UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004
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: 1-13004
CITIZENS, INC.
(512) 837-7100
N/A
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
[X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange.
As of August 1, 2004, the Registrant had 34,935,419 shares of Class A common stock, no par value, outstanding and 874,935 shares of Class B common stock, no par value, outstanding.
CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES
INDEX
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF FINANCIAL POSITION, CONTINUEDJune 30, 2004 and December 31, 2003
See accompanying notes to consolidated financial statements.
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(Unaudited)
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(Continued)
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUEDSix Months Ended June 30, 2004 and 2003
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
In the first quarter of 2003, the Company issued 2,560,994 Class A common shares in connection with the acquisition of First Alliance Corporation. In conjunction with the acquisition, cash and cash equivalents were provided as follows:
On March 9, 2004, the Company entered into coinsurance agreements, effective January 1, 2004, ceding the majority of its accident and health premiums and corresponding benefits and claims. Due to this cession, the Company ceded its January 1, 2004, deferred policy acquisition costs and cost of customer relationships acquired and increased reinsurance recoverable and funds withheld under coinsurance agreements by $2,197,434, $2,886,060, $14,960,408 and $10,439,830, respectively, resulting in a loss of $634,461 and a deferred gain of $71,545. Of that deferred gain, $23,848 was amortized to earnings in second quarter of 2004. The remaining deferred gain at June 30, 2004, amounting to $47,697, will be amortized to earnings over the remaining settlement period of the accident and health coinsurance agreements.
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ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
On June 17, 2004, the Company entered into a Stock Purchase Agreement to acquire all of the outstanding shares of Security Plan Life Insurance Company (Security), a Louisiana life insurance company with extensive marketing operations in Louisiana, for $85 million. The transaction requires approval by regulatory authorities in Colorado and Louisiana. Closing of the acquisition is contemplated to occur by October 2004, assuming all closing conditions are met and regulatory approval is obtained.
Management believes that the acquisition should enhance premium income and total revenue and augment our domestic marketing program.
Overview
During 2004, management has focused on several key areas. The Company’s international life business continues to grow, despite continuing economic problems in some Latin American markets that historically have been large sources of new premiums. During 2003, new marketing organizations were contracted in the Pacific Rim and other locations around the world, which are making contributions to new business in the current year. Management believes that the remainder of 2004 will result in further increases in new production.
During the latter part of 2003, discussions began with another insurer that culminated in a reinsurance arrangement that was signed in March 2004, whereby the majority of our in force accident and health business was ceded to another reinsurer effective January 1, 2004 (See discussion of Accident and Health business below). As a result of this activity, overhead reductions of approximately $763,000 have been achieved in the first six months of 2004 and management expects to achieve reductions of more than $1 million for the 2004 year.
Development of our USA marketing operations continued. Changes were made in the management of this program in late 2003 and early 2004, and senior company executives have taken over the development program. Management is optimistic that the acquisition of Security Plan will provide a significant opportunity to expand USA operations.
Management continues to seek acquisitions that can add value to the Company. During 2003, two transactions were completed. Because of the growth in the Company’s asset base and level of capital, management is exploring opportunities for larger acquisition transactions (those in the $30 million to $75 million purchase price range). During the second quarter of 2004, the acquisition of Security for $85 million was announced and is expected to close by October 2004. A $30 million line of credit was negotiated with Regions Bank during the first quarter of 2004 in order to permit the Company to pursue such transactions. In addition, the Company completed a private placement of $12.5 million of Series A-1 Convertible Preferred Stock to four independent institutional investors in July 2004. Management expects to utilize both of these capital sources, as well as available cash on hand, to fund the Security acquisition.
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Results of Operations
The Company’s operations have historically focused on three areas: international life insurance; USA life insurance; and acquisition of other USA life insurance companies. Beginning in 2002 with the acquisition of Citizens National (formerly Combined), a new area was added, that of USA supplemental accident and health business. The Company significantly decreased the accident and health segment through the cession of a majority of such business, effective January 1, 2004.
International Operations
The acceptance of applications for U.S. dollar-denominated ordinary whole life insurance from high net worth foreign nationals has been the core business for the Company for more than 30 years. This niche allows the Company to participate in a marketplace where the policies are typically large face amount, the premiums are paid annually, the persistency is high compared to U.S. policies, the mortality is as good as or better than that experienced in the U.S., the caliber of the marketers from whom applications are received for consideration is above the average, and there is no advancing of commissions to producers. Overall, we expect our international operations to continue to expand. The number of independent marketers contracted has grown over the past few years. Historically, the majority of such business was focused on Central and South America. During the past two years, applications have been received from thirty-six countries, with the Pacific Rim representing a growing presence of new applications. Our foreign life insurance operations are performed by our primary insurance subsidiary, Citizens Insurance Company of America (“CICA”). Foreign business made up more than 86% of CICA’s premium revenues in 2003.
New submitted premiums for 2003 from the international market totaled more than $13.5 million compared to $13.2 million in 2002. For the first six months of 2004, submitted annualized international premiums were 32.7% higher than the same period in 2003, reflecting a broad-based increase in new life production. During late 2002 and into 2003, expansion in the Pacific Rim, particularly in Taiwan, was accomplished. CICA has established relationships with a number of marketing organizations in the Pacific Rim and during 2003 received approximately $2 million in submitted premiums from that region.
Management is pleased with the growth in international production, because several countries from which significant numbers of applications have been received have undergone financial crises over the past few years, particularly Argentina and Venezuela. These two countries represented more than 18% of the annual premium income of the Company in 2003. During the late 1980’s Argentina became the largest source of new business for CICA, particularly as a new middle class emerged in that country’s society. Because of this emerging middle class, CICA (which has historically only focused on the upper income groups) began offering a plan in Argentina that was designed for this group that was popularly received. When the economic crises occurred, the middle class was severely impacted and CICA experienced a decrease in new business and an increase in surrenders. Since that time, management has refocused the marketing organizations in this area on the high net worth individuals that have historically been the core group of insureds. During 2003, international surrenders declined compared to 2002 and have continued to decline for the first six months of 2004. Management is optimistic that in future years, production will increase from this area as the world-wide economy recovers.
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Also during 2003, Venezuela’s economy was dramatically disrupted as the export of oil was halted. This event caused the volume of new business from that country to drop significantly during the year. Management is optimistic that once this situation is resolved, the volume of new business received from that market should return to previous levels. Total premium income from the international market amounted to $26,943,412 during the first six months of 2004 compared to $22,566,710 for the same period of 2003. (See Note 6 of the “Notes to Consolidated Financial Statements” for an analysis of the International Life segment.)
U.S. Operations
The Company’s focus historically has been on the international market because of the key advantages described above. However, throughout the Company’s history, it has always written U.S. business, and through the acquisition of other U.S. life insurers, has accumulated more than $11.3 million of annual U.S. life premium.
In 2000, management perceived an opportunity for the Company to serve middle-income American families through the sale of an ordinary whole life insurance product containing a no-load annuity benefit. This product was introduced in Texas in 2000 and we have begun emphasizing the development of a sales force comprised primarily of second career sales associates. Recent acquisitions, such as our acquisition of Mid-American Alliance Corporation in Missouri (MAAC), have created opportunities to increase U.S. production. Mid American Century Life Insurance Company, a Missouri-domiciled life insurer acquired in the acquisition of MAAC, is writing approximately $1.5 million of annual life premium. Through this and contacts developed therefrom, marketing operations are being conducted in several states.
Additionally, through the 2002 acquisition of Combined Underwriters Life Insurance Company, (now Citizens National), the Company acquired a “Stipulated Premium” company, which has the capacity to recruit and train marketers and permit them to begin selling based upon a “certificate of authority” issued by the Company. This means that a potential recruit can begin to sell insurance (up to $20,000 per year of premium and face amounts of insurance less than $15,000) immediately without the delays required by today’s agent licensing requirements. By facilitating a potential marketer’s ability to make sales while preparing for his/her Group 1 (standard agent license), the Company believes it can generate a larger population of new agents. Marketing associates under contract to Citizens National submitted approximately $1 million of new life premium in 2003, and management expects similar production in 2004. Additionally, the Company has a block of Credit Life and Disability business written through furniture stores in Texas, Louisiana and Arkansas. This business is typically single premium, and amounted to more than $850,000 in 2003. During the first six months of 2004, credit premiums were more than $598,000. Total premium income from the life domestic market amounted to $6,678,549 during the first six months of 2004 compared to $6,115,449 for the same period of 2003. Management intends to broaden the portfolio of ordinary whole life products available in the United States to include products similar to those available to overseas clients as well.
Accident and Health Business
For more than 30 years, we have maintained a small block of USA accident and health business. This business grew through acquisitions in the mid-1990’s that brought other books of accident and health business, including some major medical business; however, the acquisition of Citizens
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National substantially increased both the amount of accident and health business in force, as well as the volume of new business. The business acquired in the mid-1990’s was initially highly unprofitable. Significant rate increases, coupled with the non-renewal of the major medical business, have over time improved the performance of these acquired blocks. The type of individual, supplemental accident and health business predominantly written by Citizens National has historically been easier to manage and more profitable than other, more volatile forms of accident and health coverages.
The accident and health book of business acquired in the Citizens National acquisition has not resulted in the type of operating profits we had sought. Skyrocketing costs of health care in the United States, coupled with regulatory limitations that have made it difficult to structure rate increases that are adequate for the unpredictable nature of the associated claims liability, have inhibited profitability. Additionally, reinsurance coverage, which the Company depends on to minimize its exposure to so-called catastrophic claims, has become less available and substantially more expensive in the past year. Also, the administration of accident and health business is burdensome in both cost and manpower. Although virtually all of the major medical business in force for Citizens National has been non-renewed over the past 24 months, and substantial rate increases imposed on the remaining business, as a whole, the accident and health business has proven to be a strain on profitability.
Due to the factors described above, management determined in late 2003 to seek a buyer for the block of accident and health business. In early 2004, management reached an agreement to transfer a majority of the in force accident and health business to a Texas-domiciled reinsurer effective January 1, 2004. The consideration for the transfer, which will initially be accomplished through a 100% coinsurance arrangement until the various state insurance departments can approve an assumption reinsurance agreement, will be a participation in any future profits on the book of business over a 10-year period. For the first six months of 2004, Accident and Health premium decreased by $6.8 million, compared to the same period in 2003. Upon closing of the transaction, CICA transferred reserves of $8,101,000, and Citizens National transferred reserves of $6,859,000 to the assuming carrier.Management estimates that this action will result in a decrease of approximately $14 million of annual premium income but should improve long-term profitability. We anticipate that overhead savings of more than $1.0 million annually will be achieved through the transfer of this business. (See Note 4 of the “Notes to Consolidated Financial Statements”.)
Due to the cession of the accident and health business effective January 1, 2004, the operations related to our Domestic Health segment have decreased significantly as discussed below. During the first six months of 2004, premium revenues from accident and health business were $448,000 compared to $7,272,000 in the first six months of 2003. Claims expenses totaled $138,000 in the first six months of 2004 and $5,193,000 for the same period in 2003. Commission expenses for the six months ended June 30, 2004 were $121,000 compared to $1,434,000 for the comparable period in 2003. Administrative expenses were approximately $199,000 in the first six months of 2004 and $1,750,000 in the first six months of 2003. Additionally, due to the high lapsation experienced in Citizens National’s accident and health block of business during the first six months of 2003, the amortization of cost of customers relationships acquired in the acquisition accelerated. During the six months ended June 30, 2003, $3.0 million of such cost was amortized. Due to the cession, the Company reduced its January 1, 2004 deferred policy acquisition costs, cost of customer relationships acquired and policy benefit reserves of approximately $2.2 million, $2.9 million and $15.0 million,
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respectively, and recorded an initial amount payable to the reinsurer of $10.4 million (settled in June 2004), resulting in a charge of approximately $634,000 and a deferred gain of approximately $72,000 that will be amortized to earnings over the remaining settlement period of the accident and health coinsurance agreements.
Three months ended June 30, 2004 and 2003
The following table sets forth the Company’s net income (loss) for periods indicated:
As further discussed below, increases in life premiums and net investment income and decreases in claims, general insurance expenses and amortization of cost of customer relationships acquired contributed to the increased earnings in second quarter 2004 compared to second quarter 2003.
The Company entered into coinsurance agreements, effective January 1, 2004, and ceded approximately $15 million of its annual accident and health premium and corresponding benefits and claims. In consideration for these cessions, the Company made a closing settlement payment of $10,440,000 to the reinsurer in June 2004. Due to this cession, the Company also reduced its January 1, 2004 deferred policy acquisition costs, cost of customer relationships acquired and policy benefit reserves by $2,197,000, $2,886,000 and $14,960,000, respectively, and recorded an initial amount payable to the reinsurer of $10,440,000, resulting in a first quarter 2004 charge of $634,000 and a deferred gain of $72,000. Of that deferred gain, $24,000 was amortized to earnings in second quarter 2004. The remaining deferred gain at June 30, 2004, amounting to $48,000, will be amortized to earnings over the remaining settlement period of the coinsurance agreements. The coinsurance agreements provide that this ceded business will revert to the reinsurer when parallel assumption reinsurance agreements are approved by the various state insurance departments holding jurisdiction. Such approval is expected during 2004. The Company also participates in future profits on the accident and health business subject to the coinsurance agreements over a 10-year period.
Total revenues for second quarter 2004 were $21,886,000 compared to $23,516,000 in 2003, a decrease of 6.9%. The cession of the majority of our accident and health premiums decreased revenues for second quarter 2004 by $3,090,000 compared to the comparable period of 2003. The acquisition of Mid-American increased second quarter 2004 revenues by $797,000. New life premiums increased 38.7%, renewal life premiums increased 10.8%, and net investment income increased by 12.4%. The increase in new life revenues was due to the continued expansion of both the international and domestic markets. The increase in renewal life premiums was due to improved persistency.
Premiums and annuity and universal life considerations for the three-month period decreased 9.4% from $19,561,000 in 2003 to $17,721,000 in 2004. The 2004 decrease was due to the $3,090,000 decrease in accident and health premiums discussed above. The acquisition of First Alliance and Mid-American increased life premiums and annuity and universal life
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considerations for second quarter 2004 by $461,000 compared to second quarter 2003. Annualized new life insurance premiums written by CICA increased 36.0% for the three months ended June 30, 2004 compared to second quarter 2003, due to a broad based international and domestic production increases. Management is optimistic about the prospects for the remainder of 2004; however, there is no assurance such increase can be maintained throughout the year.Additionally, as discussed above, renewal life insurance premiums increased 10.8% from second quarter 2003 to second quarter 2004.
Net investment income increased 12.4% during second quarter 2004 to $3,790,000 from $3,373,000 during second quarter 2003. The 2004 increase reflected expansion of our asset base from $372,279,000 at June 30, 2003 to $390,674,000 at June 30, 2004. Because of the types of bonds purchased in recent years, we experienced a significant amount of call activity on our bond portfolio. During second quarter 2004 and 2003, more than $30 million and $39 million, respectively, of bonds were called or matured. This activity was anticipated when the instruments were purchased.
A majority of new investment activity over the past three years has focused on the acquisition of bonds issued by public agencies that carry the implied full faith and credit of the Federal government, such as FNMA and FHLMC. These bonds typically have stated maturities of 15 years, but will carry a call feature (at par) that varies between three months and two years. All bonds purchased are at par or at a discount, so that the yield to call will be equal to or greater than the yield to maturity. By choosing to invest in these securities, the Company is exposed to reinvestment risk in the event that interest rates fall for an extended period because the securities will typically be called and the likelihood of increases in market value above par is unlikely because the expectation is that the bond will be called. Such events may require reinvestment of the proceeds at levels lower than the yields of the called bonds.
During 2003, such a period occurred; however, in many cases, the Company was able to reinvest in bonds at levels at or near those of the called bonds. These recently purchased bonds offer yields of 100 to 200 basis points above the Treasury curve and carry minimal credit risk. Recent scrutiny and concern expressed over the levels of mortgages owned by the various government backed corporations (FNMA and FHLMC) has not resulted in decreases in the credit ratings of such entities and management continues to make investments in these bonds in 2004.
The change in future policy benefit reserves increased from $3,579,000 in second quarter 2003 to $4,564,000 in second quarter 2004. CICA’s life reserves increased $4.3 million in second quarter 2004 compared to an increase of $2.7 million in second quarter 2003 predominantly due to increased persistency. Due to the cession of the majority of the accident and health business, CICA experienced a minimal change in accident and health reserves for the three months ended June 30, 2004. CICA’s accident and health reserves decreased by approximately $65,000 in the second quarter of 2003.
Citizens National’s life reserves increased approximately $235,000 in the second quarter of 2004 compared to an increase of approximately $721,000 in second quarter 2003. These increases are primarily related to sales of newly developed whole life products that carry increased reserves contrasted with the existing life business that was in force at the acquisition date. Due to the cession of the majority of its accident and health business, Citizens National had no change in its accident and health reserves for the three months ended June 30, 2004. Citizens National’s accident and health reserves, however, decreased by approximately $400,000 in second quarter
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2003. The decrease in second quarter 2003 is primarily attributed to Citizens National experiencing high lapsation on new accident and health policies issued.
The remaining change in future policy benefit reserves primarily relates to $1,048,000 decrease in the change in First Alliance’s life reserves between second quarter 2003 and 2004 and a $296,000 increase in Mid-American’s reserves in second quarter 2004. First Alliance's decrease is primarily related to the high surrender activity discussed below. The Mid-American increase is primarily related to the sales production and persistency of its life insurance block.
Policyholder dividends increased 14.3% during second quarter 2004 to $999,000 from 2003 second quarter dividends of $874,000. Virtually all of CICA’s overseas policies are participating, representing approximately 48% of our business in-force. Policyholder dividends are factored into premiums and as such dividend increases should have no adverse impact on profitability.
As noted in the table below, claims and surrenders decreased 22.3% from $9,833,000 for second quarter of 2003 to $7,644,000 for second quarter 2004. The 2004 decrease primarily related to the cession of most of our accident and health business as discussed above.
Death benefits decreased 14.9% from $1,627,000 in 2003 to $1,385,000 in 2004 primarily due to improved mortality. CICA has historically adhered to an underwriting policy which requires thorough medical examinations including x-rays and electrocardiograms on all applicants who are foreign residents, except children, regardless of age or face amount of the policy applied for. On all policies of $150,000 or more, inspection reports are required which detail the background, resources and lifestyle of the applicant. CICA has developed numerous contacts with whom our underwriters can validate information contained in applications, medical or inspection reports. CICA also retains the first $100,000 of risk and cedes to other reinsurers the excess.
Accident and health benefits decreased for the three-month period from $2,509,000 in 2003 to $31,000 in 2004 due to the cession of the majority of the Company’s accident and health business in force as discussed above pursuant to coinsurance agreements effective January 1, 2004.
Endowment benefits increased 14.1% from $1,599,000 in second quarter of 2003 to $1,824,000 in the comparable period of 2004. CICA has a series of international policies that carry an immediate endowment benefit of an amount elected by the policyowner. This endowment is factored into the premium of the policy and is paid annually. Like policy dividends, endowments
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are factored into the premium and as such the increase should have no adverse impact on profitability.
Policy surrenders increased 6.7% from $3,947,000 in 2003 to $4,210,000 in 2004 due primarily to the increased surrender activity at First Alliance and the acquisition of Mid-American, discussed above, which generated $622,000 in additional surrenders in second quarter 2004 compared to second quarter 2003. First Alliance has experienced significantly higher surrender activity since its acquisition by us in 2003 through former marketing associates of First Alliance placing numerous policies with other companies. Surrenders of our international business declined by 11.1% during the period.
During the three months ended June 30, 2004, commissions increased 6.4% to $4,489,000 from $4,218,000 in second quarter 2003 primarily due to the 38.7% increase in production of new life premiums discussed above. Accident and health commissions on the business ceded in 2004 were approximately $694,000 for the three months ended June 30, 2003. In addition, the acquisitions of First Alliance and Mid-American contributed an additional $114,000 of commissions to the second quarter 2004 increase.
Underwriting, acquisition and insurance expenses decreased 12.6% to $4,183,000 in second quarter 2004 compared to $4,784,000 in second quarter 2003 due primarily to economies of scale being achieved in the administration of the business of First Alliance and Citizens National. The second quarter of 2003 also included severance related expenses from the acquisitions of First Alliance and Citizens National. Administration costs on the ceded accident and health business in second quarter 2004 were reduced by $369,000. The acquisition of Mid-American contributed $311,000 to these second quarter 2004 expenses. Management expects to achieve expense reductions over the balance of 2004 due to the accident and health business being assumed by a reinsurer.
Capitalized deferred policy acquisition costs increased 18.6% from $3,673,000 in second quarter 2003 to $4,357,000 in second quarter 2004 primarily related to the 38.7% increase in second quarter 2004 new life production discussed above. Due to the cession of the accident and health business, capitalization of accident and health related deferred policy and acquisition costs was minimal in 2004, compared to $356,000 during the second quarter of 2003.
Amortization of these costs was $2,320,000 and $2,750,000, respectively, in the second quarter of 2004 and 2003. During the second quarter of 2003, the amortization of deferred policy acquisition costs on accident and health policies was $243,000. Amortization of these costs in 2004 was minimal due to the cession of the majority of the accident and health business discussed above.
Amortization of cost of customer relationships acquired and other intangibles decreased from $1,255,000 in the second quarter of 2003 to $635,000 in the second quarter of 2004. With the majority of the accident and health business ceded in 2004, amortization of these costs was minimal in second quarter 2004. During the three months ended June 30, 2003, $767,000 of these accident and health costs were amortized. The acquisitions of First Alliance and Mid-American contributed an additional $109,000 of amortization of these costs in 2004. Amortization of other intangibles was $138,000 during second quarter 2004.
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Six months ended June 30, 2004 and 2003
As further discussed below, increases in life premiums and net investment income and decreases in claims, general insurance expenses and amortization of cost of customer relationships acquired in excess of losses on the accident and health business related to the impact of coinsurance agreements effective January 1, 2004 contributed to the increased earnings in first six months of 2004 compared to first six months of 2003.
The Company entered into coinsurance agreements, effective January 1, 2004 as discussed above under “Three months ended June 30, 2004 and 2003.”
Total revenues for the first six months of 2004 were $41,991,000 compared to $43,222,000 in 2003, a decrease of 2.8%. The cession of the majority of our accident and health premiums decreased revenues for the first six months of 2004 by $6,824,000 compared to the comparable period of 2003. The acquisitions of First Alliance and Mid-American increased 2004 revenues by $1,684,000. New life premiums increased 29.6%, renewal life premiums increased 13.6%, and net investment income increased by 12.7%. The increase in new life revenues was due to the continued expansion of both the international and domestic markets. The increase in renewal life premiums was due to increased persistency.
Premiums and annuity and universal life considerations for the six-month period decreased 5.1% from $35,583,000 in 2003 to $33,760,000 in 2004. The 2004 decrease was due to the $6,824,000 decrease in accident and health premiums discussed above. The acquisition of First Alliance and Mid-American increased life premiums and annuity and universal life considerations for the first six months of 2004 by $1,457,000 compared to the first six months of 2003. Annualized new life insurance premiums written by CICA increased 31.6% for the first six months of 2004 compared to the first six months of 2003, due to broad based international and domestic production increases.Management is optimistic about the prospects for the remainder of 2004; however, there is no assurance such increase can be maintained throughout the year.
Net investment income increased 12.7% during first six months of 2004 to $7,644,000 from $6,801,000 during the first six months of 2003. The 2004 increase reflected expansion of our asset base from $372,279,000 at June 30, 2003 to $390,674,000 at June 30, 2004. The 2003 acquisition of Mid-American and First Alliance increased 2004 net investment income by $253,000. Because of the types of bonds we purchased in recent years, we experienced a significant amount of call activity on our bond portfolio. During the first six months of 2004 and 2003, more than $62 million and $86 million, respectively, of bonds were called or matured. This activity was anticipated when the instruments were purchased.
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As discussed above, a majority of our new investment activity over the past three years has focused on the acquisition of bonds issued by public agencies that carry the implied full faith and credit of the Federal government, such as FNMA and FHLMC.
The change in future policy benefit reserves increased from $2,042,000 in the first six months of 2003 to $7,240,000 in the first six months of 2004. CICA’s life reserves increased $6.7 million in first six months of 2004 compared to an increase of $3.9 million in first six months of 2003 predominantly due to increased persistency on the Company’s business. Due to the cession of the majority of the accident and health business, CICA experienced a minimal change in accident and health reserves for the six months ended June 30, 2004. CICA’s accident and health reserves decreased by approximately $50,000 in first six months of 2003.
Citizens National’s life reserves increased approximately $275,000 in the first six months of 2004 compared to a decrease of approximately $479,000 in the first six months of 2003. This increase was primarily related to sales of newly developed whole life products that carry increased reserves contrasted with the existing life business that was in force at the acquisition date. Due to the cession of all of its accident and health business, Citizens National had no change in its accident and health reserves for the six months ended June 30, 2004. Citizens National’s accident and health reserves, however, decreased by approximately $2.4 million in first six months of 2003. The non-renewal of the major medical block of accident and health business accounted for $1.2 million of the 2003 decrease. In addition, during the first six months of 2003, Citizens National experienced high lapsation on new accident and health policies issued.
The remaining change in future policy benefit reserves primarily related to $1.6 million decrease in the change in First Alliance’s life reserves between the first six months of 2003 and 2004 and a $670,000 increase in Mid-American’s reserves in 2004. The First Alliance decrease in the change in reserves was primarily related to the high surrender activity discussed below. The Mid-American increase was primarily related to the sales production and persistency of its life insurance block.
Policyholder dividends increased 9.4% during the first six months of 2004 to $1,730,000 from 2003 dividends of $1,581,000. Virtually all of CICA’s overseas policies are participating, and participating policies represent approximately 48% of our business in-force. Policyholder dividends are factored into the premium and as such the increase should have no adverse impact on profitability.
As noted in the table below, claims and surrenders decreased 16.9% from $19,597,000 for the first six months of 2003 to $16,289,000 for the first six months of 2004. The 2004 decrease primarily related to the cession of most of our accident and health business as discussed above.
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Death benefits increased 4.2% from $3,170,000 in 2003 to $3,302,000 in 2004 due to slight increases in both claims volume and average claim amount. The impact of the above-discussed acquisitions increased death claims by $16,000. As discussed above, CICA has historically adhered to an underwriting policy which requires thorough medical examinations on all applicants who are foreign residents.
Accident and health benefits decreased for the six-month period from $5,193,000 in 2003 to $138,000 in 2004 as discussed above due to the cession of the majority of the Company’s accident and health business in force pursuant to coinsurance agreements effective January 1, 2004.
Endowment benefits increased 17.8% from $2,851,000 in the first six months of 2003 to $3,358,000 in the comparable period of 2004. CICA has a series of international policies that carry an immediate endowment benefit of an amount elected by the policyowner. This endowment is factored into the premium of the policy and is paid annually. Like policy dividends, endowments are factored into the premium and as such the increase should have no adverse impact on profitability.
Policy surrenders increased 13.3% from $8,091,000 in 2003 to $9,165,000 in 2004. The 2004 increase was primarily related to the acquisitions of First Alliance and Mid-American, discussed above, which generated $1,396,000 in additional surrenders. First Alliance has experienced significantly higher surrender activity since its acquisition in 2003 due to the actions of former marketing associates of First Alliance placing numerous policies with other companies. Surrenders of our international business declined during the period by 4.9%.
During 2004, commissions increased 6.0% to $8,263,000 from $7,791,000 in 2003 primarily due to the 29.6% increase in the production of new life premiums during the first six months of 2004 discussed above. Accident and health commissions on the business that has been ceded in 2004 were approximately $1,373,000 for the six months ended June 30, 2003. In addition, the acquisition of First Alliance and Mid-American contributed an additional $279,000 of commissions to the 2004 increase.
Underwriting, acquisition and insurance expenses decreased 21.7% to $7,619,000 in 2004 compared to $9,727,000 in 2003 due primarily to the economies of scale being achieved in the administration of the business of First Alliance and Citizens National. In addition, the first six months of 2003 included severance related expenses from the acquisitions of First Alliance and Citizens National. Administration costs on the ceded accident and health business in 2004 reduced expenses by $763,000. The acquisitions of First Alliance and Mid-American contributed $405,000 to underwriting, acquisition and insurance expenses for the six months ended June 30,
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2004. Management expects to achieve expense reductions over the balance of 2004 due to the accident and health business being assumed by a reinsurer.
Capitalized deferred policy acquisition costs increased 15.8% from $6,910,000 in the first six months of 2003 to $7,999,000 in the first six months of 2004 primarily related to the 29.6% increase in new life production discussed above. Due to the cession of the accident and health business, capitalization of accident and health related deferred policy and acquisition costs was minimal in 2004, compared to $713,000 during the first six months of 2003.
Amortization of these costs was $4,968,000 and $5,661,000, respectively, in the first six months of 2004 and 2003. During the first six months of 2003, the amortization of deferred policy acquisition costs on accident and health policies was $624,000. Amortization of these costs in 2004 was minimal due to the cession of the majority of the accident and health business discussed above.
Amortization of cost of customer relationships acquired and other intangibles decreased from $4,265,000 in the first six months of 2003 to $1,360,000 in the first six months of 2004. With the majority of the accident and health business ceded in 2004, amortization of these costs was minimal in the first six months of 2004. During the six months ended June 30, 2003, $3,031,000 of these accident and health costs were amortized. The acquisitions of First Alliance and Mid-American contributed an additional $266,000 of amortization of these costs in 2004. Amortization of other intangibles was $285,000 during the first six months of 2004.
Liquidity and Capital Resources
Stockholders’ equity decreased from $127,027,000 at December 31, 2003 to $124,529,000 at June 30, 2004 due to unrealized losses, net of tax, of $(3,754,759) for the first six months of 2004 in excess of the income earned during the period. Decreases in the market value of our bond portfolio caused by lower bond prices resulted in the increase in unrealized losses since December 31, 2003.
Invested assets decreased to $235,325,000 at June 30, 2004 from $275,188,000 at December 31, 2003, a decrease of 14.5%. The decrease relates to sales and call activity in the first six months of 2004. The increase in cash on hand at June 30, 2004 ($39 million versus $15 million at December 31, 2003) was generated through the sale of fixed maturities to fund the purchase for $85 million in cash of Security Plan Life Insurance Company (Security) that is expected to close by October 2004. The excess cash on hand is being invested in cash equivalents with maturities of approximately 30 days. A 16.8% decrease in fixed maturities available-for-sale from $237,506,000 at December 31, 2003 to $197,571,000 at June 30, 2004 was the primary reason for the decrease in invested assets. Fixed maturities are categorized into two classifications: fixed maturities held-to-maturity, which are valued at amortized cost, and fixed maturities available-for-sale, which are valued at fair value. Fixed maturities available-for-sale and fixed maturities held-to-maturity were 84.0% and 5.1%, respectively, of invested assets at June 30, 2004. Fixed maturities held to maturity, amounting to $11,969,000 at June 30, 2004, consist of U.S. Treasury and U.S. government agency securities. Management has the intent and believes we have the ability to hold the securities to maturity.
Policy loans comprised 9.1% of invested assets at June 30, 2004 compared to 7.9% at December 31, 2003. These loans, which are secured by the underlying policy values, have annual yields
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ranging from 5% to 10% percent and maturities that are related to the maturity or termination of the applicable policies. Management believes that we maintain adequate liquidity despite the uncertain maturities of these loans.
Our cash balances at our primary depositories were significantly in excess of Federal Deposit Insurance Corporation coverage at June 30, 2004 and December 31, 2003. Management monitors the solvency of all financial institutions in which we have funds to minimize the exposure for loss. Management does not believe we are at significant risk for such a loss. During 2004, we intend to continue to utilize callable securities issued by Federal agencies as cash management tools to minimize excess cash balances and enhance returns except for the excess cash that is being generated to fund the acquisition of Security as discussed above. During 2003, the Company transferred its primary banking relationship from JP Morgan Chase to Regions Bank.
We do not utilize special purpose entities as investment vehicles. Nor are there any such entities in which we have an investment that engage in speculative activities of any description, and we do not use such investments to hedge our investment positions.
The NAIC has established minimum capital requirements in the form of Risk-Based Capital (“RBC”). Risk-based capital factors the type of business written by an insurance company, the quality of its assets, and various other factors into account to develop a minimum level of capital called “authorized control level risk-based capital” and compares this level to an adjusted statutory capital that includes capital and surplus as reported under Statutory Accounting Principles, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level risk-based capital fall below 200%, a series of actions by the affected company would begin. At June 30, 2004 and December 31, 2003, all of the Company’s insurance subsidiaries were above required minimum levels.
Effective January 1, 2001, the NAIC implemented codified rules for statutory accounting. These rules were approved and implemented by each state in which all of our insurance subsidiaries operations are domiciled. CICA is domiciled in Colorado, Citizens National is domiciled in Texas, FAIC in Kentucky, MACLIC in Missouri, SAIC in Arkansas and CUSA in Illinois. CICA follows certain Colorado state laws that differ from NAIC’s codified rules. The primary difference between the Colorado statutes and the codified rules involve the establishment of a liability for future policy dividends payable. Under codification such reserve is mandated; however, Colorado has an exception if the difference between the premium charged and the mortality factor included in the premium on participating policies exceeds the reserve that would be established. Such is the case for CICA. As a result, CICA did not establish a reserve of approximately $3 million in its statutory financial statements as of and for the six months ended June 30, 2004 and for the year ended December 31, 2003. Texas, Illinois, Kentucky, Missouri and Arkansas codified rules must be followed unless the Commissioner of Insurance permits specific practices that differ from codified rules. None of our insurance subsidiaries has requested any permission to deviate from NAIC codified rules.
During March 2004, the Company’s shareholders approved amendments to the Articles of Incorporation increasing the number of authorized Class A and Class B shares and authorizing preferred stock that could be issued upon approval of the Board of Directors. As discussed below, the Company completed a private placement of $12.5 million of Series A-1 Convertible Preferred Stock in July 2004.
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On July 12, 2004, the Company completed a private placement of $12.5 million of Series A-1 Convertible Preferred Stock to four independent institutional investors. The shares of Series A-1 Convertible Preferred Stock carry a 4% per annum dividend, are convertible at the option of the investor at any time into Class A common shares at a conversion price of $7.24 per share and are redeemable in five years. The Company may, if certain conditions have been met, pay dividends and redemptions in shares of Class A common stock at a minimum price of $7.00. The Company may, at its option, subject to certain conditions, increase the issue to $25 million.
In connection with the sale of the Series A-1 Convertible Preferred Stock, the Company issued to the investors seven-year warrants to purchase up to 474,792 Class A common shares at an exercise price of $7.96 per share. To the extent the Company increases the issue from $12.5 million, the number of Class A common shares purchased pursuant to the seven-year warrants would increase proportionately. The Company also issued to the investors unit warrants entitling the investors to purchase from the Company for a period of approximately 12 months up to $5 million of Series A-2 Convertible Preferred Stock and additional seven-year warrants to purchase additional Class A common shares at an exercise price of $7.96.
If issued, the Series A-2 Convertible Preferred Stock would be convertible into Class A common shares at a conversion price calculated as 110% of the average market closing price of the Class A stock for the 30 trading days prior to the date of issuance of the Series A-2 Convertible Preferred Stock, but not less than $7.00 or greater than $11.50 per share. Otherwise, the Series A-2 Convertible Preferred Stock has substantially identical terms to the Series A-1 Convertible Preferred Stock. The Company expects to utilize the funds in the acquisition of Security discussed above.
The Company would be required to redeem the Preferred shares 7 months after the issuance date if the average market price (for a consecutive 42 day trading period) is $5.50 per share or less. The Company can choose to redeem for cash or Class A common stock. If the average price is less than $4.00 per share, the redemption must be in cash. The Holder can take stock in place of cash (if the price is below $4). Redemption rights terminate if the price of the Class A common stock exceeds 130% ($9.41 for the Series A-1 Convertible Preferred Stock) of their conversion price for any 25 consecutive trading days period.
The Company signed a revolving line of credit agreement with Regions Bank for a $30 million credit facility for use in acquisitions in March 2004. As of June 30, 2004, no amounts have been borrowed under this revolving line of credit. The Company has historically avoided the incurrence of significant amounts of debt; however, this facility should allow management to pursue larger acquisitions. If a decision is made to utilize the facility in conjunction with a transaction, management intends to view the debt as a bridge facility. Before drawing on the debt, management expects to develop a strategy designed to retire the debt without restricting growth.
The Sarbanes-Oxley Act of 2002 (“the Act”) established sweeping new guidelines for corporate governance. Subsequently, the New York Stock Exchange adopted new rules that relate to such matters as the composition of listed companies’ Boards of Directors and various committees thereof, the need to adopt specific policies as well as the establishment of a Code of Ethics. The Company’s Board of Directors, Compensation Committee and Audit Committee were already configured in such a way as to comply with the Act. Citizens has operated under a “Principles, Purposes, Philosophy and Beliefs” for numerous years that sets forth the manner in which the
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Company and its officers, directors and employees are expected to function. However, the Board of Directors has implemented a formal Code of Ethics applicable to all officers, directors and employees.
Additionally, the Act imposes a duty upon public companies to document and test all internal controls and have such audited by independent auditors. The Company has begun the process of documenting all such control procedures and expects to complete the documentation and testing in 2004.
The Company has committed to the following contractual obligations as of June 30, 2004 with the payments due by the period indicated below:
Financial Accounting Standards
See Note 9 of our Consolidated Financial Statements for a discussion of recently promulgated accounting standards and interpretations, which we have adopted, and our estimates of their impact upon us.
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ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK
Our exposure to interest rate changes results from our significant holdings of fixed maturity investments, mortgage loans on real estate and policy loans, all of which comprised almost 99% of our investment portfolio as of June 30, 2004. These investments are mainly exposed to changes in treasury rates. Our fixed maturities investments include U.S. government bonds, securities issued by government agencies, and corporate bonds. Approximately 94% of the fixed maturities we owned at June 30, 2004 are instruments of the United States government or are backed by U.S. government agencies or private corporations carrying the implied full faith and credit backing of the U.S. government.
To manage interest rate risk, we perform periodic projections of asset and liability cash flows to evaluate the potential sensitivity of our investments and liabilities. We assess interest rate sensitivity with respect to our available-for-sale fixed maturities investments using hypothetical test scenarios that assume either upward or downward 100 basis point shifts in the prevailing interest rates. The following tables set forth the potential amount of unrealized gains (losses) that could be caused by 100 basis point upward and downward shifts on our available-for-sale fixed maturities investments as of the dates indicated:
While the test scenario is for illustrative purposes only and does not reflect our expectations regarding future interest rates or the performance of fixed-income markets, it is a near-term change that illustrates the potential impact of such events. Due to the composition of our book of insurance business, we believe it is unlikely that we would encounter large surrender activity due an interest rate increase that would force us to dispose of our fixed maturities at a loss.
There are no fixed maturities or other investments that we classify as trading instruments. At June 30, 2004 and December 31, 2003, there were no investments in derivative instruments.
Market Risk Related to Equity Prices
Changes in the level or volatility of equity prices affect the value equity securities we hold as investments. However, our equity investments portfolio was less than 1% of our total investments at June 30, 2004 and December 31, 2003. Thus, we believe that significant decreases in the equity markets would have an immaterial impact on our total investment portfolio. See also. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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ITEM 4
CONTROLS AND PROCEDURES
As of the end of the period covered by this report, we evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer and President and Treasurer, the effectiveness of the design and operation of our disclosure controls and procedures over financial reporting pursuant to Rule 13a-15 and 15d-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and our President and Treasurer concluded that our disclosure controls and procedures over financial reporting are adequate and effective in timely alerting them to material information required to be included in this quarterly report on Form 10-Q.
Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity’s disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in disclosure controls and procedures. These limitations include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors or mistakes or because of intentional circumvention of the established process.
During the period covered by this report, there have been no significant changes in our internal controls over financial reporting or in other factors, which could significantly affect internal controls over financial reporting, including any corrective actions with regard to significant deficiencies or material weaknesses.
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PART II. OTHER INFORMATION
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Item 2. Changes in Securities
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
The following exhibits are filed herewith:
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37
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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EXHIBIT INDEX
Exhibits
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41
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