.
Note 16--RELATED PARTY TRANSACTIONS
The Company has various transactions with its President and Chairman of the
Board (the "Chairman") or entities he controls. The Chairman provides investment
portfolio management for the Company and Citizens Security, through SMC
Advisors, Incorporated (of which the Chairman is the principal officer, a
director, and the sole shareholder). The investment portfolio management
contracts provide for total annual fixed fees of $30,000 and incentive
compensation equal to five percent (5%) of the sum of the net realized and
unrealized capital gains in the fixed maturities and equity securities
portfolios of the Company and Citizens Security during each contract year. Any
excess of net realized and unrealized capital losses over net realized and
unrealized capital gains at the end of a contract year is not carried forward to
the next contract year. Incentive fees of $306,747 and $245,578 were incurred
and paid for 1997 and 1995, respectively. Such fees were paid within
seventy-five days of the respective year-ends. No incentive fees were incurred
during 1996. The Company also maintains a portion of its investments under a
Trust Agreement with a bank controlled by its Chairman. Fees to the bank are
based on assets held. Such fees were $26,451, $17,316, and $11,121 in 1997,
1996, and 1995, respectively. In addition, the Chairman guarantees certain debt
of the Company for which he is compensated as described in Note 6.
43
<PAGE>
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There has been no change in accountants nor have there been any
disagreements on accounting and financial disclosure requiring disclosure
pursuant to the Instructions to this Item.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS,
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
The information required by this Item is set forth under the captions
"Election of Directors" and "Executive Officers of the Company" in the Board of
Director's Proxy Statement for the Annual Meeting of Shareholders of the Company
now scheduled for May 21, 1998, and such information is here incorporated by
reference.
ITEM 10. EXECUTIVE COMPENSATION
The information required by this Item is set forth under the caption
"Executive Compensation" in the Board of Directors' Proxy Statement for the
Annual Meeting of Shareholders of the Company now scheduled for May 21, 1998,
and such information is here incorporated by reference.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT
The information required by this Item is set forth under the captions
"Security Ownership of Certain Beneficial Owners and Management" and "Election
of Directors" in the Board of Directors' Proxy Statement for the Annual Meeting
of Shareholders of the Company now scheduled for May 21, 1998, and such
information is here incorporated by reference.
ITEM 12. CERTAIN RELATIONSHIPS
AND RELATED TRANSACTIONS
The information required by this Item is set forth under the captions
"Certain Transactions" and "Certain Transactions Relating to Acquisition of
Integrity Life Insurance Company" in the Board of Directors' Proxy Statement for
the Annual Meeting of Shareholders of the Company now scheduled for May 21,
1998, and such information is here incorporated by reference.
44
<PAGE>
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
The following documents are filed as part of this Form 10-KSB:
(a) Financial Statements.
The audited Consolidated Financial Statements of the Company and its
subsidiaries, and the related Report of Independent Auditors listed in the Index
to Financial Statements appearing under Item 7 of this Form 10-KSB.
(b) Reports on Form 8-K.
Effective March 31, 1998, Form 8-K/A was filed to provide financial
statements, prepared on the basis of generally accepted accounting principles,
for the 1995 acquisition of Integrity National Life Insurance Company. Such
statements were previously filed on the basis of statutory accounting
principles.
Effective December 16, 1997, Form 8-K was filed to disclose that, subject
to satisfactory completion of business and legal reviews and closing
adjustments, the Company agreed to acquire the stock of United Liberty Life
Insurance Company.
(c) Exhibits.
The exhibits listed in the Index to Exhibits appearing on page 47.
45
<PAGE>
SIGNATURES
In accordance with of Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CITIZENS FINANCIAL CORPORATION
March 25, 1998 By/s/Darrell R. Wells
Darrell R. Wells
President
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 Company
and in the capacities and on the dates indicated.
/s/ Darrell R. Wells Director and President March 25, 1998
Darrell R. Wells (principal executive officer)
/s/ Lane A. Hersman Director and Executive March 25, 1998
Lane A. Hersman Vice President
/s/ Brent L. Nemec Vice President, Accounting, March 25, 1998
Brent L. Nemec Chief Financial Officer, and
Treasurer (principal financial
and accounting officer)
/s/ John H. Harralson, Jr. Director March 25, 1998
John H. Harralson, Jr.
/s/ Frank T. Kiley Director March 25, 1998
Frank T. Kiley
/s/ Charles A. Mays Director March 25, 1998
Charles A. Mays
/s/ Earle V. Powell Director March 25, 1998
Earle V. Powell
/s/ Thomas G. Ward Director March 25, 1998
Thomas G. Ward
/s/ Margaret A. Wells Director March 25, 1998
Margaret A. Wells
46
<PAGE>
INDEX TO EXHIBITS
(Item 13(b))
The documents listed in the following table are filed as Exhibits in
response to Item 13(b). Exhibits listed that are not filed herewith are
incorporated herein by reference.
Exhibit Sequential
No. Description Page No.
- - ------ ----------------------------------------------------------- ----------
2.1 Stock Purchase Agreement dated March 24, 1995 between
Southwestern Life Corporation and the Company (Exhibit B
omitted) (filed as Exhibit 2.1 to the Company's Form 8-K dated
September 22, 1995)
2.2 Amendment to Stock Purchase Agreement dated September 22,
1995 between Southwestern Life Corporation and the Company
(Exhibits omitted) (filed as Exhibit 2.2 to the Company's Form 8-K
dated September 22, 1995)
3.1 Articles of Incorporation of the Company dated September 11,
1990 as amended December 14, 1995 and June 5, 1996) (filed as
Exhibit 3.1 to the Company's Form 10-Q for the quarter ended June
30, 1996)
3.2 Bylaws of the Company adopted September 12, 1990 as amended
March 25, 1994 (filed as Exhibit 3.2 to the Company's Form 10-K
dated March 28, 1996)
4 Provisions of Articles of Incorporation of the Company Defining
the Rights of Holders of Class A Stock (filed as Exhibit 4 to the
Company's Form 10 Registration Statement)
10.1 Investment Management Agreements dated July 1, 1994 between
Citizens Security and the Company and SMC Advisors,
Incorporated (filed as Exhibit 10.1 to the Company's Form 10-K
dated March 29, 1995)
10.2 Resolution of Board of Directors of the Company adopted February
4, 1992 granting stock options to Lane A. Hersman (filed as Exhibit
10.2 to the Company's Form 10 Registration Statement)
10.6 Quota Share Coinsurance and Assumption Reinsurance Agreement
dated September 21, 1995 between Integrity Life Insurance
Company and Union Bankers Insurance Company (Exhibits
omitted) (filed as Exhibit 10.6 to the Company's Form 8-K dated
September 22, 1995)
47
<PAGE>
Exhibit Sequential
No. Description Page No.
- - ------ ----------------------------------------------------------- -----------
10.8 Guarantor's Compensation Agreement dated as of September 22,
1995 between the Company and Darrell R. Wells (including
Exhibit C, form of Guaranty Note) (Other exhibits omitted) (filed
as Exhibit 10.8 to the Company's Form 8-K dated September 22,
1995)
10.8A First Amendment to Guarantor's Compensation Agreement dated
September 21, 1996 between the Company and Darrell R. Wells
(filed as Exhibit 10.8A to the Company's Form 10-Q for the quarter
ended September 30, 1996)
10.8B Second Amendment to Guarantor's Compensation Agreement dated 49
September 22, 1997 between the Company and Darrell R. Wells
(filed herewith)
10.9 Form of Employment Agreement with Certain Executives of the
Company and Schedule of Data (filed as Exhibit 10.9 to the
Company's Form 10-K dated March 28, 1996)
21.1 Subsidiaries of the Registrant (filed herewith) 51
27 Financial Data Schedule (electronic filing only)
The Company agrees to furnish supplementally to the Commission upon request
a copy of the omitted schedules to Exhibits Nos. 2.1 and 2.2 as contemplated by
Rule 601(b)(2).
48
<PAGE>
EXHIBIT 10.8B
SECOND AMENDMENT TO GUARANTOR'S COMPENSATION AGREEMENT
THIS SECOND AMENDMENT ("Amendment") is made as of September 22, 1997 by and
between CITIZENS FINANCIAL CORPORATION, a Kentucky corporation ("CFC"), and
DARRELL R. WELLS, a Kentucky resident ("Mr. Wells"), TO the GUARANTOR'S
COMPENSATION AGREEMENT dated as of September 22, 1995 by and between them (the
"Original Agreement", defined terms in which shall have the same meanings when
used herein unless otherwise defined herein).
CFC and Mr. Wells have previously entered into a First Amendment to
Guarantor's Compensation Agreement dated as of September 21, 1996 solely with
respect to the period from September 22, 1996 through September 22, 1997.
CFC and Mr. Wells now desire to amend the Original Agreement in certain
particulars set forth herein and no further solely with respect to the period
from September 22, 1997 through September 22, 1998.
NOW, in consideration for their respective agreements set forth herein and
other valuable consideration, the receipt and sufficiency of which are hereby
acknowledged, CFC and Mr. Wells are agreed and intending to be bound do hereby
agree, as follows:
1. Guaranty. Mr. Wells affirms that he continues to be bound by the
Guaranty.
2. Interim Compensation to Mr. Wells. Solely with respect to the period
beginning September 22, 1997 (that is, the second anniversary of the date CFC
issued the Bank Note to the Bank) and ending September 22, 1998 (the "Second
Interim Period"), Mr. Wells waives and relinquishes his right to the Annual
Guaranty Fee provided by the Original Agreement. In consideration therefor, CFC
agrees to pay to SMC Advisors, Inc., a Kentucky corporation with which Mr. Wells
is affiliated and that serves as an investment adviser for CFC and its
affiliates ("SMC"), a supplemental portfolio management fee with respect to its
services under the Investment Management Agreement dated as of July 1, 1994
between CFC and SMC (the "Management Agreement"), determined as follows (the
"Supplemental Fee"), which shall be in addition to (and not in lieu of) the
consideration otherwise payable to SMC pursuant to the Management Agreement:
A. The Supplemental Fee shall be payable solely with respect to the period
beginning October 1, 1997 and ending September 30, 1998 (the "Applicable
Period").
B. Subject to the provisions of paragrahs 2C and 2D next following, the
Supplemental Fee shall be equal to 15% of the sum of the "Net Unrealized Capital
Gains" or "Net Unrealized Capital Losses" plus the "Net Realized Capital Gains"
or "Net Realized Capital Losses" (as the terms in quotations are defined in the
Management Agreement) over the Applicable Period on the assets of the CFC
brokerage trading account known as the Morgan Stanley Margin Account (the
"Morgan Stanley Account"). All provisions (other than the applicable percentage)
of and definitions in the Management Agreement applicable to calculating
compensation under paragraph 5B thereof shall be applicable to calculating the
Supplemental Fee hereunder.
C. In the event CFC pays all or any portion of the principal of the Bank
Note during the Second Interim Period, the Supplemental Fee shall be reduced to
an amount that bears the same proportion to the Supplemental Fee calculated
according to paragraph B next preceding as the daily average outstanding
principal balance of the Bank Note during the Second Interim Period bears to
$1,610,000.
D. In the event the Management Agreement is terminated or the Morgan
Stanley Account is fully liquidated (other than for cash and cash equivalents)
at any time during the Second Interim Period, the Supplemental Fee calculated
according to paragraphs B and C next preceding shall be prorated to the date of
such termination or account liquidation.
49
<PAGE>
E. In the event the Management Agreement is terminated at any time during
the Second Interim Period, CFC shall pay to Mr. Wells an amount equal to
133-1/3% of the difference between the Supplemental Fee calculated according to
paragraphs B and C preceding and the amount paid to SMC pursuant to paragraph D
preceding.
F. In the event the Morgan Stanley Account is fully liquidated at any time
during the Second Interim Period, CFC shall pay to Mr. Wells the Annual Guaranty
Fee at the percentage rate provided in the Original Agreement for the period
corresponding to the Second Interim Period for the balance of the Second Interim
Period calculated on the outstanding principal balance of the Bank Note as of
the date of liquidation of the Morgan Stanley Account (the "Post-Liquidation
Guaranty Fee").
Payment. As soon as practicable after September 30, 1997, CFC shall
calculate [i] the Supplemental Fee, if any, payable to SMC pursuant to
paragraphs B, C and D of section 2, [ii] if applicable, the amount, if any,
payable to Mr. Wells pursuant to paragaph E of section 2, and [iii] the
Post-Liquidation Guaranty Fee, if any, payable to SMC pursuant to paragraph F of
section 2. Subject to receipt of any necessary approval from the Bank, CFC shall
pay to SMC and, if applicable, Mr. Wells in cash the amount or amounts, if any,
calculated pursuant to the preceding sentence as soon as possible after they are
calculated but in any event prior to November 15, 1998; provided, however, that
if the Bank shall not give any necessary consent, CFC shall pay such amount or
amounts in the form of a Guaranty Note or Guaranty Notes as provided in and
subject to the applicable terms and conditions of the Original Agreement.
3. Reaffirmation of Original Agreement. Except as provided herein with
respect to the Second Interim Period, the Original Agreement remains in full
force and effect in accordance with its terms. Except as the parties may
otherwise agree, CFC's obligation to pay the Guaranty Fee shall resume effective
September 22, 1998 according to the schedule set forth in the Original
Agreement.
IN WITNESS WHEREOF, the parties have executed this Agreement as of the day
and year first above written.
CITIZENS FINANCIAL CORPORATION
by: /s/ Lane A. Hersman
Lane A. Hersman
Executive Vice President
/s/ Darrell R. Wells
Darrell R. Wells
50
<PAGE>
EXHIBIT 21.1
Subsidiaries of the Registrant
Citizens Financial Corporation
(Kentucky corporation)
100% 100%
----------------------------------------------------------
Citizens Security Life Citizens Financial
Insurance Company Properties, Inc.
(Kentucky corporation) (Kentucky corporation)
Citizens Financial Properties, Inc. is presently inactive and has no
material assets or liabilities.
51
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 43,030
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 14,943
<MORTGAGE> 171
<REAL-ESTATE> 3,891
<TOTAL-INVEST> 65,550
<CASH> 6,181
<RECOVER-REINSURE> 83
<DEFERRED-ACQUISITION> 3,820
<TOTAL-ASSETS> 84,750
<POLICY-LOSSES> 42,230
<UNEARNED-PREMIUMS> 190
<POLICY-OTHER> 1,220
<POLICY-HOLDER-FUNDS> 15,539
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4,044
0
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17,691
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</TABLE>
