UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For the quarterly period ended March 31, 2005
or
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 o No
Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange.
As of May 1, 2005, the Registrant had 37,457,307 shares of Class A common stock, no par value, outstanding and 936,181 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 POSITIONMarch 31, 2005 and December 31, 2004
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF FINANCIAL POSITION, CONTINUEDMarch 31, 2005 and December 31, 2004
(Continued)
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See accompanying notes to consolidated financial statements.
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSThree Months Ended March 31, 2005 and 2004
(Unaudited)
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSThree Months Ended March 31, 2005 and 2004
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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUEDThree Months Ended March 31, 2005 and 2004
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
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. The deferred gain was fully amortized to earnings in 2004.
On July 12, 2004, the Company completed a private placement of $12.5 million of Series A-1 Senior Convertible Preferred Stock to four unaffiliated institutional investors. The Company initially recognized deferred issuance costs of $1,485,846, discounts on beneficial conversion
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features of $3,073,204 and discounts on fair value of options and warrants of $2,718,959, respectively. The Company has recognized accretion of those deferrals and discounts amounting to $679,280 in 2004 and $363,900 in the first quarter of 2005. These discounts and deferrals have decreased the carrying amount of the Convertible Preferred Stock in the statement of financial position.
CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2005
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ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS
Three months ended March 31, 2005 and 2004
Overview
In 2004, the Company achieved several milestones. Production of new ordinary life premium increased to record levels during the year. Additionally, the acquisition of Security Plan in October added a substantial amount of U.S. revenues as well as creating a new marketing division, home service life, from which to further expand the Company’s U.S. presence.
The Company’s book of accident and health business, which had been a source of significant overhead and attention was ceded of through a reinsurance arrangement that was signed in March 2004 under which the majority of the in force accident and health business was ceded to another reinsurer effective January 1, 2004. This cession lowered overhead and removed the inherent volatility of the accident and health business.
In 2005, management expects to focus on the conversion of Security Plan to the data processing system used by the Company. Additionally, implementation of the Sarbanes-Oxley Section 404 evaluation was deferred for Security Plan until 2005. The Company will begin the documentation and testing required in June 2005. Additionally, the Company is moving to consolidate insignificant or dormant subsidiaries in order to take advantage of economics of scale and achieve expense reductions.
Management continues to seek acquisitions that can add value to the Company. 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 $50 million to $100 million purchase price range). 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 larger transactions.
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 has effectively exited the accident and health segment through the cession of virtually all of that 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 the past 30 years. Our niche allows the Company to participate in a marketplace where the policies are typically large face amounts, the premiums are paid annually, the persistency is high compared to U.S. policies, the mortality is as
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good as or better than that experienced in the United States, the caliber of the marketers from whom applications are received for consideration is higher and more professional than that typically seen in the U.S., 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; however CICA has established relationships with a number of marketing organizations in the Pacific Rim and during 2004 received approximately $2 million in submitted premiums from that region Our foreign life insurance operations are performed by our primary insurance subsidiary, Citizens Insurance Company of America (“CICA”).
Total premium income from the international market amounted to $14,825,000 during the first three months of 2005 compared to $12,556,000 for the same period of 2004. (See Note 4 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, 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. Since that time, the Company has sought the marketing management necessary to build a U.S. sales organization from scratch and to begin to write the product in volume. After several attempts to bring in such expertise, in early 2004, senior executives in the Company’s home office staff assumed this new management responsibility. 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, have created opportunities to increase production. Mid American Century Life Insurance
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Company, a Missouri-domiciled life insurer acquired in the acquisition of Mid-American Alliance Corporation, is writing approximately $1 million of annual life premium. Through this and other acquisitions, marketing operations are being conducted in several states.
Total U.S. life premium income and annuity and universal life considerations for the first quarter of 2005 amounted to $3,516,000 compared to $4,366,000 in the first quarter of 2004. 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.
Home Service Operations
The acquisition of Security Plan created a new segment for the Company. Security Plan has focused on writing ordinary whole life insurance utilizing the home service marketing distribution method, whereby employee/agents working “routes” make regular collections of premiums from clients. This marketing method dates back to the creation of the life insurance industry in the United States and Security Plan utilizes approximately 390 agents to write and collect premiums. Because Security Plan was acquired on October 1, 2004, its activities are not included in first quarter 2004 results from operations.
Under the management of its previous owner, Security Plan had focused on limiting the amount of new business sold in order to maximize profits under regulatory accounting. As such, its book of premium revenues has decreased each year for the past five years. Management is optimistic that a new emphasis on sales can halt the shrinkage in the premium income and serve as a base from which to expand the home service or debit business. Security Plan is made up of books of business from more than 100 small life insurance carriers that it had acquired during its history. For the first quarter of 2005, Home Service premium revenues amounted to $9.8 million
Consolidated Results
The following table sets forth the Company’s net income for periods indicated:
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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 $10,497,000 to the reinsurer in May 2004. Due to this cession, the Company also ceded 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 that was amortized to earnings during 2004. 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 2005. The Company also participates in future profits on the accident and health business subject to the coinsurance agreements over a 10-year period. During 2004, the Company’s share of profits amounted to approximately $800,000.
Total revenues for the first three months of 2005 were $35,397,000 compared to $20,105,000 in 2004, an increase of 76.1%. The inclusion of Security Plan in the first quarter of 2005 contributed $12.8 million of revenue.
Premiums and annuity and universal life considerations for first quarter increased to $28,579,000 in 2005 from $16,039,000 in 2004. The 2005 increase is attributable to the inclusion of Security Plan, which had $9,790,000 of premium income during the quarter, as well as the growth in premium income for CICA, who benefited from the large increase in new premiums written in 2004, as well as an increase in new business during 2005. First year issued and paid annualized life premium for CICA increased 33.2% from $4,045,000 in the first quarter of 2004 to $5,388,000 in 2005.
Net investment income increased 57.6% during first quarter 2005 to $6,106,000 from $3,874,000 during first quarter 2004. Security Plan’s inclusion added $2,991,000 to the 2005 results. Available yields remained low during the first part of 2005, with Treasury returns falling to two year lows. The Company continues to invest in 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. Management believes the Company’s cash flow is strong enough to take advantage of opportunities for higher return, should those present themselves in the coming months. Currently, the Company has been able to earn returns in the 6% range on newly invested money, which are greater than its obligations on reserves and any annuity obligations, and substantially higher than available through the treasury market.
The change in future policy benefit reserves increased from $2,676,000 in first quarter 2004 to $5,598,000 in first quarter 2005. CICA’s life reserves increased $4.8 million
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in first quarter 2005 compared to an increase of $2.4 million in first quarter 2004 predominantly due to an increase in persistency on the Company’s international business. Security Plan’s operations added $512,000 to the 2005 increase.
Policyholder dividends increased 19% during first quarter 2005 to $870,000 from 2004 dividends of $731,000. Virtually all of CICA’s overseas policies are participating, and the improvement in persistency on the Company’s international business has contributed to the growth in dividends.
As noted in the table below, claims and surrenders increased 41.8% from $8,642,000 in first quarter 2004 to $12,254,000 in first quarter 2005. The 2005 increase primarily relates to the acquisition of Security Plan in October, 2004, as discussed above.
Death benefits increased 228.7% from $1,918,000 in first quarter 2004 to $6,305,000 in first quarter 2005. Security Plan’s death claims totaled $4,326,000. Claims on the Company’s remaining books of business remained static or down slightly during early 2005. Because of the nature of Security Plan’s business, its incurred claims historically are higher than those incurred on the Company’s international business. CICA has historically adhered to an underwriting policy which requires thorough medical examinations on all applicants who are foreign residents, except children, regardless of age or face amount of the policy applied for, including x-rays and electrocardiograms. On all policies of $150,000 or more, inspection reports are required which detail the background, resources and lifestyle of the applicant. We have developed numerous contacts with whom our underwriters can validate information contained in applications, medical or inspection reports. CICA also retains only the first $100,000 of risk and cedes to other reinsurers the excess.
Accident and health benefits are nominal since the cession of the majority of the Company’s accident and health business in force according to coinsurance agreements effective January 1, 2004.
Endowment benefits increased 24.4% from $1,534,000 in first quarter 2004 to $1,909,000 in first quarter 2005. 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.
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Policy surrenders decreased 25.1% in 2005 to $3,710,000 from $4,955,000 in the first quarter of 2004. The relative policy size of Security Plan’s business coupled with the nature of the policies is such that surrenders on that book of business are relatively low. However, the inclusion of Security Plan in 2005 added $411,000 in surrender benefits to the 2005 results. Lower surrenders on the First Alliance book of business as well as improved persistency on the Company’s international business contributed to the decrease in surrenders.
Other policy benefits amounted to $209,000 for the first quarter of 2005, compared to $127,000 for the first quarter of 2004. These benefits are comprised of supplemental contract benefits, interest on policy funds and assorted other miscellaneous policy benefits.
During 2005, commissions increased 86.7% to $7,046,000 from $3,773,000 in 2004 primarily due to Security Plan’s inclusion. Commissions paid by Security plan during the first quarter of 2005 totaled $2,480,000. Additionally, CICA’s commissions were higher in 2005 as a result of the increase in issued new business described above.
Underwriting, acquisition and insurance expenses increased 124.7% to $7,719,000 in first quarter 2005 compared to $3,436,000 in first quarter 2004. The increase is largely attributable to Security Plan, whose expenses were approximately $3,220,000 in the first three months of 2005, coupled with the expenses incurred in the conversion process and approximately $330,000 of interest expense on the Company’s term loan.
Capitalized deferred policy acquisition costs increased 37.9% from $3,642,000 in first quarter 2004 to $5,021,000 in first quarter 2005 primarily related to the increase in new life production discussed above. Security Plan’s capitalized expenses were $533,000. Amortization of these costs was $1,971,000 and $2,649,000, respectively, in the first quarters of 2005 and 2004. The improvement in persistency contributed to the slowdown in amortization during 2005.
Amortization of cost of customer relationships acquired and other intangibles increased from $725,000 in the first quarter of 2004 to $1,150,000 in the first quarter of 2005. Amortization of these items related to the Security Plan acquisition was $777,000 in 2005.
Liquidity and Capital Resources
Stockholders’ equity at March 31, 2005 was $134,406,000 compared to $135,131,000 at December 31, 2004. Unrealized losses on the Company’s bond portfolio, net of tax, offset the income earned during the period.
Invested assets decreased to $462,767,000 at March 31, 2005 from $475,802,000 at year-end 2004. The decrease related to call activity in the first quarter of 2005 that management chose to accumulate for the purpose of retiring the outstanding term loan. Fixed maturities are categorized into two classifications: fixed maturities held-
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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 92.3% and 1.6%, respectively, of invested assets at March 31, 2004. Fixed maturities held to maturity, amounting to $7,546,000 at March 31, 2005, 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 5.3% of invested assets at March 31, 2005 compared to 5.1% at December 31, 2004. These loans, which are secured by the underlying policy values, have yields 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 March 31, 2005 and December 31, 2004. 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 2005, we intend to continue to utilize high grade commercial paper as cash management tools to minimize excess cash balances and enhance returns.
In the wake of bankruptcy filings by large corporations in 2000-2001, concern was raised regarding the use of certain off-balance sheet special purpose entities such as partnerships to hedge or conceal losses related to investment activity. 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 March 31, 2005 and December 31, 2004, all of the Company’s insurance subsidiaries were above required minimum levels.
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During the first quarter of 2005, we continued to engage in discussions with the investment banking community regarding raising additional equity capital. Should we decide to pursue equity capital, the purpose would be to utilize the proceeds to pursue acquisitions. Management believes the Company has sufficient capital for its long-term operating needs; however, management may pursue additional equity capital to finance larger acquisitions.
The Company signed a revolving line of credit agreement from Regions Bank for a $30 million credit facility for use in acquisitions in March 2004. On October 1, 2004, the Company entered into a Second Amendment to the Loan Agreement that converted into a term loan its $30 million advance against the line of credit made in connection with the acquisition of Security Plan. The loan was repaid in April of 2005.
The Sarbanes-Oxley Act of 2002 (the “Act”) established significant new guidelines for corporate governance. Subsequently, the New York Stock Exchange adopted new
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rules relating to such matters as the composition of listed companies’ Boards of Directors and various committees thereof, the need to adopt specific policies and 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 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 controls audited by independent auditors.
The Company has committed to the following contractual obligations as of March 31, 2005 with the payments due by the period indicated below:
The payments related to the future policy benefits and policy claims payable reflected in the table above have been projected utilizing assumptions based upon the Company’s historical experience and anticipated future experience.
Financial Accounting Standards
See Note 7 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 December 31, 2004 and March 31, 2005. 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 94.6% of the fixed maturities we owned at December 31, 2004 and March 31, 2005 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:
March 31, 2005
December 31, 2004
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 March 31, 2005 and December 31, 2004, 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 March 31, 2005 and December 31, 2004. 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
(a) Disclosure Controls and Procedures
We have established disclosure controls and procedures to ensure, among other things, that material information relating to the Company, including its consolidated subsidiaries, is made known to the officers who certify our financial reports and to the other members of senior management and the Board of Directors.
Our Chief Executive Officer (CEO) and our President and Chief Financial Officer (CFO) are responsible for establishing and maintaining disclosure controls and procedures for the Company (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)). Based upon our evaluation at the end of the period, the Chief Executive Officer and the President and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective as of the end of the period covered by this annual report because of the material weakness discussed below.
A “material weakness” in internal control over financial reporting is defined by the Public Company Accounting Oversight Board’s (“PCAOB”) Auditing Standard No. 2 as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
The material weakness relates to the inadequate and ineffective management oversight and review of the Company’s financial reporting process. Specifically, the Company did not revise its management oversight and review protocols to address changes in the qualifications of personnel performing financial reporting functions, and did not provide for effective cross-training of personnel performing financial reporting functions. As a result, numerous material errors were identified in the Company’s annual financial statement footnotes. These errors were corrected prior to issuance of the Company’s 2004 consolidated financial statements.
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The aforementioned material weakness in internal control over financial reporting resulted in more than a remote likelihood that the Company’s financial statements could have been materially misstated. The conditions identified at December 31, 2004 remained at March 31, 2005.
(b) Change in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The conditions identified at December 31, 2004 remained at March 31, 2005.
However, we are in the process of completing remediation efforts relating to the material weakness, which are set forth in detail below, which primarily include hiring additional personnel who will be competent to address U.S. GAAP relating to our operations, additional training for our accounting staff, particularly relating to U.S. GAAP, and enhanced management review procedures.
In order to address the findings of our internal control assessment, we are implementing the following improvements to our internal controls and procedures in the financial accounting area which we believe will improve our internal control over financial reporting in future periods:
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We believe these efforts will address the material weakness identified by management during its assessment of internal control over financial reporting.
Additionally, during 2005, management must evaluate, test and report on the internal controls over financial reporting at Security Plan. Management expects to begin this process during the second quarter of 2005, as well as the continuation of reviewing and updating of the findings of the 2004 evaluation. Effective January 1, 2005, the Company’s book of accident and health business is being administered by the reinsurer. Should the assuming reinsurer of the accident and health business not complete the assumption process during 2005, the Company must evaluate the internal controls of the assuming company during the course of 2005.
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PART II. OTHER INFORMATION
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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.
Date: May 13, 2005
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EXHIBIT INDEX
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