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U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended DECEMBER 31, 2003
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
(Exact name of registrant as specified in its charter)
Kentucky 61-1187135
(State of Incorporation) (I.R.S. Employer Identification No.)
12910 Shelbyville Road, Louisville, Kentucky 40243
(Address of principal executive offices)
(502) 244-2420
(Registrant's telephone number)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Class A Stock, No
Par Value
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, and (2) has been subject to such filing requirements
for the past 90 days. Yes ~~X~~ No ~~~~~
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [~X~]
Indicate by check mark whether the registrant is an accelerated filer (as
determined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ~~~~~
No ~~X~~
State the aggregate market value of the common equity held by non-affiliates of
the registrant: $5,015,673 (based on an $7.89 per share average of bid and asked
prices on March 25, 2004).
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 1,685,228 shares of Class A
Stock as of March 25, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the issuer's Board of Director's Proxy Statement for the Annual
Meeting of Shareholders now scheduled for June 30, 2004 are incorporated into
Part III of this Form 10-K. The date of this Report is March 29, 2004.
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CONTENTS
PART I
Page
ITEM 1. BUSINESS .................................................. 3
ITEM 2. PROPERTIES ................................................ 10
ITEM 3. LEGAL PROCEEDINGS ......................................... 10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ....... 10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS ...................... 11
ITEM 6. SELECTED FINANCAL DATA .................................... 12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS......................... 13
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. 24
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................ 26
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE .............. 26
ITEM 9a. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES.......... 26
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ........ 54
ITEM 11. EXECUTIVE COMPENSATION .................................... 54
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS ....... 54
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS ..................................... 54
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES .................... 54
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
AND REPORTS ON FORM 8-K .................... 54
SIGNATURES ............................................................. 55
EXHIBIT INDEX .......................................................... 56
EXHIBITS................................................................ 57
This report contains projections and other forward-looking statements regarding
future events or the future financial performance of the Company. Actual events
and results may differ materially from those in the projections and other
forward-looking statements set forth herein. Among the important factors that
could cause actual events or results to differ materially from those in the
projections and other forward-looking statements are: changes in the market
value of the Company's investments, including stock market performance and
interest rate changes; customer response to marketing efforts; mortality and
morbidity trends; regulatory changes; actions of independent rating agencies;
general economic conditions and increased competition; the Company's ability to
achieve operating efficiencies; unanticipated adverse litigation; and changes in
Federal tax law. Readers are referred to the Items 1, 7, 7a and 8 in this report
and to the Company Report on Financial Statements in the Company's Annual Report
to Shareholders for the year ended December 31, 2003 for a discussion of these
and other important risk factors concerning the Company and its operations.
PART I
ITEM 1. 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 and
United Liberty Life Insurance Company ("United Liberty") (herein collectively,
the "Life Insurance Subsidiaries"). The Company also owns Citizens Insurance
Company ("Citizens Insurance"), which is licensed as a property and casualty
insurer but currently has no business inforce. The Life Insurance Subsidiaries
and Citizens Insurance are herein collectively referred to as the "Insurance
Subsidiaries".
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. In 1995, the
Company and Citizens Security purchased all of the stock of Integrity National
Life Insurance Company ("Integrity") and merged it into Citizens Security.
During May 1998, Citizens Security purchased all of the outstanding shares of
United Liberty. In October 1999, the Company acquired Citizens Insurance and in
January 2001, it contributed the stock of Citizens Insurance to Citizens
Security. See Item 7 and Note 2 of the Notes to Consolidated Financial
Statements, for descriptions of certain of these acquisitions. The Life
Insurance Subsidiaries are currently licensed to transact the business of life
insurance, annuities, and accident and health insurance. Citizens Security is
licensed in twenty states and the District of Columbia while United Liberty is
licensed in twenty-three states and Citizens Insurance is licensed in six
states.
Insurance Operations
The Company, through its Life Insurance Subsidiaries, operates in five segments
-- 1) home service life insurance, 2) broker-sold life insurance and annuities,
3) preneed life insurance, 4) dental insurance, and 5) other health and accident
insurance. The home service and preneed life segments provide individual
coverages; the dental segment provides group coverages; while the broker life
and other health segments include individual and group insurance coverages. The
following table presents each business segment's revenue; pretax profit or loss
excluding realized investment gains and interest expense; and ending assets for
each of the last three fiscal years. Additional segment information is contained
in Item 7 and in Note 9 of the Notes to Consolidated Financial Statements.
Segment Revenue, Profit or Loss, and Assets:
December 31 2003 2002 2001
----------------------------------------------------------- ----------------- ---------------- -----------------
Revenue:
Home Service Life $ 9,147,813 $ 9,260,097 $ 9,290,120
Broker Life 6,019,952 5,964,089 6,497,286
Preneed Life 14,780,938 19,706,136 9,974,405
Dental 8,417,118 8,209,257 8,025,375
Other Health 1,381,981 1,432,607 1,487,562
----------------------------------------------------------- ----------------- ---------------- -----------------
Segment Totals 39,747,802 44,572,186 35,274,748
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
----------------------------------------------------------- ----------------- ---------------- -----------------
Total Revenue $41,725,437 $ 42,102,418 $ 27,362,919
----------------------------------------------------------- ----------------- ---------------- -----------------
Year Ended December 31 2003 2002 2001
----------------------------------------------------------- ----------------- ---------------- -----------------
Segment Profit (Loss):
Home Service Life $ 75,520 $ 275,809 $ 382,723
Broker Life (121,851) (265,488) 74,960
Preneed Life (955,227) (670,349) (264,488)
Dental 230,289 297,740 256,385
Other Health (201,385) (191,289) 10,847
----------------------------------------------------------- ----------------- ---------------- -----------------
Segment Totals (972,654) (553,577) 460,427
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
Interest expense 363,273 305,715 532,962
----------------------------------------------------------- ----------------- ---------------- -----------------
Income (Loss) before income tax and cumulative $ 641,708 $(3,329,060) $(7,984,364)
effect of a change in accounting principle
----------------------------------------------------------- ----------------- ---------------- -----------------
December 31 2003 2002 2001
----------------------------------------------------------- ----------------- ---------------- -----------------
Assets:
Home Service Life $ 41,312,914 $ 45,219,971 $ 44,818,038
Broker Life 54,585,019 53,874,949 54,954,194
Preneed Life 60,100,723 46,739,831 34,138,535
Dental 930,279 660,334 726,728
Other Health 1,951,397 1,946,447 1,959,588
----------------------------------------------------------- ----------------- ---------------- -----------------
Total Assets $158,880,332 $148,441,532 $136,597,083
----------------------------------------------------------- ----------------- ---------------- -----------------
Home Service Life. The Home Service Life segment consists primarily 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. Agents for these products sell primarily small face value
policies (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.
Broker Life. The Broker Life segment offers traditional whole life insurance;
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; annuities; group life; accidental
death and dismemberment; and dependent life insurance. The majority of Broker
Life sales consist of whole life graded death benefit and simplified issue
policies.
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. If the insured dies of an accidental cause, the
benefit payable is the face amount of the policy. The simplified issue product
provides full face amount coverage from date of issue, is more extensively
underwritten and carries lower premium rates than the graded death benefit
product. These products are targeted towards 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 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 Life Insurance Subsidiaries has been within expected ranges, in relation to
the mortality assumptions used to price the products.
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.
Preneed Life. The Preneed Life segment products are traditional whole life
policies sold to individuals in connection with prearrangement of their funeral
and include single and multi-pay coverages, generally in amounts of $10,000 and
less. These policies are generally sold to older individuals at increased
premium rates.
The following table provides information concerning the Life 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.
Year Ended December 31 (Dollars in Thousands) 2003 2002 2001
-------------------------------------------------- --------------------- -------------------- ---------------------
Gross In-force at beginning of period1 $792,722 $812,515 $809,045
New business issued during period:
Individual $103,239 $95,706 $ 113,119
Group 10,377 13,063 7,632
-------------------------------------------------- --------------------- -------------------- ---------------------
New business total $113,616 $108,769 $ 120,751
Terminations during period $141,287 $128,562 $ 117,281
Termination rate2 17.8% 15.8% 14.5%
Gross In-force at end of period1:
Individual $661,720 $663,394 $668,565
Group 103,331 129,328 143,950
-------------------------------------------------- --------------------- -------------------- ---------------------
Gross In-force total at end of period $765,051 $792,722 $812,515
-------------------------------------------------- --------------------- -------------------- ---------------------
Reinsurance ceded at end of period 91,480 96,202 109,227
-------------------------------------------------- --------------------- -------------------- ---------------------
Net In-force at end of period $673,571 $696,520 $703,288
-------------------------------------------------- --------------------- -------------------- ---------------------
1Before deduction of reinsurance ceded.
2Represents the percentage of individual policies terminated during the indicated period by lapse, surrender,
conversion, maturity, or otherwise.
Dental Insurance. 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.
Other Health Insurance. Other Health products include individual accident and
health insurance policies, which 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. Group health plans are also offered, providing coverage
for short-term disability, and income protection. The Company is not allocating
significant marketing resources to this segment.
Marketing. The Life Insurance Subsidiaries are currently licensed to sell
products in 29 states and the District of Columbia. Citizens Security and United
Liberty are both licensed in the states designated below with a "b" while only
Citizens Security is licensed in the states designated "c" and only United
Liberty in the states designated "u".
b Alabama b Indiana u Nebraska u Oregon
u Arizona u Kansas u Nevada c Pennsylvania
b Arkansas b Kentucky c New Jersey b South Carolina
u Colorado b Louisiana u New Mexico b Tennessee
c Delaware b Maryland c North Carolina b Texas
c District of b Mississippi u Oklahoma u Utah
Columbia
b Florida b Missouri c Ohio c Virginia
c Georgia b West Virginia
The Life Insurance Subsidiaries market products through the personal producing
general agent distribution system. Approximately 3,200 sales representatives are
licensed as independent agents for the Life Insurance Subsidiaries. Nearly all
of these agents also represent other insurers. Approximately 500 of these agents
specialize in the home service market. That market consists primarily of middle
and 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. Approximately 600 agents specialize in the preneed market.
Typically, these agents are funeral directors or operate from facilities owned
by funeral directors.
The Life Insurance Subsidiaries furnish 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. The Life Insurance Subsidiaries
have 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. The Life Insurance Subsidiaries follow 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. In addition, certain types of life
insurance policies are offered with higher premium rates and less stringent
underwriting requirements. The Life Insurance Subsidiaries also rely 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 Life 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. The Life Insurance Subsidiaries have 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 revenue from
investments. The Life Insurance Subsidiaries maintain diversified investment
portfolios that are 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, the
Life Insurance Subsidiaries follow a general strategy to maximize total return
(current income plus appreciation) without subjecting themselves to undue risk.
Where deemed appropriate, the Life Insurance Subsidiaries 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"). The Company's non-investment grade bonds,
based on reported fair values, represented 7.0% of the Company's cash and
invested assets as of December 31, 2003. Citizens Security has maintained
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. The Company also maintains an investment portfolio
of equity securities separate from those of the Life Insurance Subsidiaries.
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 4.4% of cash and invested assets as of December 31, 2003. Neither
the Company nor its subsidiaries owned any collateralized mortgage-backed
securities as of December 31, 2003 that would be included in the high-risk
classification.
For additional information concerning investment results, see Item 7.
Reinsurance. In keeping with industry practice, the Life Insurance Subsidiaries
reinsure, with unaffiliated insurance companies, portions of the life and health
insurance risks which they underwrite. The Life Insurance Subsidiaries retain 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 and simplified issue
coverages above $4,000 are generally 50% reinsured, with the Life Insurance
Subsidiaries maintaining a maximum $10,000 risk on any one life. Individual and
group accidental death coverage is 100% reinsured. At December 31, 2003,
approximately $91,480,000 or 12% of life insurance in force was reinsured under
arrangements described in Note 11 of the Notes to the Consolidated Financial
Statements. Under most reinsurance arrangements described above, new insurance
is reinsured automatically rather than on a basis that would require the
reinsurer's prior approval. Generally, the Life Insurance Subsidiaries enter
into indemnity reinsurance arrangements to assist in diversifying their risks
and to limit their 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, the Life Insurance Subsidiaries
remain 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 approximately
1,500 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 the Life Insurance
Subsidiaries. Financial and claims-paying ratings assigned to insurers by A.M.
Best Company ("Best") and by nationally-recognized statistical rating
organizations have become more important to policyholders. Citizens Security's
rating was last changed by Best in October, 2001, when it was downgraded to B-
(Fair) from B (Fair). United Liberty's rating has remained at B- (Fair) since
its 1998 acquisition. According to Best, B- ratings are assigned to companies
that have on balance, fair financial strength, operating performance and market
profile when compared to the standards established by Best. Also according to
Best, B- companies have an ability to meet their current obligations to
policyholders, but their financial strength is vulnerable to adverse changes in
underwriting or economic conditions. There are seven Best rating categories
above the B- category from B to A++. The Life Insurance Subsidiaries will
continue to pursue upward revisions in their Best ratings. Citizens Insurance
has no insurance business inforce and is not rated by Best.
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. In 1998, S&P changed its rating methodology and revised Citizens
Security's rating from BBq to BBpi. (The "q" subscript designated the
quantitative method of rating while the "pi" subscript designates the public
information method). United Liberty has not been rated by S&P. 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.
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.
The Life Insurance Subsidiaries compete primarily on the basis of the
experience, size, accessibility and claims response of their customer service
representatives, product design, service and pricing. The Company believes that
the Life Insurance Subsidiaries are generally competitive in the markets in
which they are engaged based upon premium rates and services, have good
relationships with their agents, and have an adequate variety of insurance and
annuity products approved for issuance.
State Insurance Regulation. The Insurance Subsidiaries, in common with other
insurers, are subject to comprehensive regulation in the states in which they
are 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, regulate the form and
content of policies, establish reserve requirements, prescribe the type and
amount of allowable investments, and review premium rates for fairness and
adequacy. The Insurance Subsidiaries file detailed annual statements with all
states in which they are licensed to transact business. The Kentucky Office of
Insurance also periodically examines the business and accounts of the Insurance
Subsidiaries. In recent years, various state insurance departments and the NAIC
have expressed concern, essentially about the "rate of return" earned by holders
of small face amount life policies, potentially including Preneed policies.
Although the Company does not believe calculating a simple "rate of return" is
meaningful for traditional life insurance products, state insurance regulators
could take steps that would alter the profitability of existing policies and/or
eliminate small face amount policies as a viable product offering.
The Life Insurance Subsidiaries also can be required, under the solvency or
guaranty laws of most states in which they do 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 the Life Insurance
Subsidiaries, net of (refunds) but before offsets for future premium or
intangible property taxes, were $6,945, $12,587, and $(1,000) in 2003, 2002, and
2001, respectively.
Kentucky, in common with substantially all states, regulates transactions
between or affecting insurance holding companies and their insurance company
subsidiaries, including the Company and the Insurance Subsidiaries. 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, the Insurance Subsidiaries may not
during any year pay dividends on their common and preferred stock to their
parent company in excess of the lesser of the net gain from operations for the
preceding year or 10% of their capital and surplus at the end of the preceding
year, without the consent of the Kentucky Commissioner of Insurance. For 2004,
the maximum amount of dividends that Citizens Insurance could pay, without the
Commissioner's approval, is $56,500. Both Citizens Security and United Liberty
are unable to pay such a dividend. The Company provides substantially all
management, operating and employee services for the Insurance Subsidiaries and
is reimbursed at actual cost plus fifteen percent. This management fee totaled
$4,734,000 for 2003. The Company currently has resources which management
believes will be adequate to service debt obligations through 2005. In addition,
the Company's Chairman has expressed potential willingness to lend up to
$2,000,000 of additional funds to the Company if necessary. Accordingly, the
Company is not relying upon affiliate dividends or preferred stock redemptions
for near-term debt service.
During recent 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 projected cash outflows
for liabilities to determine reserve adequacy.
The Life Insurance Subsidiaries' AVR, as of December 31, 2003, 2002 and 2001, is
shown in Item 7. Cash flow testing and the results of such testing as applied to
the Life Insurance Subsidiaries are also described and discussed in Item 7.
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 RBC computations as of December 31, 2003, the Insurance Subsidiaries
each have capital which is in excess of minimum regulatory requirements.
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. In
addition, various proposals are being considered for permitting insurers to
elect Federal regulation. Given their comparatively small size, it may be
expected that the Life Insurance Subsidiaries 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.
Income Taxation. The Life Insurance Subsidiaries are 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 7 and Note 7 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, the Life Insurance
Subsidiaries have established and carry as liabilities actuarially determined
reserves to meet their 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. The Life Insurance Subsidiaries do not continue
accumulating reserves on reinsured business after it is ceded. The Life
Insurance Subsidiaries are 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 in this Form 10-K are
calculated on the basis of accounting principles generally accepted in the
United States and differ from the reserves specified by laws of the various
states, which govern preparation of financial statements on the statutory basis
of accounting for the Life Insurance Subsidiaries. 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 accounting principles generally accepted in
the United States.
Employees. As of March 16, 2003, 70 people, excluding agents, were employed by
the Company. As of that date, the Company had approximately 3,200 independent
agents licensed to sell its products.
ITEM 2. PROPERTIES
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 its Subsidiaries occupy about 31% of the building for their headquarters and
home offices. The Company leases the remaining space to tenants under leases of
various durations. Market conditions for this property are generally 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. 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
An action was filed against United Liberty in the Court of Common Pleas for
Butler County, Ohio by two policyholders in June 2000. The Complaint refers to a
particular class of life insurance policies that United Liberty issued over a
period of years ending around 1971. It alleges that United Liberty's dividend
payments on these policies from 1993 through 1999 were less than the required
amount. It does not specify the amount of the alleged underpayment but implies a
maximum of about $850,000. The plaintiffs also allege that United Liberty is
liable to pay punitive damages, also in an unspecified amount, for breach of an
implied covenant of good faith and fair dealing to the plaintiffs in relation to
the dividends. The action has been certified as a class action on behalf of all
policyholders who were Ohio residents and whose policies were still in force in
1993. United Liberty has denied the material allegations of the Complaint and is
defending the action vigorously. Pre-trial discovery is continuing. United
Liberty has filed a motion for summary judgment, which has been completely
briefed and argued and awaits decision by the Court. At United Liberty's
request, an initial mediation session has been completed and negotiations are
continuing. As a pre-requisite for the mediation, United Liberty offered to
settle the matter for payments over time, which would include attorneys' fees,
and which would be contingent upon an exchange or reformation of the insurance
policies currently owned by the members of the class. At this stage of the
litigation, the Company is unable to determine whether an unfavorable outcome of
the action is likely to occur or, alternatively, whether the chance of such an
outcome is remote. Therefore, at this time, management has no basis for
estimating potential losses, if any. There are no other 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 10-K to a vote of the Company's security holders, through the
solicitation of proxies or otherwise.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS
As of March 22, 2004, there were approximately 2,500 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 volume in 2003 was about 10% of the average shares outstanding during
the year and trading volume by non-affiliates was about 23% of the average
shares owned by non-affiliates during the year.
The following table summarizes quarterly high and low bid quotations for the
Class A Stock in 2003 and 2002 as reported by NASDAQ. Such quotations reflect
inter-dealer prices 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, 2003 $ 8.590 $ 6.500
September 30, 2003 $ 6.940 $ 6.030
June 30, 2003 $ 6.950 $ 4.250
March 31, 2003 $ 5.750 $ 3.950
December 31, 2002 $ 5.260 $ 3.350
September 30, 2002 $ 8.000 $ 3.800
June 30, 2002 $ 8.900 $ 7.500
March 31, 2002 $ 9.000 $ 8.050
The Company has not paid a dividend on the Class A Stock. 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 outstanding borrowings compared to
dividends and income before interest expense, amortization, depreciation and
income tax expense for (5) consecutive quarters and provided that there is no
default or potential default under the loan agreement. As of January 2004, the
bank loan covenant precludes the Company from paying any dividends. 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 the Insurance Subsidiaries, and Citizens Security's
repurchase of its preferred stock owned by the Company. Provisions of the
Kentucky Insurance Code subject transactions between the Insurance Subsidiaries
and their respective parents, including dividend payments, to certain standards
generally intended to prevent such transactions from adversely affecting the
adequacy of the Insurance Subsidiaries' capital and surplus available to support
policyholder obligations. 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.
Below is summary of securities available for issuance under equity compensation
plans.
a B c
-------------------------- ------------------------ ---------------------- --------------------------------------
Number of Securities Weighted-Average Number of Securities Remaining
to be Issued Upon Exercise Price of Available for Future Issuance Under
Plan Category Exercise of Outstanding Options, Equity Compensation Plans (Excluding
Outstanding Options, Warrants and Rights Securities Reflected in Column (a))
Warrants and Rights
-------------------------- ------------------------ ---------------------- --------------------------------------
-------------------------- ------------------------ ---------------------- --------------------------------------
Equity compensation
plans approved by 0 Not applicable 110,000
security holders
-------------------------- ------------------------ ---------------------- --------------------------------------
-------------------------- ------------------------ ---------------------- --------------------------------------
Equity compensation
plans not approved by 0 Not applicable 0
security holders
-------------------------- ------------------------ ---------------------- --------------------------------------
-------------------------- ------------------------ ---------------------- --------------------------------------
Total 0 Not applicable 110,000
-------------------------- ------------------------ ---------------------- --------------------------------------
ITEM 6. SELECTED FINANCIAL DATA
Year Ended December 31 2003 2002 2001 2000 1999
----------------------------------------- -------------- -------------- -------------- -------------- --------------
RESULTS OF OPERATIONS
----------------------------------------- -------------- -------------- -------------- -------------- --------------
Premiums and other considerations $33,586,478 $38,479,150 $28,744,376 $23,822,424 $20,844,828
Investment and other income, net 6,161,324 6,093,036 6,530,372 6,291,309 6,042,945
Policy benefits and reserve change 27,574,154 31,878,748 22,989,732 19,400,397 17,038,433
Commissions, expense, amortization, net 13,146,302 13,247,015 11,824,589 10,676,953 10,007,817
----------------------------------------- -------------- -------------- -------------- -------------- --------------
Segment profit (loss) (972,654) (553,577) 460,427 36,383 (158,477)
Realized investment gains (losses), net 1,977,635 (2,469,768) (7,911,829) 1,180,879 9,375,339
Interest expense 363,273 305,715 532,962 769,132 553,017
Cumulative effect - accounting change --- --- (311,211) --- ---
Income tax expense (benefit) (70,114) (757,000) (2,090,000) 210,000 2,225,000
----------------------------------------- -------------- -------------- -------------- -------------- --------------
NET INCOME (LOSS) $ 711,822 $(2,572,060) $(6,205,575) $ 238,130 $ 6,438,845
NET INCOME (LOSS) APPLICABLE
TO COMMON STOCK $711,822 $(2,572,060) $(6,205,575) $ 238,130 $ 6,438,845
NET INCOME (LOSS) PER SHARE:
Before accounting change $ .42 $(1.50) $(3.39) $0.14 $3.59
Basic $ .42 $(1.50) $(3.57) $0.14 $3.59
FINANCIAL POSITION
----------------------------------------- -------------- -------------- -------------- -------------- --------------
Total assets $158,880,332 $148,441,532 $136,597,083 $135,538,006 $137,980,030
Notes payable $ 7,133,335 $ 7,779,168 $ 7,095,834 $ 8,000,000 $ 8,500,000
Shareholders' equity $ 20,833,409 $ 17,757,632 $ 20,002,483 $ 23,274,109 $ 28,036,457
Shareholders' equity per share $12.47 $10.53 $11.65 $13.24 $15.86
INVESTMENTS
----------------------------------------- -------------- -------------- -------------- -------------- --------------
Average cash and invested assets $131,440,555 $117,460,459 $112,982,243 $121,807,002 $115,045,517
Average equity portfolio (cost basis) $10,030,727 $6,966,585 $ 9,736,625 $ 20,017,915 $ 20,650,875
Investment income yield 4.5% 4.8% 5.6% 4.9% 5.1%
Change in unrealized investment gains
(losses), net of tax $ 2,371,714 $ 466,654 $ 3,019,188 $ (4,896,265) $ 243,355
LIFE INSURANCE DATA
----------------------------------------- -------------- -------------- -------------- -------------- --------------
Premiums $ 23,943,062 $ 28,948,728 $ 19,362,994 $ 14,553,493 $ 12,443,385
Insurance in force, net at end of period $671,559,000 $696,520,000 $703,288,000 $706,044,000 $646,439,000
HEALTH INSURANCE DATA
Premiums $ 9,643,416 $ 9,530,422 $ 9,381,382 $ 9,268,931 $ 8,401,443
Benefit ratio 69.6% 69.5% 67.9% 66.7% 65.2%
Note: See Item 7 for additional information relevant to the above data. The above amounts include results from
acquisitions: National Affiliated Investors Life Insurance Company (reinsurance assumption) and Citizens
Insurance Company from the date of their acquisition in 2000 and 1999, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's 2003 net income was $712,000 compared a net loss of $2,572,000 in
2002 and net loss of $6,206,000 in 2001. Comprehensive gains and losses (which
combine net gains and losses and net unrealized gains and losses) were a
comprehensive gain of $3,084,000, and comprehensive losses of $2,105,000, and
$2,875,000 for 2003, 2002, and 2001, respectively. During 2003, the Company
continued to be adversely affected by declining yields on its fixed income
investment portfolio. The 2003 increase in net income and the comprehensive gain
were attributable to a turn around, particularly in the fourth quarter, in the
equity market. Equity markets continue to be volatile but were much more
favorable during 2003 than results experienced during the prior three years.
Late in the second quarter of 2003, interest yields on fixed maturity
investments finally began to rise. Although this adversely impacts market value
of the Company's bond portfolio, the opportunity to invest new money at higher
yields would have a positive impact on the Company's operating earnings.
Additionally, improving economic activity and equity valuations have resulted in
a lower level of securities impairment writedowns during 2003. The 2003
environment as described continues to generate a relatively high level of
qualitative investment risk. However, measures of quantitative investment risk
are not believed to have changed significantly from those previously disclosed
in the Company's 2002 Form 10-K. The majority of the 2002 and 2001 declines in
net income and the comprehensive losses were attributable to adverse securities
markets during those years, including the effects of declines in the
telecommunications and technology sectors, a general economic recession and
terrorist events.
During 2003, the Company saw a 12.43% or $4,940,000 decrease in premiums. A 27%
decrease in the Preneed Life segment accounts for essentially all of the net
decrease, along with an approximate 2.5% increase in the Dental segment,
partially offset by moderate reductions in Home Service Life, Broker Life and
Other Accident and Health. Pretax segment profit (loss), excluding realized
investment gains and losses and interest expense, was ($973,000), ($554,000) and
$460,000 for 2003, 2002, and 2001 respectively. The decline in pretax segment
profit in 2003 was primarily attributable to decreased Preneed Life premium and
adverse mortality, the decline in 2002 was primarily attributable to lower
interest yields and adverse mortality, while the 2001 improvement was primarily
attributable to increased Preneed Life production.
The Company repurchased 1,600, 29,987, and 41,400 shares of its common stock
during 2003, 2002, and 2001 respectively, at average prices of $4.79, $4.65 and
$9.58 per share, respectively.
The Company manages its operations in five business segments, Home Service Life,
Broker Life, Preneed Life, Dental, and Other Health. Products in all five
segments are sold through independent agency operations. Home Service Life
consists primarily of traditional life insurance coverage sold in amounts of
$10,000 and under to middle and lower income individuals. This distribution
channel is characterized by a significant amount of agent contact with customers
throughout the year. Broker Life product sales consist primarily of simplified
issue and graded-benefit policies in amounts of $10,000 and under. Other
products in the Broker Life segment which comprise a significant portion of
existing business include group life, universal life, annuities and
participating life coverages. Preneed Life products are sold to individuals in
connection with prearrangement of their funeral and include single and multi-pay
coverages, generally in amounts of $10,000 and less. These policies are
generally sold to older individuals at increased premium rates. Dental products
are term coverages generally sold to small and intermediate size employer
groups. Other Health products include various accident and health coverages sold
to individuals and employer groups. Profit or loss for each segment is reported
on a pretax basis, without an allocation of realized investment gains or
interest expense.
EXECUTIVE SUMMARY
The Company's management continuously monitors the performance and outlook of
the Company by analyzing several indicators that they judge to be critical.
Some, but not all, of the indicators of particular interest to management are:
o The general economic environment
o Trend of premium volume
o Lapse rates
o Mortality and morbidity rates
o Trend of general expense levels
o Asset and Capital and Surplus growth
o General interest rate movements
o Investment yields
o Diversity (e. g. by industry) and mix (e.g. between fixed income
securities and equity securities) of our portfolios
o Segment performance and trends
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's discussion and analysis of its financial condition and results of
operations are based on its consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. Preparation of these financial statements requires the Company to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, the Company evaluates its estimates,
including those related to investments, agent receivables, intangible assets,
policy liabilities, income taxes, regulatory requirements, contingencies and
litigation. The Company bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions. The Company believes the following accounting
policies, judgments and estimates, which have been discussed with the Audit
Committee of the Board of Directors, critically impact preparation of its
consolidated financial statements.
Investment in Debt and Equity Securities. The Company holds debt and equity
interests in a variety of companies, many of which are seeking to exploit recent
technology advancements. The majority of these are publicly traded and many have
experienced volatile market prices. We periodically evaluate whether the
declines in fair value of our investments are other-than-temporary. These
evaluations involve significant judgment. Our evaluation consists of a review of
qualitative and quantitative factors, including analysis of the Company's
competitive position in its markets, deterioration in the financial condition of
the issuer, downgrades of the security by a rating agency, and other publicly
available issuer-specific news or general market conditions. Declines in fair
values of securities deemed to be temporary are included as an unrealized loss
in shareholders' equity. Declines in fair values of securities deemed to be
other-than-temporary are included in net income as realized investment losses.
Future adverse changes in market conditions or poor operating results of
underlying investments could result in losses or an inability to recover the
current carrying value of the investments, thereby possibly requiring an
impairment charge in the future.
Deferred Acquisition Costs ("DAC"). The Company is required to defer certain
policy acquisition costs and amortize them over future periods. These costs
include commissions and certain other expenses that vary with and are primarily
associated with acquiring new business. The deferred costs are recorded as an
asset commonly referred to as deferred policy acquisition costs. The DAC asset
balance is subsequently charged to income over the lives of the underlying
contracts in relation to the anticipated emergence of revenue or profits. Actual
revenue or profits can vary from Company estimates resulting in increases or
decreases in the rate of amortization. The Company regularly evaluates its DAC
balances to determine if actual experience or other evidence suggests that
earlier estimates should be revised. Assumptions considered significant include
surrender and lapse rates, mortality, expense levels, investment performance,
and estimated interest spread. Should actual experience dictate that the Company
change its assumptions regarding the emergence of future revenues or profits
(commonly referred to as "unlocking"), the Company would record a charge or
credit to bring its DAC balance to the level it would have been if using the new
assumptions from the inception date of each policy.
DAC is also subject to periodic recoverability and loss recognition testing.
These tests ensure that the present value of future contract-related cash flows
will support the capitalized DAC balance to be amortized in the future. The
present value of these cash flows, less the benefit reserve, is compared with
the unamortized DAC balance and if the DAC balance is greater, the deficiency is
charged to expense as a component of amortization and the asset balance is
reduced to the recoverable amount. For more information about accounting for DAC
see Note 1, Summary of Significant Accounting Policies, in the Notes to
Consolidated Financial Statements.
Goodwill and Intangible Impairment. The balance of our goodwill and intangible
assets was $3.8 million at December 31, 2003. The recovery of this asset is
dependent on the fair value of the business to which it relates. Effective in
2002, pursuant to SFAS No. 142, "Goodwill and Other Intangible Assets", ("SFAS
No. 142"), goodwill is no longer amortized but is subject to annual impairment
tests based on the estimated fair value of the respective assets. There are
numerous assumptions and estimates underlying the determination of the estimated
fair value of these assets. Different valuation methods and assumptions can
produce significantly different results that could affect the amount of any
potential impairment charge that might be required to be recognized. During both
2003 and 2002, the Company concluded that no impairment adjustment was necessary
for its goodwill or other intangible assets.
Policy Liabilities and Policy Intangible Assets. Establishing policy liabilities
and related intangible assets, including deferred acquisition costs and the
value of acquired insurance, for the Company's long-duration insurance contracts
requires making many assumptions, including policyholder persistency, mortality
rates, investment yields, discretionary benefit increases, new business pricing,
and operating expense levels. The Company evaluates historical experience for
these factors when assessing the need for changing current assumptions. However,
since many of these factors are interdependent and subject to short-term
volatility during the long-duration contract period, substantial estimates and
judgment are required. Accordingly, if actual experience emerges differently
from that assumed, any such difference would be recognized in the current year's
Consolidated Statement of Operations.
Deferred Taxes. The Company records a valuation allowance to reduce its deferred
tax assets to the amount that it believes is more likely than not to be
realized. In assessing the need for the valuation allowance, the Company has
considered ongoing prudent and feasible tax planning strategies but has not
assumed future taxable income. In the event the Company were to determine that
it would be able to realize its deferred tax assets in the future in excess of
its net recorded amount, an adjustment to deferred tax assets would increase
income in the period such determination was made. Likewise, should the Company
determine that it would not be able to realize all or part of its net deferred
tax assets in the future, an adjustment to deferred tax assets would be charged
to income in the period such determination was made.
Litigation. As further described in Note 12 of the Notes to Consolidated
Financial Statements, United Liberty is party to an outstanding lawsuit
concerning payment of policyholder dividends. The Company is currently unable to
determine whether an unfavorable outcome of this action is likely, and no
provision has been recorded for an unfavorable outcome. Accordingly, if an
unfavorable outcome occurs, a financial statement adjustment would be required.
ACQUISITIONS
National Affiliated Investors Life
On July 7, 2000, the Company acquired, through an assumption reinsurance
agreement, 100% of the inforce business of National Affiliated Investors Life
Insurance Company ("NAIL") for a net cash purchase price of approximately
$355,000 (the "NAIL Acquisition"). The acquisition was coordinated through the
National Organization of Life and Health Guaranty Associations. The acquired
business consists primarily of individual life insurance business with policy
reserves and annual premium of approximately $3,500,000 and $300,000,
respectively.
Citizens Insurance Company
On October 14, 1999, the Company acquired 100% of the stock of Citizens
Insurance (formerly Kentucky Insurance Company) from an unaffiliated insurance
holding company (the "Citizens Insurance Acquisition"). Citizens Insurance is
licensed as a property and casualty insurance company in six states and has
approximately $3.6 million of statutory capital and surplus; however, it
currently has no insurance operations. The aggregate purchase price for the
Citizens Insurance Acquisition was approximately $3,550,000 (including net costs
associated with the transaction of approximately $50,000).
United Liberty Life Insurance Company
On May 12, 1998, the Company and Citizens Security acquired 100% of the common
stock of United Liberty from an unaffiliated insurance holding company (the
"United Acquisition"). The aggregate purchase price for the United Acquisition
was approximately $7,076,000 (including net costs associated with the
acquisition of approximately $445,000). In conjunction with the acquisition, the
seller retained approximately $2,100,000 of United Liberty's real estate related
and other assets, which were replaced with cash by Citizens Security.
FINANCIAL POSITION
Assets. At December 31, 2003, the Company's available-for-sale fixed maturities
had a fair value of $108,640,262 and amortized cost of $104,767,393. The
Company's fixed maturities portfolio increased approximately 4% during 2003 and
33% during 2002, on an amortized cost basis. These increases are primarily
attributable to Preneed Life sales growth. Shown below is a distribution by
rating category of the Company's fixed maturities portfolio as of December 31,
2003.
Standard & Poor's Corporation Rating Amortized Cost1 Fair Value 2
--------------------------------------- --------------------- ---------------
Investment grade:
AAA to A- $ 60,157,465 $62,128,592
BBB+ to BBB- 35,752,387 37,090,369
--------------------------------------- --------------------- ---------------
Total investment grade 95,909,852 99,218,961
Non-investment grade:
BB+ to BB- 3,864,156 4,053,251
B+ to B- 3,337,506 3,581,223
CCC+ to C 1,070,066 1,085,014
CI to not rated 586,813 701,813
--------------------------------------- --------------------- ---------------
--------------------------------------- --------------------- ---------------
Total non-investment grade 8,858,541 9,421,301
--------------------------------------- --------------------- ---------------
Total fixed maturities $104,768,393 $108,640,262
--------------------------------------- --------------------- ---------------
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, 2003 were obtained primarily from Interactive
Data Corporation.
The Company believes it has a well diversified portfolio and has no plans to
adjust its non-investment grade portfolio significantly, 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.
Non-investment grade securities comprised 8.5% and 5.1% of the fixed maturities
portfolio, on an amortized cost basis, at December 31, 2003 and 2002,
respectively. During 2003, the Company recognized approximately $83,000 of
impairment losses on fixed maturities, with the majority of these related to the
airline and health care industries. The Company is monitoring its fixed maturity
portfolio and, although it has no specific projections, if the overall economy
does not improve, additional impairments could occur during 2004.
Realized investment losses included $135,000, $1,255,000 and $2,272,000 of
pretax impairment losses for the three years ended December 31, 2003, 2002 and
2001. The impairments recorded were primarily the result of the continued credit
deterioration of specific issuer's in the bond and equity markets and the
effects on such markets due to the overall slowing of the economy.
Shown below are the Company's four largest holdings in non-investment grade
bonds by a single issuer as of December 31, 2003.
Non-Investment Grade
December 31, 2003 Amortized Cost Fair Value
------------------------------- ------------------- ------------------
Largest $1,498,184 $1,590,748
Second largest 430,475 1,445,950
Third largest 873,700 1,340,000
Fourth largest 1,026,711 1,050,000
------------------------------- ------------------- ------------------
Total $3,829,070 $5,426,698
------------------------------- ------------------- ------------------
The Company had no guarantee or other type of enhancement associated with the
issuers represented above.
During 2003, the Company's investment in equity securities increased $953,000
and $3,575,000 on a cost and fair value basis, respectively, after increasing
$53,000 on a cost basis and decreasing $355,000 on a fair value basis,
respectively, during 2002. As of December 31, 2003 2002 and 2001, there were
$3,275,000, $653,000 and $1,062,000 respectively, of unrealized gains on equity
securities.
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 can involve qualitative and quantitative
information relating to an individual company or industry and general factors
impacting the economy. However, due to wide market fluctuations occurring during
the past two years, determining whether declines are temporary has become much
more complex and judgmental. These reviews resulted in the recognition of
impairment losses on equity securities totaling $52,000 during 2003 ($28,000 and
$24,000 for the first and second quarters, respectively). In addition, $83,000
of impairment losses were recognized on fixed maturities during 2003 ($40,000
and $43,000 during the first and second quarters, respectively). During 2003,
equity securities were sold which contained impairment writedowns of $741,000.
Citizens Security owns the building in which the Company and its subsidiaries
maintain their home offices. They occupy approximately 31% of the building with
the balance leased to third-party tenants. Market conditions for this property
are generally favorable. An updated appraisal obtained during 2002 indicates the
market value of the property is approximately $2,700,000 higher than its
carrying value.
At December 31, 2003 the Company has recorded $756,000 of goodwill and
$13,445,000 of other intangible assets for deferred policy acquisition costs and
value of insurance acquired. As noted in the above discussion of critical
accounting policies and estimates, these intangibles, and the recorded value of
policy liabilities, are based on many assumptions that require substantial
estimates and judgment. In connection with adoption of SFAS No. 142, the Company
reassessed the assumptions supporting these values. Although no impairment was
considered necessary, a continued historically low interest rate environment
could require adjustment of these recorded values.
Liabilities. A comparison of total policy liabilities as of December 31, 2003,
2002 and 2001 is shown below. Approximately 88% of the 2003 total consists of
insurance policy benefit reserves while policyholder deposit liabilities
represent 12% of the total.
Year Ended December 31 2003 2002 2001
------------------------------- -------------- -------------- --------------
Home Service Life $ 34,986,350 $ 33,970,723 $ 32,609,959
Broker Life 44,849,326 45,054,589 44,414,974
Preneed Life 44,609,059 38,971,203 27,512,646
Dental 579,277 524,249 565,119
Other Health 2,113,792 2,194,869 2,137,079
------------------------------- -------------- -------------- --------------
Total $127,137,804 $120,715,633 $107,239,777
------------------------------- -------------- -------------- --------------
Home Service Life sales have been favorable in recent years, with net growth in
policy liabilities of 3.0% and 4.2% in 2003 and 2002, respectively, through a
combination of attracting new producers and continuing to focus on meeting the
needs of existing customers and agents. The Broker Life decline for the year is
primarily attributable to competition from other carriers in the final expense
marketplace. Preneed Life premiums are lower, due in part to the Company's
decision to emphasize the lower annual premium "multi-pay" policies rather than
"single-pay" policies and some loss of volume attributable to reducing
commission levels and the rate of annual growth credited to policies. During
2003, Dental premiums were favorably impacted by additional broker relationships
and normal inflationary premium increases. The Other Health segment products are
not being actively marketed.
Shown below is a progression of the Company's policyholder deposit activity for
the year ended December 31, 2003.
Year Ended December 31, 2003 Total Annuity and Universal
Other Life
------------------------------- --------------- --------------- ---------------
Beginning Balance $15,743,293 $ 9,805,082 $ 5,938,211
Deposits 620,188 58,246 561,942
Withdrawals 1,528,220 600,672 927,548
Interest Credited 695,563 453,218 242,345
-------------------------------- --------------- --------------- ---------------
Ending Balance $15,530,824 $ 9,715,874 $ 5,814,950
-------------------------------- --------------- --------------- ---------------
As indicated above, total policyholder deposits decreased by a net $212,000
during 2003. The Company is not devoting significant marketing effort towards
Annuity, Universal Life and other deposit products and has elected not to
aggressively compete in crediting excess interest on such products.
OFF-BALANCE SHEET ARRANGEMENTS
The Company does not participate in any off-balance sheet arrangements.
CONSOLIDATED RESULTS AND ANALYSIS
Premiums and Other Considerations. The following table details premiums and
other considerations received during the past three fiscal years.
Year Ended December 31 2003 2002 2001
----------------------------- -------------- -------------- --------------
Home Service Life $ 7,288,004 $ 7,334,030 $ 7,152,242
Broker Life 3,514,873 3,621,053 3,812,841
Preneed Life 13,106,019 17,993,645 8,397,911
Dental 8,385,774 8,182,483 7,988,620
Other Health 1,291,808 1,347,939 1,392,762
----------------------------- -------------- -------------- --------------
Total $ 33,586,478 $ 38,479,150 $ 28,744,376
----------------------------- -------------- -------------- --------------
Home Service Life premium decreased 0.1% during 2003 and increased 2.5% during
2002. New sales levels continue to be favorable, at levels that more than exceed
normal policy lapses. The Company continues to attract a number of successful,
experienced Home Service agents without subsidizing inexperienced agents. In
addition, the Company's program to automate and streamline agent field
accounting continues to expand with favorable reaction among the agency force.
During early 2003 the Company terminated a small Home Service marketing joint
venture in two southern states with a much larger property and casualty
insurance carrier. To mitigate effects of the lower interest rate environment,
during the second quarter of 2003 the Company introduced premium rate increases
on its Home Service products.
The 3% and 5% decrease in Broker Life premium during 2003 and 2002,
respectively, resulted from reduction of business provided by certain larger
brokers during 2002 and continuing pressure from the overall economic slowdown
on middle and lower-income consumers. The Company is evaluating opportunities
for revising its product design and commission rates to counteract the softening
in demand for its simplified issue and graded benefit life policies.
The 27% decrease in Preneed Life premium during 2003 resulted from the Company's
modification of certain policy benefits and commissions. The 114% increase in
Preneed Life premium during 2002 resulted from intensified marketing efforts
aimed at defining the Company as a committed participant in this market,
successfully negotiating competitive third-party marketing agreements,
implementing various product enhancements, and positive referrals from customers
who comment favorably on the Company's organization and customer service.
The 2.5% growth in Dental premium during 2003 resulted primarily from a renewed
effort to expand the Company's presence in the Dental business. The 2.4% growth
in 2002, resulted primarily from normal inflationary increases. During the past
two years, new business production has become increasingly competitive as larger
providers expand their marketing initiatives. However, the Company has
historically maintained strong customer and agent loyalty by continuing to
improve customer service, including sales and administrative support functions.
The Company has not been actively marketing Other Health coverages for several
years. However, in response to agent requests, certain cancer and disability
protection products have been updated and promoted. Pricing, underwriting, and
claims experience on these products are closely monitored.
Investments. The Company monitors its available-for-sale fixed maturities and
equity securities to assure they are strategically positioned within the current
market environment. This practice has historically resulted in holding
significant equity security positions, which tend to dampen current income
yields in favor of an overall total return focus. The Company's equity
securities comprised 8.8% and 6.5% of its total investment portfolios at
December 31, 2003 and 2002, respectively. The Company's investment income yields
were 4.5%, 4.8%, and 5.6% for 2003, 2002, and 2001, respectively. The 2003 and
2002 yield declines resulted primarily from substantially lower interest rates
on new investments, the Company's 4% and 33% net addition to its fixed maturity
portfolio during the years and a 13% increase in equity holdings during 2003,
much of which is attributable to new Preneed Life business. Although the
Company's total return on investments has historically been very favorable,
returns for the past three years have been severely impacted by declines in the
telecommunications and technology sectors, a general economic recession and the
effect of terrorist events on the securities markets. As detailed below, net
realized and unrealized investment gains totaled approximately $862,000 for the
three years ended December 31, 2003, while net realized and unrealized gains
totaled approximately $3,522,000 for the two years ended December 31, 2000. The
Company does not anticipate continued severe deterioration in the securities
markets, although some additional losses on fixed income securities may occur if
the overall economic slowdown returns. At December 31, 2003, the Company's
investment portfolios contain a net unrealized gain outstanding of $6,894,000.
Below is an approximate calculation of investment income yields and total return
rates for the five years ending December 31, 2003.
Year Ended December 31, 2003 2002 2001 2000 1999
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Investment Income $5,909,696 $5,665,596 $6,274,143 $5,993,362 $5,885,312
Gains and Losses:
Fixed Maturities:
Realized gains (losses) 67,903 (228,710) (1,260,092) 1,061,089 243,949
Unrealized gains (losses) 1,079,228 1,130,402 2,303,205 (1,655,112) (1,804,929)
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Net Fixed Maturities 1,147,131 901,692 1,043,113 (594,023) (1,560,980)
Equity Securities:
Realized gains (losses) 1,909,732 (2,241,058) (7,123,269) 119,790 9,131,390
Unrealized gains (losses) 2,622,024 (408,399) 2,160,985 (5,812,184) 2,238,293
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Net Equity Securities 4,531,756 (2,649,457) (4,962,284) (5,692,394) 11,369,683
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Total Gains and Losses 5,678,887 (1,747,765) (3,919,171) (6,286,417) 9,808,703
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Total Return $ 11,588,583 $3,917,831 $2,354,972 $(293,055) $ 15,694,015
-------------------------------- --------------- --------------- ---------------- --------------- ---------------
Average Cash and Investments $131,440,555 $117,460,000 $112,980,000 $121,810,000 $115,050,000
Yield - Income 4.5% 4.8% 5.6% 4.9 % 5.1%
Yield - Total Return 8.8% 3.3% 2.1% (0.2)% 13.6%
Segment Earnings. The 2003 gain before income tax was $642,000 compared to a
loss of $3,329,000 in 2002 and $7,984,000 in 2001. Pretax profit (loss) is shown
below for the Company's five business segments, along with total realized
investment gains and interest expense.
Year Ended December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Profit (Loss):
Home Service Life $ 75,520 $ 275,809 $ 382,723
Broker Life (121,851) (265,488) 74,960
Preneed Life (955,227) (670,349) (264,488)
Dental 230,289 297,740 256,385
Other Health (201,385) (191,289) 10,847
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Totals (972,654) (553,577) 460,427
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
Interest expense 363,273 305,715 532,962
------------------------------------------------------ ----------------- ---------------- -----------------
Income (Loss) before income tax $ 641,708 $ (3,329,060) $ (7,984,364)
------------------------------------------------------ ----------------- ---------------- -----------------
The 2003 Preneed Life loss resulted from lower investment yields, unfavorable
mortality, and increased expenses. During 2002, the Company accepted a
significant amount of single-premium business, which generally has higher than
average mortality rates. In addition, significant management and marketing
resources were devoted to this business. To improve profitability, annual
benefit growth rates were reduced in early 2003, and twice during 2002, certain
commission rates were reduced and agent contracts revised to encourage
production of the more profitable multi-pay products. Although the Company is
optimistic about improving profitability in this highly competitive market, if
adverse profitability trends continue, several options are available. These
options, including further lowering discretionary annual benefit increases and
adjusting premiums and commissions on new business, could further adversely
impact the Company's ability to compete for new business.
Information regarding Dental profitability is included below. The "contribution
margin" shown below is a direct margin without allocable investment income and
general expense.
Year Ended December 31 2003 2002 2001
-------------------------- ----------------- ---------------- -----------------
Premium $8,385,774 $8,182,483 $7,988,620
Claims and Reserves $5,778,191 $5,634,940 $5,551,624
Contribution Margin $1,611,198 $1,560,208 $1,465,017
Claim Ratio 68.9% 68.9% 69.5%
The overall Dental contribution margin increased slightly during both 2003 and
2002 due to improved claim levels. Also, the Company has begun encountering more
competition as additional insurers are expanding in the Dental market and Dental
providers are continuing to provide higher levels of care to patients. The
Company is continuing its ongoing efforts to maintain profitability in this line
by reconfiguring products to provide adequate margins for the various dental
procedures, utilizing a third-party company to provide expert assistance with
ongoing adjudication of claims, and continuing its program of aggressive renewal
underwriting and re-rating. The Company has not devoted significant marketing
effort towards its Other Health products in recent years. However, during 2002,
a significant increase in disability claims occurred, with a concentration in
New Jersey. The Company has strengthened underwriting practices in this area and
has taken steps toward filing for a rate increase on its disability products.
Income Taxes. Historically, the Company has experienced a relatively low
effective current income tax rate, due primarily to the small life insurance
company deduction. The effective rate was approximately (11%) and 23% in 2003
and 2002, respectively.
The small life insurance company deduction allows the Life Insurance
Subsidiaries to reduce their taxable income by 60% before computing their
current provisions for regular or alternative minimum tax. However, for purposes
of computing deferred income tax liabilities under the provisions of Statement
of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income
Taxes", the Company is precluded from assuming the small life insurance company
deduction will be available in the future. Accordingly, by disallowing this
deduction, SFAS No. 109 significantly increases the deferred taxes on the Life
Insurance Subsidiaries' 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 may
actually be paid on these net liabilities (when realized) at a rate potentially
as low as 17% (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 7 of
the Notes to Consolidated Financial Statements. All deferred tax assets of the
Company are realizable by offset against existing deferred tax liabilities or by
carryback to recapture prior years' taxes paid on operating income and capital
gains. The deferred tax assets are offset, to some extent, by valuation
allowances related to the Company and to the Life Insurance Subsidiaries. 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,
the Insurance Subsidiaries report on the basis of statutory accounting
principles ("SAP"). In recent years, various state insurance departments and the
NAIC have expressed concern, essentially about the "rate of return" earned by
holders of small face amount life policies, potentially including Preneed
policies. Although the Company does not believe calculating a simple "rate of
return" or premium "pay-back" measure is meaningful for traditional life
insurance products, certain state insurance regulators are considering actions
that could alter the profitability of existing contracts or eliminate small face
amount policies as a viable product offering. During 2002, A.M. Best Company
("Best") affirmed Citizens Security's B- rating. This rating was previously
lowered from a B in 2001. United Liberty's rating has remained at B- by Best
since it was acquired in 1998, and Citizens Insurance, due to its lack of
insurance operations, is not rated.
During December 2002, Citizens Financial strengthened the statutory capital
position of Citizens Security by acquiring $2,000,000 of Citizens Security
redeemable preferred stock. During January 2001, Citizens Financial contributed
100% of the capital stock of Citizens Insurance to Citizens Security. The
statutory value of this contribution was $3,540,555. Citizens Security has
reported its investments in United Liberty and Citizens Insurance on the equity
method of accounting, since their acquisition in 1998 and 2001, respectively.
However, beginning in 2001, new rules changed the statutory equity method of
accounting to preclude a parent insurer from recording as income, its share of
undistributed subsidiary earnings. Accordingly, Citizens Security's net income
includes United Liberty's net earnings of $289,489 and $234,853, in 2000 and
1999, respectively. For 2003, 2002, and 2001, Citizens Security reported as
income the $116,400, $214,000 and $292,000 respectively, of dividend
distributions that it received from United Liberty and Citizens Insurance. At
December 31, 2003, Citizens Security reported its investments in United Liberty
and Citizens Insurance at their statutory equity values of $2,610,375 and
$3,777,624, respectively. 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, 2003.
Net Statutory Asset
Year Ended Net Operating Capital and Valuation Capital
December 31 Income (Loss) Income (Loss) Surplus Reserves1 Ratio2
------------------- ----------------- ----------------- ---------------- ----------------- -------------
2003 $ 706,397 $ (496,618) $11,128,656 $2,637,741 13.1%
2002 $(1,184,496) $ (64,815) $ 9,903,639 $ 862,732 11.6%
2001 $(3,497,701) $ 361,863 $ 9,687,289 $ 978,418 13.6%
2000 $ 1,868,575 $ 715,250 $ 8,315,902 $1,589,735 13.7%
1999 $ 4,945,708 $ 568,436 $12,942,331 $4,335,111 22.4%
------------------- ------------------ ----------------- ---------------- ----------------- -------------
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. The 1999 through 2003
amounts also include United Liberty's asset valuation reserves.
2 Represents Statutory Capital and Surplus plus Asset Valuation Reserves divided by invested
assets plus cash.
During 2003, statutory capital and surplus and asset valuation reserves
increased approximately $3,000,000. This increase resulted primarily from
$706,000 of net income for the year and $2,415,000 of unrealized gains. During
2002, statutory capital and surplus and asset valuation reserves increased
approximately $101,000. This increase resulted primarily from the $2,000,000
issuance of preferred stock described above, net of the $1,184,000 net loss for
the year and $950,000 of unrealized losses. During 2001, statutory capital and
surplus and asset valuation reserves increased approximately $760,000. This
increase resulted primarily from the Citizens Insurance capital contribution
noted above, plus $1,082,000 of unrealized gains offsetting the $3,498,000 net
loss and a $572,000 increase in nonadmitted assets. During 2000, statutory
capital and surplus and asset reserves decreased by approximately $7,413,000.
This decrease resulted primarily from $1,869,000 of statutory net income offset
by $7,875,000 of unrealized losses and a $1,200,000 redemption of Citizens
Security's preferred capital stock. During 1999, statutory capital and surplus
and asset reserves increased by approximately $2,443,000. This increase resulted
primarily from $4,946,000 of statutory net income offset by a $1,200,000
redemption of preferred capital stock, and a $1,000,000 shareholder dividend
paid.
In addition to the statutory totals shown above, Citizens Insurance generated
statutory net income of approximately $63,000, $76,000, and $93,000 during,
2002, 2001, and 2000, respectively without remitting any dividends to its
parent. Citizens Insurance generated statutory net income in 2003 of $56,000 and
paid a dividend of $62,400 to Citizens Security.
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 (surplus strain)
often occurs on these sales during the first policy year. Historically, the
Company's level of life insurance sales has not significantly impacted statutory
surplus. However, as multi-pay Preneed Life sales increase, the Company
anticipates that surplus strain will dampen statutory earnings.
CASH FLOW AND LIQUIDITY
Due to losses during the past three years and the adverse impact of the low
interest rate environment on operating results, during 2002 the Company borrowed
$2,000,000 from its Chairman to strengthen the statutory capital position of its
principal insurance subsidiary. The Company borrowed an additional $1,000,000
from its chairman in 2003 for general operating capital. The borrowings from the
Company's Chairman are considered current debt as a result of a 90 day call
provision in the loan agreement. The Company also has $4,133,335 of commercial
bank debt outstanding, with scheduled repayments due through 2007. During 2003
and 2002, the Company did not comply with a loan covenant (debt to earnings
ratio) on this debt and received a waiver of such violation through December 31,
2003. For the quarter ended September 30, 2003, the Company did not meet one of
its bank debt covenants (debt to earnings ratio), however the lender has waived
this violation. In return for the waiver the Company's Chairman agreed to
personally guarantee the outstanding bank debt. However, since the Company is
not assured of meeting this covenant throughout 2004, the full balance of
$4,133,335 can be considered payable within one year. Although the Company does
not expect the full balance to be called during 2004, it believes such an
obligation could be met through a refinancing arrangement or sale of selected
assets or a block of insurance business. Regarding the currently scheduled debt
repayments, the Company believes its available funds will be adequate to service
2004 debt obligations. In addition, the Company's Chairman has expressed
potential willingness to loan the Company an additional $2,000,000 if necessary,
which could service debt obligations through the majority of 2006. Additional
information regarding debt obligations is included in Note 5 of the Notes to
Consolidated Financial Statements.
A summary of all known commitments of the Company as of December 31, 2003,
including the aforementioned borrowings, is as follows:
------------------------------------------- ---------------------------------------------------------------
Contractual Obligations Payments Due by Period
------------------------------------------- ---------------------------------------------------------------
Total Less than 1 1-3 years 4-5 years After 5
Year years
------------------------------------------- ------------- ------------- ------------ ----------- ----------
Note Payable to Bank $ 4,133,335 $ 4,133,335 --- --- ---
------------------------------------------- ------------- ------------- ------------ ----------- ----------
Note Payable to Related Party $ 3,000,000 $ 3,000,000 --- --- ---
------------------------------------------- ------------- ------------- ------------ ----------- ----------
Operating Leases $ 76,621 $ 30,809 $ 45,812 --- ---
------------------------------------------- ------------- ------------- ------------ ----------- ----------
Management is not aware of any other commitments or unusual event that could
materially affect the Company's capital resources.
The Company is completing a strategic review of its products and operations. A
key element of this initiative is mitigating the significant losses incurred on
the Preneed Life business segment and strengthening profitability in the Broker
Life and Home Service Life segments by increasing premiums, strengthening
underwriting policies, modifying commissions, and where possible, lowering
interest crediting or policy growth rates.
The Company generated approximately $6,069,000, $16,554,000 and $6,394,000 of
cash flow from operations during 2003, 2002, and 2001, respectively. The 2003
and 2002 fluctuations are principally attributable to growth of Preneed Life
premiums in 2002 and a decrease in Preneed Life premiums in 2003.
Cash used by investment activities of $2,618,000, $27,877,000, and $5,555,000
during 2003, 2002, and 2001 respectively, relates primarily to investing
additional Preneed Life premiums in fixed maturity securities, although the 2002
total also includes investing $11,734,000 of cash and short term balances
outstanding at December 31, 2001. The $1,562,000 of cash used by financing
activities during 2003 includes $1,646,000 of debt repayments and $903,000 of
net withdrawals of policyholder deposits, partially offset by additional
borrowings of $1,000,000. The quarterly bank loan payment due January 1, 2004
was paid by December 31, 2003, accordingly, the outstanding bank loan balance
decreased by five quarterly installments during 2003. Cash used by financing
activities during 2002 includes net withdrawals of policyholder deposits of
approximately $956,000, debt repayments of $1,317,000, partially offset by
additional borrowings of $2,000,000. Cash used by financing activities during
2001 includes net withdrawals of policyholder deposits of approximately
$1,200,000 and debt repayments of $904,000. The policyholder deposit withdrawals
are principally due to the Company's decision not to aggressively compete in
crediting higher interest returns on such funds.
The Company is subject to various market risks. However, the most significant
such risks relate to fluctuations in prices of equity securities and interest
rates. Although the Company experienced negative total returns on its equity
portfolio during the years 2003, 2002, and 2001, historically these returns have
been very favorable and the Company has successfully managed the risk of equity
security price fluctuations over many years. As described above, the Company
does not anticipate that investment markets will continue to deteriorate at the
rate encountered during that period. The Company devotes significant attention
to the equity markets and reposition the Company's portfolio upon detection of
adverse risk trends associated with individual securities or overall markets.
The Company also manages market risks associated with investments in option
securities, as described in Note 3 of the Notes to Consolidated Financial
Statements. The fair value of the Company's equity portfolio was approximately
$11,337,000 and $7,762,000 at December 31, 2003 and 2002, respectively.
Accordingly, a 10% decline in equity prices would have reduced the fair value of
the Company's equity portfolio by $1,113,000 and $776,200 at December 31, 2003
and 2002, respectively. The average cost value of the Company's equity portfolio
was $10,031,000 and $6,967,000 during 2003 and 2002, respectively.
Regarding interest rate risk, the value of the Company's fixed-maturity
investment portfolio will increase or decrease in an inverse relationship with
fluctuations in interest rates while net investment income earned on
newly-acquired fixed-maturities increases or decreases in direct relationship
with interest rate changes. Management estimates that a 100 basis point increase
in interest rates ("rate shock") would have decreased the fair value of its
$108.6 million fixed maturity portfolio by approximately 6.0% or $6.5 million at
December 31. 2003 and 3.2% or $3.3 million at December 31, 2002. From an income
perspective, the Company does not believe rising interest rates present a
significant risk, as essentially all of the Company's policy liabilities bear
fixed rates. However, approximately 45% of policy liabilities contain provisions
permitting interest or benefit adjustments at the discretion of the Boards of
Directors of the Insurance Subsidiaries. The Company's cash flow testing
(described below) indicates that overall profitability will generally be
enhanced in rising interest rate scenarios. From a liquidity perspective, the
Company's fixed rate policy liabilities have been relatively insensitive to
interest rate fluctuations. Accordingly, the Company believes gradual increases
in interest rates do not present a significant liquidity exposure. The Company
monitors economic conditions on a regular basis and manages this interest rate
risk primarily by adjusting the duration of its fixed-maturity portfolio.
Historically, the Company has maintained conservative durations in its
fixed-maturity portfolio. During 2003, the Company increased durations of the
fixed maturity portfolio significantly. At December 31, 2003 cash and
fixed-maturity investments with maturities of less than five years equaled
approximately 32% of total policy liabilities compared to approximately 60% at
December 31, 2002. Notwithstanding the foregoing, if interest rates rise
significantly in a short timeframe, there can be no assurance that the life
insurance industry, including the Company, would not experience increased levels
of surrenders and reduced sales, and thereby be materially adversely affected.
Interest expense on the Company's debt varies quarterly and is therefore also
subject to interest rate risk. For its commercial bank debt, the Company elects
the lower of the prime lending rate or the one-month LIBOR rate plus 2.75%. For
its related party debt, the interest rate is the higher of 6% or the commercial
bank prime lending rate plus 1%. At December 31, 2003, the weighted average rate
on the Company's $7,133,335 of borrowings was 5.07%. The Company believes its
current liquidity position and profitability levels are adequate to guard
against this interest rate risk.
In addition to the measures described above, the Life Insurance Subsidiaries
comply with the NAIC promulgated Standard Valuation Law ("SVL") which specifies
minimum reserve levels and prescribes methods for determining them, with the
intent of enhancing solvency. The SVL also requires the Company to perform
annual cash flow testing for its Life Insurance Subsidiaries. This testing is
designed to ensure that statutory reserve levels will maintain adequate
protection in a variety of potential interest rate scenarios. The Actuarial
Standards Board of the American Academy of Actuaries also requires cash flow
testing as a basis for the actuarial opinion on the adequacy of the reserves
which is a required part of the annual statutory reporting process.
Cash flow testing projects cash inflows from assets and cash outflows for
liabilities in various assumed economic and yield curve scenarios. 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.)
The Life Insurance Subsidiaries' most recent cash flow testing, which was
completed in February 2004, 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 10-30 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 the Life Insurance
Subsidiaries to continue without exhausting surplus. Again, depending upon
severity and frequency, corrective measures might be needed. Based on results of
the testing, 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 Life Insurance
Subsidiaries' 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 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 cash flow from operations give it substantial resources to
administer its existing business and fund growth generated by direct sales.
FORWARD-LOOKING INFORMATION
All statements, trend analyses and other information contained in this report
relative to markets for the Company's products and trends in the Company's
operations or financial results, as well as other statements including words
such as "anticipate", "believe", "plan", "estimate", "expect", "intend", and
other similar expressions, constitute forward-looking statements under the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements are subject to known and unknown risks, uncertainties and other
factors which may cause actual results to be materially different from those
contemplated by the forward-looking statements. Such factors include, among
other things:
|X| the market value of the Company's investments, including stock market
performance and prevailing interest rate levels (see the Cash Flow
and Liquidity section of this Item 7 - Management's Discussion and
Analysis of Financial Condition and Results of Operations);
|X| customer and agent response to new products, distribution channels and
marketing initiatives, including exposure to unrecoverable advanced
commissions;
|X| mortality, morbidity, lapse rates, and other factors which may affect
the profitability of the Company's insurance products;
|X| regulatory changes or actions, including those relating to regulation
of insurance products and insurance companies (see the State
Insurance Regulation section of Item 1 - Business);
|X| ratings assigned to the Company and its subsidiaries by independent
rating organizations which the Company believes are important to the
sale of its products;
|X| general economic conditions and increasing competition which may affect
the Company's ability to sell its products;
|X| the Company's ability to achieve anticipated levels of operating
efficiencies and meet cash requirements based upon projected
liquidity sources;
|X| unanticipated adverse litigation outcomes (see Item 3 - Legal
Proceedings); and
|X| changes in the Federal income tax laws and regulations which may affect
the relative tax advantages of some of the Company's products.
There can be no assurance that other factors not currently anticipated by
management will not also materially and adversely affect the Company's results
of operations.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative and qualitative disclosures about market risk are described in the
Cash Flow and Liquidity section of Item 7 - Management's Discussion and
Analysis.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS
CITIZENS FINANCIAL CORPORATION AND SUBSIDIARIES
Financial Statements For Full Fiscal Years Page
Report of Independent Auditors...........................................27
Consolidated Statements of Operations for the
years ended December 31, 2003, 2002 and 2001 ...........................28
Consolidated Balance Sheets at
December 31, 2003 and 2002...............................................29
Consolidated Statements of Shareholders' Equity
for the years ended December 31, 2003, 2002 and 2001.....................31
Consolidated Statements of Cash Flows for the
years ended December 31, 2003, 2002 and 2001.............................32
Notes to Consolidated Financial Statements...............................33
ITEM 9. 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.
ITEM 9A. EVALUATION OF DISCLOSURE OF CONTROLS AND PROCEDURES
The Company's chief executive officer and chief financial officer, with the
participation of management, have evaluated the Company's disclosure controls
and procedures (as defined in the Securities Exchange Act of 1934 Rule 13a-14c)
as of December 31, 2003. Based on the evaluation, they concluded that the
controls and procedures are effective. There have been no significant changes in
the Company's internal controls or in other factors that could significantly
affect these controls subsequent to the date of their evaluation.
REPORT OF INDEPENDENT AUDITORS
The Shareholders and Board of Directors
Citizens Financial Corporation
We have audited the accompanying consolidated balance sheets of Citizens
Financial Corporation and subsidiaries at December 31, 2003 and 2002, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 2003. Our
audits also included the financial statement schedules listed in the Index at
Item 15(a). These financial statements and schedules are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Citizens Financial
Corporation and subsidiaries at December 31, 2003 and 2002, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion, the related
financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
/s/ Ernst & Young LLP
Louisville, Kentucky
March 19, 2004
Citizens Financial Corporation and Subsidiaries
Consolidated Statements of Operations
Year Ended December 31 2003 2002 2001
---------------------------------------------------- -------------------- -------------------- --------------------
Revenues:
Premiums and other considerations $ 34,781,963 $ 39,722,589 $ 29,969,756
Premiums ceded (1,195,485) (1,243,439) (1,225,380)
---------------------------------------------------- -------------------- -------------------- --------------------
Net premiums earned 33,586,478 38,479,150 28,744,376
Net investment income 5,909,696 5,665,596 6,274,143
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
Other income 251,628 427,440 256,229
---------------------------------------------------- -------------------- -------------------- --------------------
Total Revenues 41,725,437 42,102,418 27,362,919
Policy Benefits and Expenses:
Policyholder benefits 21,236,405 19,210,582 17,537,817
Policyholder benefits ceded (1,081,327) (1,340,821) (1,129,446)
---------------------------------------------------- -------------------- -------------------- --------------------
Net benefits 20,155,078 17,869,761 16,408,371
Increase in net benefit reserves 6,723,513 13,226,999 5,846,674
Interest credited on policyholder deposits 695,563 781,988 734,687
Commissions 6,295,506 7,394,498 6,414,289
General expenses 6,612,964 6,246,475 6,145,361
Interest expense 363,273 305,715 532,962
Policy acquisition costs deferred (1,872,133) (2,712,796) (3,177,040)
Amortization expense:
Deferred policy acquisition costs 1,311,886 1,445,740 1,279,485
Value of insurance acquired 497,993 560,305 706,773
Goodwill --- --- 96,013
Depreciation expense 300,086 312,793 359,708
---------------------------------------------------- -------------------- -------------------- --------------------
Total Policy Benefits and Expenses 41,083,729 45,431,478 35,347,283
---------------------------------------------------- -------------------- -------------------- --------------------
Income (Loss) before income tax and cumulative 641,708 (3,329,060) (7,984,364)
effect of a change in accounting principle
Income Tax benefit (70,114) (757,000) (2,090,000)
---------------------------------------------------- -------------------- -------------------- --------------------
Income (Loss) before cumulative effect of a 711,822 (2,572,060) (5,894,364)
change in accounting principle
Cumulative effect - prior years (since January 1,
1999) accounting for embedded options --- --- (311,211)
---------------------------------------------------- -------------------- -------------------- --------------------
Net Income (Loss) $ 711,822 $(2,572,060) $(6,205,575)
---------------------------------------------------- -------------------- -------------------- --------------------
Per Share Amounts:
Income (Loss) before cumulative effect of a
change in accounting principle $.42 $(1.50) $(3.39)
Cumulative effect - prior years (since January 1,
1999) accounting for embedded options --- --- (0.18)
---------------------------------------------------- -------------------- -------------------- --------------------
Net Income (Loss) $.42 $(1.50) $(3.57)
---------------------------------------------------- -------------------- -------------------- --------------------
See Notes to Consolidated Financial Statements.
Citizens Financial Corporation and Subsidiaries
Consolidated Balance Sheets
December 31 2003 2002
------------------------------------------------------------------------ -------------------- --------------------
ASSETS
Investments:
Securities available-for-sale, at fair value:
Fixed maturities (amortized cost of $104,768,393
and $101,161,174 in 2003 and 2002, respectively) $ 108,640,262 $ 103,953,815
Equity securities (cost of $8,061,783 and
$7,108,735 in 2003 and 2002, respectively) 11,336,964 7,761,892
Investment real estate 3,162,223 3,252,424
Policy loans 4,409,301 4,239,128
Short-term investments 642,748 632,381
------------------------------------------------------------------------ -------------------- --------------------
Total Investments 128,191,498 119,839,640
Cash and cash equivalents 8,588,896 6,699,171
Accrued investment income 1,685,776 1,330,036
Reinsurance recoverable 2,834,222 2,886,256
Premiums receivable 256,140 215,759
Property and equipment 2,640,579 2,767,763
Deferred policy acquisition costs 10,325,660 9,915,288
Value of insurance acquired 3,119,609 3,617,602
Goodwill 755,782 755,782
Federal income tax receivable 421,676 250,158
Other assets 60,494 164,077
------------------------------------------------------------------------ -------------------- --------------------
Total Assets $ 158,880,332 $ 148,441,532
------------------------------------------------------------------------ -------------------- --------------------
See Notes to Consolidated Financial Statements.
Citizens Financial Corporation and Subsidiaries
Consolidated Balance Sheets
December 31 2003 2002
------------------------------------------------------------------------ -------------------- --------------------
LIABILITIES
Policy liabilities:
Future policy benefits $ 109,383,695 $ 102,649,565
Policyholder deposits 15,530,824 15,743,293
Policy and contract claims 1,663,249 1,797,195
Unearned premiums 249,572 247,625
Other 310,464 277,955
------------------------------------------------------------------------ -------------------- --------------------
Total Policy Liabilities 127,137,804 120,715,633
Note payable - bank 4,133,335 5,779,168
Note payable - related party 3,000,000 2,000,000
Accrued expenses and other liabilities 1,805,934 1,851,467
Deferred federal income tax 1,969,850 337,632
------------------------------------------------------------------------ -------------------- --------------------
Total Liabilities 138,046,923 130,683,900
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY
Common stock, 6,000,000 shares authorized;
1,685,228 and 1,686,828 shares issued and
outstanding in 2003 and 2002, respectively 1,685,228 1,686,828
Additional paid-in capital 7,170,321 7,176,480
Accumulated other comprehensive income 4,595,473 2,223,759
Retained earnings 7,382,387 6,670,565
------------------------------------------------------------------------ -------------------- --------------------
Total Shareholders' Equity 20,833,409 17,757,632
------------------------------------------------------------------------ -------------------- --------------------
Total Liabilities and Shareholders' Equity $ 158,880,332 $ 148,441,532
------------------------------------------------------------------------ -------------------- --------------------
See Notes to Consolidated Financial Statements.
Citizens Financial Corporation and Subsidiaries
Consolidated Statements of Shareholders' Equity
Common Accumulated Retained Comprehensive
Additional Other
Paid-in Comprehensive
Stock Capital Income (Loss) Earnings Loss Total
----------------------------------- ---------------- ---------------- -------------- ------------- --------------
Balance at January 1, 2001 $ 1,758,215 $ 7,640,988 $(1,573,294) $ 15,448,200
Net Loss before cumulative
effect of a change in (5,894,364) $(5,894,364)
accounting principle
Cumulative effect - prior years
accounting for embedded
options 311,211 (311,211) ---
Net unrealized depreciation of 3,019,188 3,019,188
available-for-sale securities
--------------
Comprehensive loss $(2,875,176)
==============
Common stock repurchases (41,400) (355,050)
----------------------------------- ---------------- ---------------- -------------- -------------
Balance at December 31, 2001 $1,716,815 $ 7,285,938 $1,757,105 $9,242,625
Net Loss (2,572,060) $(2,572,060)
Net unrealized appreciation of 466,654 466,654
available-for-sale securities
--------------
Comprehensive loss $(2,105,406)
==============
Common stock repurchases (29,987) (109,458)
----------------------------------- ---------------- ---------------- -------------- -------------
Balance at December 31, 2002 $1,686,828 $ 7,176,480 $2,223,759 $6,670,565
Net Income 711,822 $711,822
Net unrealized appreciation of 2,371,714 2,371,714
available-for-sale securities
--------------
Comprehensive gain $3,083,536
==============
Common stock repurchases (1,600) (6,159)
----------------------------------- ---------------- ---------------- -------------- -------------
Balance at December 31, 2003 $1,685,228 $ 7,170,321 $4,595,473 $7,382,387
=================================== ================ ================ ============== =============
See Notes to Consolidated Financial Statements.
Citizens Financial Corporation and Subsidiaries
Consolidated Statements of Cash Flows
Year Ended December 31 2003 2002
2001
---------------------------------------------------------- --------------------- ------------------- ------------------
Cash Flows from Operations:
Net income (loss) $ 711,822 $ (2,572,060) $ (6,205,575)
Adjustments reconciling to cash from operations:
Increase in benefit reserves 6,739,457 13,296,995 5,979,218
Increase (decrease) in claim liabilities (133,946) 354,839 (374,591)
(Increase) decrease in reinsurance recoverable 52,034 (130,576) (68,933)
Interest credited on policyholder deposits 695,517 781,762 734,687
Provision for amortization and depreciation,
net of deferrals 237,832 (393,958) (735,061)
Amortization of premium and accretion
of discount on securities purchased, net 75,056 26,712 (138,180)
Net realized investment (gains) losses (1,977,635) 2,469,768 7,911,829
(Increase) decrease in accrued investment income (355,740) 60,514 (62,060)
Change in other assets and liabilities (169,252) 468,709 (391,533)
Deferred income tax expense (benefit) 365,764 (413,000) 923,000
(Increase) decrease in federal income taxes
receivable (171,518) 2,604,775 (1,490,431)
Cumulative effect - change in accounting principle --- --- 311,211
---------------------------------------------------------- --------------------- ------------------- ------------------
Net Cash provided by Operations 6,069,391 16,554,480 6,393,581
Cash Flows from Investment Activities:
Securities available-for-sale:
Purchases - fixed maturities (75,888,126) (69,026,797) (18,440,196)
Purchases - equity securities (14,662,490) (13,333,227) (13,909,021)
Sales and Maturities - fixed maturities 72,708,562 43,724,194 13,210,562
Sales - equity securities 15,551,998 10,922,498 13,829,235
Investment management and brokerage account fees --- (48,716) (177,786)
Short-term investments sold (acquired), net --- 19,811 (41,813)
Additions to real estate (26,529) --- (154,262)
Additions to property and equipment, net (70,025) (31,908) (40,392)
Other investing activities, net (231,417) (102,479) 168,763
---------------------------------------------------------- --------------------- ------------------- ------------------
Net Cash used in Investment Activities (2,618,027) (27,876,624) (5,554,910)
Cash Flows from Financing Activities:
Policyholder deposits 68,022 741,863 1,006,892
Policyholder withdrawals (976,069) (1,698,063) (2,205,095)
Proceeds from additional borrowings - related party 1,000,000 2,000,000 ---
Payments on notes payable - bank (1,645,833) (1,316,666) (904,166)
Repurchase of common stock (7,759) (139,445) (396,450)
---------------------------------------------------------- --------------------- ------------------- ------------------
Net Cash used in Financing Activities (1,561,639) (412,311) (2,498,819)
---------------------------------------------------------- --------------------- ------------------- ------------------
Net Increase (Decrease) in Cash and Cash Equivalents 1,889,725 (11,734,455) (1,660,148)
Cash and Cash Equivalents at Beginning of Period 6,699,171 18,433,626 20,093,774
---------------------------------------------------------- --------------------- ------------------- ------------------
Cash and Cash Equivalents at End of Period $ 8,588,896 $ 6,699,171 $ 18,433,626
---------------------------------------------------------- --------------------- ------------------- ------------------
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1--NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation and Presentation. The accompanying consolidated
financial statements include the accounts of Citizens Financial Corporation and
its wholly owned subsidiaries: Citizens Security Life Insurance Company
("Citizens Security"), United Liberty Life Insurance Company ("United Liberty"),
Citizens Insurance Company ("Citizens Insurance"), and Corporate Realty Service,
Inc. ("Corporate Realty"). These entities are collectively hereinafter referred
to as the "Company." United Liberty, and (effective January 31, 2001) Citizens
Insurance, are also wholly owned subsidiaries of 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.
Nature of Operations. The Company engages primarily in the business of life
insurance, annuities and accident and health insurance through Citizens Security
and United Liberty ("the Life Insurance Subsidiaries"). The Life Insurance
Subsidiaries offer life, fixed-rate annuity and accident and health insurance
products to individuals and groups through independent agents. Citizens
Insurance was acquired during 1999 (see Note 2) and is licensed as a property
and casualty insurer in six states. The Company is planning to offer home
service fire and casualty insurance coverage; however, Citizens Insurance
currently has no business inforce. Corporate Realty manages the Company's real
estate along with two other properties affiliated with the Company's Chairman.
The individual life insurance products currently offered by the Life Insurance
Subsidiaries 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
20 states primarily located in the South and Southeast. United Liberty is
licensed to sell products in 22 states primarily located in the South, Midwest,
and West. United Liberty's ongoing sales efforts are focused primarily in nine
states where Citizens Security is not licensed.
The Life Insurance Subsidiaries market their portfolio of products through the
personal producing general agent distribution system and presently have
approximately 3,200 sales representatives. Many of these also represent other
insurance carriers. Approximately 500 of the agents specialize in the home
service market while approximately 600 are Preneed representatives who market
through funeral homes. These markets consist primarily of individuals who desire
whole life policies with policy limits typically below $10,000.
Use of Estimates. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States ("GAAP") 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 accumulated other comprehensive
income (loss), net of applicable deferred taxes and adjustments to related
deferred policy acquisition costs. Mark-to-market accounting is used for equity
options embedded in convertible bonds and all other derivatives. Changes in the
fair value of derivatives are reported currently as realized gains or losses.
Cash equivalents include investments with contractual maturity dates within
three months at the time of purchase.
We periodically evaluate whether the declines in fair value of our investments
are other-than-temporary. Our evaluation consists of a review of qualitative and
quantitative factors, including analysis of the Company's competitive position
in its markets, deterioration in the financial condition of the issuer,
downgrades of the security by a rating agency, and other publicly available
issuer-specific news or general market conditions. For investments in companies
with no quoted market price, we consider similar qualitative and quantitative
factors and also take into account the cost of the investment, the type of
investment, subsequent purchases of the same or similar investments, the current
financial position and operating results of the company invested in, and such
other factors as may be relevant. Declines in fair values of securities deemed
to be other-than-temporary are included in net income as realized investment
losses. Determining what constitutes an other-than-temporary decline involves
significant judgment. Declines in fair value below cost not considered
other-than-temporary in the current period could be considered
other-than-temporary in a future period and reduce earnings to the extent of the
write-down.
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 balances. Investment real estate is carried at depreciated cost.
Short-term investments, which consist of certificates of deposit, 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, 2003 was $2,661,266 ($2,361,180 at December 31, 2002).
Goodwill and Value of Insurance Acquired. Goodwill represents the excess of
purchase price of purchased subsidiaries, over amounts assigned (based on
estimated fair values at the date of acquisition) to the identifiable net assets
acquired. Effective January 1, 2002, the Company discontinued amortizing
goodwill and began testing for potential impairment of goodwill on an annual
basis. Prior to 2002, the Company amortized goodwill over 10 to 20 years using
the straight-line method. At December 31, 2003 and 2002, accumulated
amortization was $412,861.
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, 2003, accumulated amortization was $6,176,765 ($5,678,772 at
December 31, 2002).
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 constituted approximately 6% of ordinary life
insurance inforce at December 31, 2003, 2002 and 2001, and 1%, 1%, and 4% of
annualized ordinary life premium inforce at December 31, 2003, 2002, and 2001,
respectively. 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 5.5% to 9.0%.
Premiums, Benefits and Expenses. Premiums for traditional individual life
(including Preneed) 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. 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 GAAP and
balances determined for tax reporting purposes.
Earnings Per Share. Basic earnings per share amounts are based on the weighted
average number of common shares outstanding during the year.
Note 2--ACQUISITIONS
On July 7, 2000, the Company acquired, through an assumption reinsurance
agreement, 100% of the inforce business of National Affiliated Investors Life
Insurance Company ("NAIL") for a net cash purchase price of approximately
$355,000. The acquisition was coordinated through the National Organization of
Life and Health Guaranty Associations. The acquired business consisted primarily
of individual life insurance with policy reserves and annual premium of
approximately $3,500,000 and $300,000, respectively.
On October 14, 1999, the Company acquired 100% of the stock of Citizens
Insurance (formerly Kentucky Insurance Company) from an unaffiliated insurance
holding company (the "Citizens Insurance Acquisition"). Citizens Insurance is
licensed as a property and casualty insurance company in six states and has
approximately $3.6 million of statutory capital and surplus; however, it
currently has no insurance operations. The aggregate purchase price for the
Citizens Insurance Acquisition was approximately $3,550,000 (including net costs
associated with the acquisition of approximately $50,000).
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. The table shows
our investments' gross unrealized losses and fair value, aggregated by
investment category and length of time that individual securities have been in a
continuous unrealized loss position, at December 31, 2003.
------------------------------------ ---------------- -------------- ------------------------------ ----------------
2003 Gross Gross Unrealized Losses
------------------------------------ ---------------- -------------- ------------------------------ ----------------
Available-for-sale securities: Amortized Cost Unrealized Less Than 12 Greater Than Fair Value
Gains Months 12 Months
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
US Government Obligations $18,407,667 $ 656,420 $ 35,345 $ --- $19,028,742
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
State and Political Subdivisions 500,000 23,705 --- --- 523,705
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
Corporate Bonds 74,952,735 3,109,890 273,473 --- 77,789,152
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
Mortgage-Backed Securities 10,907,991 432,383 41,711 --- 11,298,663
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
Total Fixed Maturity Securities 104,768,393 4,222,398 350,529 --- 108,640,262
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
Equity Securities 8,061,783 3,455,279 179,243 855 11,336,964
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
Total $112,830,176 $ 7,677,677 $ 529,772 $ 855 $119,977,226
------------------------------------ ---------------- -------------- -------------- --------------- ----------------
------------------------------------ ---------------- --------------- ------------- ---------------
2002 Gross Gross
------------------------------------ ---------------- --------------- ------------- ---------------
Available-for-sale securities: Amortized Cost Unrealized Unrealized Fair Value
Gains Losses
------------------------------------ ---------------- --------------- ------------- ---------------
US Government Obligations $38,940,067 $1,241,430 $ 7,864 $40,173,633
------------------------------------ ---------------- --------------- ------------- ---------------
State and Political Subdivisions 500,000 --- --- 500,000
------------------------------------ ---------------- --------------- ------------- ---------------
Corporate Bonds 51,650,022 1,876,778 683,232 52,843,568
------------------------------------ ---------------- --------------- ------------- ---------------
Mortgage-Backed Securities 10,071,085 371,403 5,874 10,436,614
------------------------------------ ---------------- --------------- ------------- ---------------
Total Fixed Maturity Securities 101,161,174 3,489,611 696,970 103,953,815
------------------------------------ ---------------- --------------- ------------- ---------------
Equity Securities 7,108,735 845,055 191,898 7,761,892
------------------------------------ ---------------- --------------- ------------- ---------------
Total $108,269,909 $ 4,334,666 $ 888,868 $111,715,707
------------------------------------ ---------------- --------------- ------------- ---------------
When a security is placed on the watch list, it is monitored for further market
value changes and additional news related to the insurer's financial condition.
The focus is on objective evidence that may influence the evaluation of
impairment factors.
The decision to impair a security incorporates both quantitative criteria and
qualitative information. The Company considers a number of factors including,
but not limited to: (a) the length of time and the extent to which the fair
value has been less than book value, (b) the financial condition and near term
prospects of the issuer, (c) the intent and ability of the Company to retain its
investment for a period of time sufficient to allow for any anticipated recovery
in value, (d) whether the debtor is current on interest and principal payments
and (e) general market conditions and industry or sector specific factors.
The Company's decision to impair a security is primarily based on whether the
security's fair value is likely to remain significantly below its book value in
light of all of the factors considered. For securities that are impaired, the
security is adjusted to fair value and the resulting losses are recognized in
realized gains/losses in the Consolidated Statements of Operations.
Investments that are impaired at December 31, 2003 for which an
other-than-temporary impairment has not been recognized consist mainly of
corporate bond issues. The impairment of these securities have been deemed as
temporary due to the assigned rating and the typical fluctuations of these
particular securities in the marketplace. The aggregated unrealized loss at
December 31, 2003 is approximately 2% of the amortized cost of these securities.
There are a total of 29 securities held that are considered temporarily
impaired, three of which have been impaired for twelve months or longer. Only
one of those impaired twelve months or longer at December 31, 2003 remained
impaired at February 29, 2004.
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.
The annual change in net unrealized investment appreciation or depreciation, at
December 31, 2003, 2002 and 2001, and the amount of net realized investment gain
or loss included in net income for the respective years then ended are shown
below. The 2002 change in net unrealized appreciation for fixed maturities shown
below is after recognizing the January 1, 2001 pretax transition adjustment of
approximately $471,532, as described in Note 16.
Year Ended December 31 2003 2002 2001
--------------------------------------------------- ----------------- ---------------- -----------------
Fixed maturities:
Change in net unrealized appreciation $ 1,079,228 $ 1,130,402 $ 2,303,205
Net realized gain (loss) $ 67,903 $ (228,710) $(1,260,092)
Equity securities:
Change in net unrealized appreciation $ 2,622,024 $ (408,399) $ 2,160,985
Net realized gain (loss) $ 1,909,732 $(2,241,058) $(6,651,737)
The amortized cost and fair value of investments in fixed maturities at December
31, 2003, 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, 2003 Amortized Cost Fair Value
------------------------------------------------------------- ------------------ ------------------
Due in one year or less $ 4,377,898 $ 4,518,538
Due after one year through five years 23,822,057 25,356,363
Due after five years through ten years 39,157,343 40,477,050
Due after ten years 26,503,104 26,989,648
------------------------------------------------------------- ------------------- ------------------
Subtotal 93,860,402 97,341,599
Mortgage-backed securities 10,907,991 11,298,663
------------------------------------------------------------- ------------------- ------------------
Total $104,768,393 $108,640,262
------------------------------------------------------------- ------------------- ------------------
Gross gains of $747,764, $555,169, and $463,679 and gross losses of $679,861,
$819,705, and $1,778,519 were realized on the sale of available-for-sale fixed
maturities during 2003, 2002, and 2001, respectively. Included in gross realized
losses during 2003, 2002, and 2001 are net adjustments to the carrying value of
available-for-sale fixed maturities of $83,000, $501,399, and $739,000
respectively, 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 increased by $33,393, $35,826, and $63,492 in 2003, 2002, and 2001
respectively, due to amortization of deferred policy acquisition costs. In
addition, net realized gains from the sale of fixed maturities have been reduced
by $309,323 and $8,744 in 2003 and 2001, respectively, for incentive fees earned
by the portfolio manager.
Gross gains of $2,652,205, $1,814,053, and $1,378,585 and gross losses of
$757,038, $4,093,424, and $8,245,943 were realized on the sale of
available-for-sale equity securities during 2003, 2002 and 2001. Included in
gross realized losses during 2003, 2002, and 2001 are adjustments to the
carrying value of available-for-sale equity securities of $51,600, $753,953, and
$1,533,000 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 increased by $42,130, $47,936, and $252,534 in 2003,
2002, and 2001 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 $7,769, $9,623, and $36,913 in 2003,
2002, and 2001, respectively, for incentive and management fees earned by the
portfolio manager.
Net unrealized appreciation of available-for-sale securities is summarized as
follows:
December 31 2003 2002
------------------------------------------------------------- ------------------- ------------------
Net appreciation on available-for-sale:
Fixed maturities $3,871,869 $2,792,641
Equity securities 3,275,181 653,157
Adjustment of deferred policy acquisition costs (184,213) (76,468)
Deferred income taxes (2,367,364) (1,145,571)
------------------------------------------------------------- ------------------ -------------------
Net unrealized appreciation $4,595,473 $2,223,759
------------------------------------------------------------- ------------------ -------------------
Investment management services were provided during these periods by a firm
affiliated with certain board members and shareholders of the Company - see Note
15 - Related Party Transactions.
Major categories of investment income are summarized as follows:
Year Ended December 31 2003 2002 2001
--------------------------------------- --------------------- -------------------- --------------------
Fixed maturities $5,359,822 $ 4,985,779 $ 4,785,712
Equity securities 325,847 269,695 284,922
Investment real estate 129,051 223,822 239,762
Mortgage loans on real estate - 9,328 14,033
Policy loans 270,648 254,693 258,135
Short-term investments and other 59,902 216,602 1,014,971
---------------------------------------- -------------------- -------------------- --------------------
Subtotal 6,145,270 5,959,919 6,597,535
Investment expense (235,574) (294,323) (323,392)
---------------------------------------- -------------------- -------------------- --------------------
Net investment income $5,909,696 $ 5,665,596 $ 6,274,143
======================================== ==================== ==================== ====================
The decrease in investment real estate is principally related to a increased
vacancy rate attributable to two large tenants vacating the Company's office
building.
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. The following is the only investment (other than the
U.S. Governments) comprising more than ten percent of shareholders' equity at
December 31, 2003: Wyeth ($2,554,039). At December 31, 2003, the Company had no
investments which had not been income producing for a period of at least twelve
months prior to year-end and had approximately $377,000 of fixed maturity
securities on non-accrual status at December 31, 2003.
The following table is a reconciliation of the net unrealized gain (loss)
arising during the period and the change in net unrealized gains (losses) as
reported on the accompanying statements of shareholders' equity.
Pretax Tax Net-of-Tax
Year Ended Amount Expense Amount
---------------------------------------- -------------------- -------------------- --------------------
December 31, 2003:
Unrealized gain $ 5,571,141 $ 1,894,188 $ 3,676,953
Less: Reclassification adjustment
for gains realized in net income 1,977,635 672,396 1,305,239
---------------------------------------- -------------------- -------------------- --------------------
Change in net unrealized gain $ 3,593,506 $ 1,221,792 $ 2,371,714
======================================== ==================== ==================== ====================
December 31, 2002:
Unrealized loss $(1,762,718) $ (599,325) $(1,163,393)
Less: Reclassification adjustment
for losses realized in net (2,469,768) (839,721) (1,630,047)
income
---------------------------------------- -------------------- -------------------- --------------------
Change in net unrealized gain $ 707,050 $ 240,396 $ 466,654
======================================== ==================== ==================== ====================
As an income generation strategy, the Company takes certain option positions,
generally on equity securities or related market indices and on equity options
embedded in convertible bonds. Although such positions may be covered by actual
securities owned or offsetting options, hedge accounting is not used.
Accordingly, all such positions are marked to market and changes in value
reported as realized gains or losses. During 2003, option purchases totaled
approximately $236,000 and related net realized gains totaled approximately
$315,000. At December 31, 2003 net option positions outstanding had a market
value of $38,000, with an associated 2003 realized gain recorded of $69,000.
Pursuant to requirements of certain state insurance departments, the Company has
investments with a carrying value of $53,415,122, at December 31, 2003, placed
on deposit at various financial institutions which are restricted from
withdrawal without prior regulatory approval.
The Company owns the building and land, which it currently occupies. At both
December 31, 2003 and 2002, the Company occupied approximately 31% of the
building with the remaining space leased or available for lease to third-party
tenants. The accompanying financial statements reflect the proportionate Company
occupied share of the building and related operating expense as property and
equipment and general expense, respectively. The remaining portion is reflected
as investment real estate and as a reduction of investment income, respectively.
Accumulated depreciation at December 31, 2003 and 2002 on the investment real
estate portion of the building was $1,264,688 and $1,153,634, respectively.
The Company leases office space to third-party tenants under noncancellable
lease agreements. Future minimum rental income is $476,000, $354,000, $140,000,
$48,000 and $35,000 for years 2004 through 2008, respectively.
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%.
Balances outstanding relate primarily to the purchase of United Liberty, two
additional companies which have been merged into Citizens Security (Integrity
National Life Insurance Company and Old South Life Insurance Company) and NAIL.
An analysis of the value of insurance acquired for the year's ended December 31,
2003, 2002 and 2001 is as follows:
Year Ended December 31 2003 2002 2001
---------------------------------------- ----------------- ---------------- -----------------
Balance at beginning of year $3,617,602 $4,177,907 $4,884,680
Accretion of interest 228,380 253,996 296,964
Amortization (726,373) (814,301) (1,003,737)
---------------------------------------- ----------------- ---------------- -----------------
Balance at end of year $3,119,609 $3,617,602 $4,177,907
---------------------------------------- ----------------- ---------------- -----------------
Amortization of the value of insurance acquired (net of interest accretion) in
each of the following five years will be approximately: 2004 - $483,000; 2005 -
$447,000; 2006 - $392,000, 2007-$353,000 and 2008 - $322,000.
Note 5--DEBT
Debt consists of the following:
December 31 2003 2002
----------------------------------------- ------------------- ------------------
Commercial bank, due 2007 $ 4,133,335 $ 5,779,168
Related party, due 2007 3,000,000 2,000,000
----------------------------------------- ------------------- ------------------
Total $ 7,133,335 $7,779,168
----------------------------------------- ------------------- ------------------
The Company's outstanding commercial bank borrowings relate primarily to various
insurance company acquisitions. Interest is payable quarterly at the lower of
the bank's prime lending rate or the one month LIBOR rate plus 2.75%. Scheduled
principal installments are due as follows: 2004 - $1,316,667; 2005 and 2006 -
$1,416,666; and 2007 - $312,502. However, the loan agreement for the bank notes
contains covenants regarding asset acquisitions, shareholder equity and
dividends, and maintenance of a debt to earnings ratio. During 2003 and 2002,
the Company did not comply with a loan covenant (debt to earnings ratio) on this
debt and received a waiver of such violation through December 31, 2003. For the
quarter ended September 30, 2003, the Company did not meet one of its bank debt
covenants (debt to earnings ratio), however the lender has waived this
violation. In return for the waiver the Company's Chairman agreed to personally
guarantee the outstanding bank debt. However, since the Company is not assured
of meeting this covenant throughout 2004, the full balance of $4,133,335 can be
considered payable within one year. Although the Company does not expect the
full balance to be called during 2004, it believes such an obligation could be
met through a refinancing arrangement or sale of selected assets or a block of
insurance business. Regarding the currently scheduled debt repayments, the
Company believes its available funds will be adequate to service 2004 debt
obligations. In addition, the Company's Chairman has expressed potential
willingness to loan the Company an additional $2,000,000 if necessary, which
management believes will service debt obligations through the majority of 2006.
The Company has pledged the issued and outstanding common and preferred stock of
Citizens Security as collateral for the commercial bank notes.
Due to losses during the past three years and the adverse impact of the low
interest rate environment on operating results, the Company borrowed $2,000,000
from its Chairman in 2002 to strengthen the statutory capital position of its
principal insurance subsidiary. The Company borrowed an additional $1,000,000
from its chairman in 2003 for general operating capital. Borrowings from the
Company's Chairman is considered current debt due to a 90 call provision in the
loan agreement Interest on the debt is payable quarterly by the Company at an
annual rate equal to the greater of 6.00% or the prime lending rate plus 1%. The
outstanding principal is callable upon 90 days notice or otherwise due on June
30, 2005, except however, under terms of a subordination agreement between the
Chairman and the Company's commercial bank, repayment is prohibited until all
outstanding commercial bank borrowings are repaid.
Cash paid for interest on debt was $431,071, $412,719, and $635,594, during
2003, 2002 and 2001, respectively.
Note 6--EARNINGS AND DIVIDENDS PER SHARE
The following table sets forth the computation of earnings (losses) per share.
No dividends were paid or accrued for 2003, 2002, or 2001.
December 31 2003 2002 2001
------------------------------------------------------------------- ---------------- ---------------- --------------
Numerators:
Income (Loss) before cumulative effect of a change in $711,822 $(2,572,060) $(5,894,364)
Accounting principle
Cumulative effect of a change in accounting principle --- --- (311,211)
------------------------------------------------------------------- ---------------- ---------------- --------------
Net Income (Loss) $711,822 $(2,572,060) $(6,205,575)
------------------------------------------------------------------- ---------------- ---------------- --------------
Denominator:
Weighted average common shares 1,685,390 1,711,627 1,740,360
Earnings (Loss) Per Share:
Income (Loss) before cumulative effect of a change in $.42 $(1.50) $(3.39)
accounting principle
Cumulative effect of a change in accounting principle --- --- (0.18)
------------------------------------------------------------------- ---------------- ---------------- --------------
Net Income (Loss) $.42 $(1.50) $(3.57)
------------------------------------------------------------------- ---------------- ---------------- --------------
Note 7--INCOME TAXES
Income taxes consist of the following:
December 31 2003 2002 2001
---------------------------------------- ---------------- ----------------- -----------------
Current tax benefit $(436,000) $(344,000) $(3,013,000)
Deferred tax expense (benefit) $ 366,000 (413,000) 923,000
---------------------------------------- ---------------- ----------------- -----------------
Income tax benefit $ (70,000) $(757,000) $(2,090,000)
---------------------------------------- ---------------- ----------------- -----------------
Tax expense includes a current state and local income tax provision (benefit) of
$0, $(36,000), and $(230,000), in 2003, 2002, and 2001 respectively. Deferred
income taxes are provided for cumulative temporary differences between balances
of assets and liabilities determined under GAAP and balances determined for tax
reporting purposes.
Significant components of the Company's deferred tax liabilities and assets as
of December 31, 2003 and 2002 are as follows:
December 31 2003 2002
------------------------------------------------------------- ------------------- ------------------
Deferred Tax Liabilities:
Value of insurance acquired $ 931,823 $ 1,229,985
Deferred policy acquisition costs 2,129,436 1,922,754
Net unrealized gains on available-for-sale securities 2,367,364 1,145,571
Other 607,655 635,594
------------------------------------------------------------- ------------------- ------------------
Total deferred tax liabilities 6,033,278 4,933,904
Deferred Tax Assets:
Policy and contract reserves 3,471,931 3,343,789
Fixed maturities and equity securities 240,412 912,329
Real estate 548,668 548,668
Alternative minimum tax credit carryforwards 62,996 201,918
Net operating and capital loss carryforwards 523,661 707,298
Other 165,070 256,767
------------------------------------------------------------- ------------------- ------------------
Total deferred tax assets 5,012,738 5,970,769
Valuation allowance for deferred tax assets (949,310) (1,374,497)
------------------------------------------------------------- ------------------- ------------------
Net deferred tax assets 4,063,428 4,596,272
------------------------------------------------------------- ------------------- ------------------
Net deferred tax assets (liabilities) $(1,969,850) $ (337,632)
------------------------------------------------------------- ------------------- ------------------
The following is a reconciliation of income tax expense at the federal statutory
rate, to the tax at the Company's effective income tax rate:
December 31 2003 2002 2001
------------------------------------ -------------- --------------- ---------------
Tax at the statutory rate $ 218,000 $ (1,132,000) $ (2,714,700)
Change in valuation allowance (411,000) 314,000 (358,500)
Small life deduction --- 106,000 1,141,100
State and local income tax --- (36,000) (165,200)
Surtax exemption and other 131,000 (2,000) 24,000
Dividend exclusion (8,000) (7,000) (16,700)
----------------------------------- --------------- --------------- ---------------
Tax at the effective rate $ (70,000) $ (757,000) $ (2,090,000)
----------------------------------- --------------- --------------- ---------------
Income taxes paid (refunded) in 2003, 2002, and 2001 were $(324,000),
$(3,065,000), and $(1,293,000), respectively. The Company has $1,599,000 of net
operating loss carryforwards and $1,752,000 of capital loss carryforwards, which
expire in years 2017 and 2018. The change in the valuation allowance is due
principally to the limitation in the recovery of prior year taxes at the full
statutory rate.
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, 2003,
Citizens Security could have paid additional dividends of approximately
$22,400,000 before paying tax on any part of its policyholders' surplus
accounts. No provision has been made for the related deferred income taxes which
total $292,000, based on current tax rates as of December 31, 2003.
Note 8--STATUTORY ACCOUNTING PRACTICES AND SHAREHOLDERS' EQUITY
The Insurance Subsidiaries are domiciled in Kentucky and prepare their
statutory-basis financial statements in accordance with statutory accounting
practices ("SAP") prescribed or permitted by the Kentucky Office of Insurance
("KOI"). "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.
Effective January 1, 2001, the NAIC revised its Accounting Practices and
Procedures Manual in a process referred to as Codification. The KOI has adopted
the revised manual, which has changed, to some extent, prescribed statutory
accounting practices which the Insurance Subsidiaries use to prepare their
statutory-basis financial statements. The primary statutory changes affecting
the Insurance Subsidiaries are, establishment of deferred income taxes,
recognizing as realized losses securities impairments considered other than
temporary, recording an allocable share of the Company's accrued employee
benefit obligations, and revision of the statutory equity method of accounting
which now precludes a parent insurer from recording as income, its share of
undistributed subsidiary earnings. Effective January 1, 2001, the Insurance
Subsidiaries recorded a net deferred tax benefit from Codification of
$1,750,000, partially offset by approximately $228,000 of accrued employee
benefit obligations.
Statutory-basis net income and capital and surplus for the Company's combined
insurance operations, for the three years ended December 31, 2003 are shown
below. These amounts are combined totals for Citizens Security, United Liberty,
and Citizens Insurance, with adjustments to eliminate intercompany holdings and
activity.
December 31 2003 2002 2001
----------------------------------- -------------- -------------- --------------
Net Income (Loss) $ 1,182,848 $ (1,663,236) $ (3,762,603)
Capital and Surplus $ 11,128,657 $ 9,903,639 $ 9,687,289
Principal differences between SAP and GAAP include: a) costs of acquiring new
policies are generally 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) the change in SAP deferred income taxes associated with timing
differences is recorded directly to equity rather than as a component of net
income as required 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.
Statutory restrictions limit the amount of dividends which the insurance
companies may pay. 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 2002, the Company purchased
$2,000,000 of redeemable preferred stock from Citizens Security, as further
described in Note 5. During 2001, the Company contributed the stock of Citizens
Insurance and $150,000 to Citizens Security. The statutory value of the
contributed Citizens Insurance stock was $3,540,555. Citizens Security
contributed the $150,000 received from the Company to Citizens Insurance. During
2000, with appropriate prior regulatory approval, Citizens Security redeemed
$1,200,000 of its outstanding preferred stock from the Company. United Liberty
paid dividends to Citizens Security of $54,000, $214,000, and $292,000 during
2003, 2002, and 2001 respectively and Citizens Insurance paid dividends to
Citizens Security of $62,400 in 2003. The Insurance Subsidiaries must each
maintain $1,250,000 of capital and surplus, the minimum required for insurance
companies domiciled in Kentucky. The KOI 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 required 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. Based on RBC
computations as of December 31, 2003, the Insurance Subsidiaries each have
statutory capital, which is in excess of minimum regulatory requirements.
Note 9--SEGMENT INFORMATION
The Company's operations are managed along five principal insurance product
lines: Home Service Life, Broker Life, Preneed Life, Dental, and Other Health.
Products in all five lines are sold through independent agency operations. Home
Service Life consists primarily of traditional life insurance coverage sold in
amounts of $10,000 and under to middle and lower income individuals. This
distribution channel is characterized by a significant amount of agent contact
with customers throughout the year. Broker Life product sales consist primarily
of simplified issue and graded-benefit policies in amounts of $10,000 and under.
Other products in this segment which are not aggressively marketed include:
group life, universal life, annuities and participating life coverages. Preneed
Life products are sold to individuals in connection with prearrangement of their
funeral and include single premium and multi-pay policies with coverages
generally in amounts of $10,000 and less. These policies are generally sold to
older individuals at increased premium rates. Dental products are term coverages
generally sold to small and intermediate size employer groups. Other Health
products include various accident and health coverages sold to individuals and
employer groups.
Segment information as of December 31, 2003, 2002 and 2001, and for the years
then ended is as follows:
December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Revenue:
Home Service Life $ 9,147,813 $ 9,260,097 $ 9,290,120
Broker Life 6,019,952 5,964,089 6,497,286
Preneed Life 14,780,938 19,706,136 9,974,405
Dental 8,417,118 8,209,257 8,025,375
Other Health 1,381,981 1,432,607 1,487,562
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Totals 39,747,802 44,572,186 35,274,748
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
------------------------------------------------------ ----------------- ---------------- -----------------
Total Revenue $ 41,725,437 $ 42,102,418 $ 27,362,919
------------------------------------------------------ ----------------- ---------------- -----------------
Below are the net investment income amounts which are included in the revenue
totals above.
Year Ended December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Net Investment Income:
Home Service Life $ 1,784,285 $ 1,790,949 $ 2,053,995
Broker Life 2,403,352 2,178,667 2,579,117
Preneed Life 1,605,477 1,592,356 1,514,638
Dental 30,071 24,896 35,312
Other Health 86,511 78,728 91,081
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Totals $ 5,909,696 $ 5,665,596 $ 6,274,143
------------------------------------------------------ ----------------- ---------------- -----------------
The Company evaluates performance based on several factors, of which the primary
financial measure is segment profit. Segment profit represents pretax earnings,
determined in accordance with the accounting policies described in Note 1,
except net realized investment gains and interest expense are excluded. A
significant portion of the Company's realized investment gains and losses are
generated from investments in equity securities.
Year Ended December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Profit (Loss):
Home Service Life $ 75,520 $275,809 $ 382,723
Broker Life (121,851) (265,488) 74,960
Preneed Life (955,227) (670,349) (264,488)
Dental 230,289 297,740 256,385
Other Health (201,385) (191,289) 10,847
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Totals (972,654) (553,577) 460,427
Net realized investment gains (losses) 1,977,635 (2,469,768) (7,911,829)
Interest expense 363,273 305,715 532,962
------------------------------------------------------ ----------------- ---------------- -----------------
Income (Loss) before income tax and cumulative $ 641,708 $ (3,329,060) $ (7,984,364)
effect of a change in accounting principle
------------------------------------------------------ ----------------- ---------------- -----------------
Depreciation and amortization amounts below consist of amortization of the value
of insurance acquired, deferred policy acquisition costs and goodwill, along
with depreciation expense.
December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Depreciation and Amortization:
Home Service Life $ 661,301 $ 750,811 $ 873,529
Broker Life 682,276 482,049 678,446
Preneed Life 673,426 983,848 779,199
Dental 61,304 61,480 68,866
Other Health 31,658 40,650 41,939
------------------------------------------------------ ----------------- ---------------- -----------------
Segment Totals $ 2,109,965 $ 2,318,838 $ 2,441,979
------------------------------------------------------ ----------------- ---------------- -----------------
Segment asset totals are determined based on policy liabilities outstanding in
each segment.
December 31 2003 2002 2001
------------------------------------------------------ ----------------- ---------------- -----------------
Assets:
Home Service Life $ 41,312,914 $ 45,219,971 $ 44,818,038
Broker Life 54,585,019 53,874,949 54,954,194
Preneed Life 60,100,723 46,739,831 34,138,535
Dental 930,279 660,334 726,728
Other Health 1,951,397 1,946,447 1,959,588
------------------------------------------------------ ----------------- ---------------- -----------------
Total Assets $158,880,332 $148,441,532 $136,597,083
------------------------------------------------------ ----------------- ---------------- -----------------
Note 10--QUARTERLY FINANCIAL DATA (Unaudited)
Below is selected consolidated quarterly financial data for each of the two
years ended December 31, 2003.
Year 2003 - Quarter 1 2 3 4
---------------------------------------- --------------- --------------- --------------- --------------
Segment Revenue $ 10,407,982 $ 10,246,444 $ 10,099,329 $ 8,994,047
Investment gains (losses), net (276,163) 111,435 925,557 1,216,806
---------------------------------------- --------------- --------------- --------------- --------------
Total Revenue 10,131,819 10,357,879 11,024,886 10,210,853
---------------------------------------- --------------- --------------- --------------- --------------
Segment Profit (Loss) (37,947) (401,774) (562,614) 29,681
Investment gains (losses), net (276,163) 111,435 925,557 1,216,806
Interest expense 92,208 97,401 90,068 83,596
Income tax expense (benefit) (73,000) (68,000) 20,000 50,886
---------------------------------------- --------------- --------------- --------------- --------------
Net Income (Loss) $ (333,318) $ (319,740) $ 252,875 $ 1,112,005
---------------------------------------- --------------- --------------- --------------- --------------
Net Income (Loss) Per Share $(.20) $(.90) $.15 $.66
---------------------------------------- --------------- --------------- --------------- --------------
Due to an upturn in the securities market, the Company realized significant
increases in realized capital gains in the 3rd and 4th quarters of 2003.
Year 2002 - Quarter 1 2 3 4
---------------------------------------- --------------- --------------- --------------- --------------
Segment Revenue $ 9,776,888 $ 11,018,089 $ 12,427,634 $ 11,349,575
Investment gains (losses), net (328,401) (1,468,150) (701,218) 28,001
---------------------------------------- --------------- --------------- --------------- --------------
Total Revenue 9,448,487 9,549,939 11,726,416 11,377,576
---------------------------------------- --------------- --------------- --------------- --------------
Segment Profit (Loss) (57,314) (646,672) 90,388 60,021
Investment gains (losses), net (328,401) (1,468,150) (701,218) 28,001
Interest expense 81,228 78,176 74,649 71,662
Income tax (benefit) (70,000) (345,000) (213,000) (129,000)
---------------------------------------- --------------- --------------- --------------- --------------
Net Income (Loss) $ (396,943) $ (1,847,998) $ (472,479) $ 145,360
---------------------------------------- --------------- --------------- --------------- --------------
Net Income (Loss) Per Share $ (.23) $ (1.08) $ (0.27) $ 0.08
---------------------------------------- --------------- --------------- --------------- --------------
Upon review for impaired securities, the Company recognized $1.1 million in
other-than-temporary market declines during the 2nd quarter of 2002.
Note 11--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 and simplified issue coverages above $4,000 are generally 50% reinsured,
with the Life Insurance Subsidiaries maintaining a maximum $10,000 risk on any
one policyholder. Individual and group accidental death coverage and a minor
portion of cancer coverage are 100% reinsured. To the extent that reinsuring
companies are unable to meet obligations under reinsurance agreements, the
Company would remain liable. Reinsurance premiums, expenses, recoveries and
reserves related to reinsured business are accounted for on bases consistent
with those used in accounting for the original policies issued and the terms of
the reinsurance contracts.
Note 12--CONTINGENCIES
United Liberty, which the Company acquired in 1998, is defending an action in an
Ohio state court brought by two policyholders. The Complaint refers to a
particular class of life insurance policies that United Liberty issued over a
period of years ending around 1971. It alleges that United Liberty's dividend
payments on these policies from 1993 through 1999 were less than the required
amount. It does not specify the amount of the alleged underpayment but implies a
maximum of about $850,000. The plaintiffs also allege that United Liberty is
liable to pay punitive damages, also in an unspecified amount, for breach of an
implied covenant of good faith and fair dealing to the plaintiffs in relation to
the dividends. The action has been certified as a class action on behalf of all
policyholders who were Ohio residents and whose policies were still in force in
1993. United Liberty has denied the material allegations of the Complaint and is
defending the action vigorously. Pre-trial discovery is continuing. United
Liberty has filed a motion for summary judgment, which has been fully briefed
and argued and awaits decision by the Court. At United Liberty's request, an
initial mediation session has been completed and negotiations are continuing. As
a pre-requisite for the mediation, United Liberty offered to settle the matter
for payments over time, which would include attorneys' fees, and which would be
contingent upon an exchange or reformation of the insurance policies currently
owned by the members of the class. At this stage of the litigation, the Company
is unable to determine whether an unfavorable outcome of the action is likely to
occur or, alternatively, whether the chance of such an outcome is remote.
Therefore, at this time, management has no basis for estimating potential
losses, if any. In addition, the Company is party to other lawsuits in the
normal course of business. Management believes that recorded claims liabilities
are adequate to ensure that these other suits will be resolved without material
financial impact to the Company.
Note 13--FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair values of financial instruments, and the methods used in estimating
these 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, 2003 and 2002, the fair value of available-for-sale fixed maturities was
$108,640,262 and $103,953,815, 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, 2003 and 2002, the fair value
of equity securities was $11,336,964 and $7,761,892, respectively.
Short-Term Investments: The carrying amount of short-term investments
approximates their fair value. At December 31, 2003 and 2002, the fair value of
short-term investments was $642,748 and $632,381, respectively.
Cash and Cash Equivalents: The carrying amount of cash and cash equivalents
approximates their fair value. At December 31, 2003 and 2002, the fair value of
cash and cash equivalents was $8,588,896 and $6,699,171, respectively.
Policy Loans: The carrying amount of policy loans approximates their fair value.
At December 31, 2003 and 2002, the fair value of policy loans was $4,409,301 and
$4,239,128, respectively.
Investment Contracts: The carrying amount of investment-type fixed annuity
contracts approximates their fair value. At December 31, 2003 and 2002, the fair
value of investment-type fixed annuity contracts was $9,854,362 and $9,805,082,
respectively.
Notes Payable: The carrying amounts of notes payable approximate their fair
values. At December 31, 2003 and 2002, the fair value of notes payable was
$7,133,335 and $7,779,168, respectively.
Note 14--BENEFIT PLANS
The Company has a 401(k) savings plan for its full-time employees. The Company
contributes matching contributions at the discretion of its Board of Directors.
Company expense associated with this plan totaled $62,388, $61,037, and $57,532
in 2003, 2002 and 2001, respectively.
Note 15--RELATED PARTY TRANSACTIONS
The Company has various transactions with its President and Chairman of the
Board (the "Chairman") or entities he controls. Through January 31, 2004 the
Chairman provided investment portfolio management for the Company and its
subsidiaries through SMC Advisors, Inc. (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 $45,000 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 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.
Fixed fees totaled $45,000, $45,000, and $45,000 in 2003, 2002, and 2001,
respectively. Incentive fees of $309,323, $0, and $48,168 were incurred and paid
for 2003, 2002, and 2001, respectively. The Company also maintains a portion of
its investments under a Trust Agreement with a bank controlled by the Chairman.
Fees to the bank are based on assets held. Such fees were $45,933, $100,675, and
$94,199 in 2003, 2002, and 2001, respectively. The Company also manages certain
commercial real estate affiliated with its Chairman. The Company charges the
real estate projects management and leasing fees at market rates, which totaled
$144,095, $213,070, and $174,746 during 2003, 2002, and 2001, respectively. In
December 2003, the Company borrowed $1,000,000 from its Chairman, in addition to
the $2,000,000 in borrowings during December 2002. Terms of the note include
that interest is payable quarterly at the greater of 6% per year or the
commercial bank prime lending rate plus 1%.
Note 16 - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2001, the Company adopted Financial Accounting Standards
Board Statement ("SFAS") No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended by SFAS Nos. 137 and 138. This statement
requires that all derivatives be recognized as either assets or liabilities in
the balance sheet at their fair value, and sets forth the manner in which gains
or losses thereon are to be recorded. The treatment of such gains or losses is
dependent upon the type of exposure, if any, for which the derivative is
designated as a hedge. Currently, the Company has not designated any derivatives
as hedges. Adoption of SFAS No. 133 resulted in a January 1, 2001 transition
adjustment that reduced net income and increased accumulated other comprehensive
income in 2001 by approximately $311,000. This adjustment consisted of a pretax
total of $471,000 less a $160,000 tax benefit.
In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 141, "Business Combinations", and No. 142,
"Goodwill and Other Intangible Assets", effective for fiscal years beginning
after December 15, 2001. Under the new rules, goodwill is no longer amortized
but is subject to annual impairment tests in accordance with the Statements.
Other intangible assets will continue to be amortized over their useful lives.
The Company applied the new rules on accounting for goodwill and other
intangible assets beginning in the first quarter of 2002. Application of the
nonamortization provisions of the Statement increased the 2003 net gain and
decreased the 2002 net loss approximately $96,000 ($0.06 per share). During
2003, the Company performed an impairment test of goodwill and concluded that no
impairment adjustment was necessary.
Below is a proforma illustration of earnings adjusted to exclude goodwill
amortization recorded during 2001 and 2000.
Year Ended December 31 2003 2002 2001
----------------------------------------------------- ----------------- ---------------- -----------------
Net Income (Loss) excluding goodwill amortization $ 711,822 $ (2,572,060) $ (6,109,562)
Goodwill amortization --- 96,013
------------------------------------------------------ ----------------- ---------------- -----------------
Net Income (Loss) - as reported $ 711,822 $ (2,572,060) $ (6,205,575)
------------------------------------------------------ ----------------- ---------------- -----------------
Net Income (Loss) per Share:
Excluding goodwill amortization $ .42 $(1.50) $(3.51)
As reported $ .42 $(1.50) $(3.57)
Total goodwill outstanding at December 31, 2003 is $756,000 with $304,000
allocable to Broker Life, $270,000 to Home Service Life and $182,000 to Preneed
Life.
In July 2003, the American Institute of Certified Public Accountants ("AICPA")
issued Statement of Position ("SOP") 03-1, "Accounting and Reporting by
Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and
Separate Accounts." The most significant accounting implications to the Company
of the SOP is amortizing DPAC over the life of deferred annuity contracts
excluding the annuitization phase.
The Company will adopt the SOP effective January 1, 2004. Although
interpretation of accounting for certain items covered by the SOP has not been
finalized, the effect of initially adopting this SOP is not expected to be
material to shareholders' equity or the trend of earnings.
In November of 2003, the Emerging Issues Task Force ("EITF") reached consensus
on EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments", that certain quantitative and qualitative
disclosures are required for equity and fixed maturity securities that are in an
unrealized loss position at the balance sheet date but for which an
other-than-temporary impairment has not been recognized. The guidance requires
companies to disclose the aggregate amount of realized losses and the related
fair value of investments with unrealized losses for securities that have been
in an unrealized loss position for less than 12 months and separately for those
that have been in an unrealized loss position for over 12 months, by investment
category. The Company has adopted the disclosure requirements in these financial
statements.
Schedule II - Condensed Financial Information of Registrant
Citizens Financial Corporation
(Parent Company Only)
Condensed Balance Sheets
December 31 2003 2002
------------------------------------------------------------------------ -------------------- --------------------
Assets:
Cash and cash equivalents $ 963,564 $ 1,166,107
Equity securities available-for-sale (cost of $847,491 and
$1,531,555 in 2003 and 2002, respectively) 1,166,452 1,532,829
Fixed maturity securities available-for-sale (amortized cost of
$23,345 in 2003 and $101,750 in 2002) 104,901 122,750
Investments in subsidiaries* 24,484,415 20,966,393
Furniture and equipment 1,214,615 1,296,421
Intercompany receivable* 799,366 634,435
Current and deferred federal income tax --- 255,546
Other assets 31,449 38,459
------------------------------------------------------------------------ -------------------- --------------------
Total Assets $ 28,764,762 $ 26,012,940
------------------------------------------------------------------------ -------------------- --------------------
Liabilities:
Note payable to bank $ 4,133,335 $ 5,779,168
Note payable to related party 3,000,000 2,000,000
Current and deferred federal income tax 360,476 320,090
Net option positions (69,425) 7,488
Other liabilities 252,476 148,562
------------------------------------------------------------------------ -------------------- --------------------
Total Liabilities 7,676,862 8,255,308
Shareholders' Equity:
Common stock 1,685,288 1,686,828
Additional paid-in capital 7,170,321 7,176,480
Accumulated other comprehensive income 264,340 14,701
Equity in accumulated other comprehensive
income of subsidiaries* 4,585,564 2,209,058
Retained earnings 7,382,387 6,670,565
------------------------------------------------------------------------ -------------------- --------------------
Total Shareholders' Equity 21,087,900 17,757,632
------------------------------------------------------------------------ -------------------- --------------------
Total Liabilities and Shareholders' Equity $ 28,764,762 $ 26,012,940
------------------------------------------------------------------------ -------------------- --------------------
* Eliminated in consolidation.
These condensed financial statements should be read in conjunction with the
Consolidated Financial Statements and accompanying footnotes of Citizens
Financial Corporation and Subsidiaries.
Schedule II - Condensed Financial Information of Registrant
Citizens Financial Corporation
(Parent Company Only)
Condensed Statements of Operations
Year Ended December 31 2003 2002 2001
---------------------------------------------------- -------------------- -------------------- --------------------
Revenues:
Net realized investment gains (losses) $ 33,393 $ (228,672) $(1,953,848)
Service fees from subsidiaries 4,674,870 4,703,880 4,705,087
Interest and dividend income --- 49,234 206,940
Other income 10,396 28,280 38,816
---------------------------------------------------- -------------------- -------------------- --------------------
Total Revenues 4,718,659 4,552,722 2,996,995
Expenses:
Administrative and general expenses 4,843,974 4,784,744 4,743,159
Interest expense 363,273 305,715 532,962
---------------------------------------------------- -------------------- -------------------- --------------------
Total Expenses 5,207,247 5,090,459 5,276,121
---------------------------------------------------- -------------------- -------------------- --------------------
Loss before income taxes and undistributed (488,588) (537,737) (2,279,126)
earnings of subsidiaries
Income tax benefit (58,959) (221,000) (940,000)
---------------------------------------------------- -------------------- -------------------- --------------------
Loss before equity in undistributed (429,629) (316,737) (1,339,126)
earnings of subsidiaries
Equity in undistributed loss of subsidiaries 1,141,451 (2,255,323) (4,866,449)
---------------------------------------------------- -------------------- -------------------- --------------------
Net Income (Loss) $ 711,822 $(2,572,060) $(6,205,575)
---------------------------------------------------- -------------------- -------------------- --------------------
* Eliminated in consolidation.
These condensed financial statements should be read in conjunction with the
Consolidated Financial Statements and accompanying footnotes of Citizens
Financial Corporation and Subsidiaries.
Schedule II - Condensed Financial Information of Registrant
Citizens Financial Corporation
(Parent Company Only)
Condensed Statements of Cash Flows
Year Ended December 31 2003 2002 2001
------------------------------------------------------ ------------------- ------------------ ------------------
Cash from operations $ (158,850) $ 1,032,505 $(1,423,335)
Cash flow from investing activities:
Purchases of available-for-sale securities (3,093,276) (3,431,955) (6,211,339)
Sales of available-for-sale securities 3,810,723 2,967,241 5,338,727
Investment in subsidiaries* --- (2,000,000) (150,000)
Investment management fees (22,527) (9,623) ---
Additions to property and equipment, net (70,025) (30,279) (40,392)
Change in investments, other (14,996) --- 37,335
------------------------------------------------------ ------------------- ------------------ ------------------
Net cash provided by (used in) investing activities 609,899 (2,504,616) (1,025,669)
Cash flow from financing activities:
Payments on notes payable - bank (1,645,833) (1,316,666) (904,166)
Proceeds from note payable - related part y 1,000,000 2,000,000 ---
Repurchase of capital stock (7,759) (139,445) (396,450)
------------------------------------------------------ ------------------- ------------------ ------------------
Net cash provided by (used in ) financing activities (653,592) 543,889 (1,300,616)
------------------------------------------------------ ------------------- ------------------ ------------------
Net decrease in cash and cash equivalents (202,543) (928,222) (3,749,620)
Cash and cash equivalents at beginning of year 1,166,107 2,094,329 5,843,949
------------------------------------------------------ ------------------- ------------------ ------------------
Cash and cash equivalents at end of year $ 963,564 $ 1,166,107 $ 2,094,329
------------------------------------------------------ ------------------- ------------------ ------------------
* Eliminated in consolidation.
These condensed financial statements should be read in conjunction with the
Consolidated Financial Statements and accompanying footnotes of Citizens
Financial Corporation and Subsidiaries.
Schedule III - Supplementary Insurance Information
Citizens Financial Corporation
For the Years Ended December 31, 2003, 2002, and 2001
Year Ended December 31 Other Policy Net
Deferred Policy and Claims and Investment Policy Amortization Other
Acquisition Claim Unearned Benefits Premium and Other Benefits of Operating
Segment Costs Reserves Premiums Payable Revenue Income1 and Claims2 Policy Costs3 Costs4
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
Column: A B C D E F G H I J
2003:
Home Service Life $ 4,075,468 $ 34,595,775 $ --- $ 390,576 $ 7,288,004 $1,718,755 $ 4,782,186 $ 574,614 $3,870,941
Broker Life 3,368,295 44,337,252 --- 509,456 3,514,873 2,315,056 3,743,281 614,558 1,368,544
Preneed Life 2,723,421 44,245,695 --- 365,981 13,106,019 2,015,212 12,421,461 607,641 3,284,707
Dental --- 365,906 5,384 207,987 8,385,774 28,967 5,778,194 --- 2,408,635
Other Health 158,476 1,680,355 244,188 189,249 1,291,808 83,334 939,336 13,066 627,754
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
Total $10,325,660 $125,224,983 $ 249,572 $1,663,249 $33,586,478 $6,161,324 $27,664,458 $1,809,879 $11,560,581
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
2002:
Home Service Life $3,717,940 $ 33,468,638 $ --- $ 502,085 $ 7,334,030 $1,926,067 $ 4,880,305 $ 663,706 $ 3,440,277
Broker Life 3,621,843 44,407,746 2,998 643,845 3,621,053 2,343,036 3,971,204 405,670 1,852,703
Preneed Life 2,414,288 38,792,405 --- 178,798 17,993,645 1,712,491 16,405,120 914,988 3,056,377
Dental --- 296,369 5,384 222,496 8,182,483 26,774 5,634,940 --- 2,276,577
Other Health 161,217 1,705,655 239,243 249,971 1,347,939 84,668 987,179 21,681 615,036
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
Total $9,915,288 $118,670,813 $ 247,625 $1,797,195 $38,479,150 $6,093,036 $31,878,748 $2,006,045 $11,240,970
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
2001:
Home Service Life $3,297,247 $ 32,093,694 $ --- $ 516,265 $ 7,152,242 $2,137,878 $ 4,474,816 $ 714,743 $3,717,838
Broker Life 3,451,936 44,067,779 3,147 344,048 3,812,841 2,684,445 3,920,434 538,374 1,963,518
Preneed Life 1,665,278 27,239,439 --- 273,207 8,397,911 1,576,494 8,223,074 711,300 1,304,519
Dental --- 264,235 5,540 295,344 7,988,620 36,754 5,551,624 --- 2,217,365
Other Health 164,962 1,590,144 244,043 302,892 1,392,762 94,801 819,784 21,841 635,091
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
Total $8,579,423 $105,255,291 $ 252,730 $1,731,756 $28,744,376 $6,530,372 $22,989,732 $1,986,258 $9,838,331
--------------------- ----------- ------------ ---------- ---------- ----------- ----------- ------------ -------------- -----------
1Amounts are allocated based on average policy reserves and deposits.
2Includes interest on policyholder deposits and dividends credited to participating policyholders.
3Amortization of Policy Costs: 2003 2002 2001
----------------- ---------------- -----------------
Deferred acquisition costs $1,311,886 $ 1,445,740 $ 1,279,485
Present value of insurance acquired 497,993 560,305 706,773
----------------- ---------------- -----------------
$1,809,879 $ 2,006,045 $ 1,986,258
================= ================ =================
4Includes commissions, general expense, goodwill amortization, and depreciation expense.
Schedule IV - Reinsurance
Citizens Financial Corporation
For the Years Ended December 31, 2003, 2002, and 2001
Year Ended December 31 Percentage
Ceded to Assumed of Amount
Gross To Other From Other Net Assumed
Amount Companies Companies Amount To Net
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
2003:
Life insurance in force: $759,310,258 $91,480,000 $5,740,742 $673,571,000 0.9%
Premiums:
Life insurance $ 24,891,000 $ 967,059 $ 19,121 $ 23,943,062 0.1%
Accident & health insurance 9,890,928 247,512 --- 9,643,416 0.0%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
Total $ 34,781,928 $ 1,214,571 $ 19,121 $ 33,586,478 0.1%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
2002:
Life insurance in force: $792,722,000 $ 96,202,000 $6,199,775 $702,719,775 0.9%
Premiums:
Life insurance $ 29,977,144 $ 1,010,513 $ 21,896 $ 28,988,527 0.1%
Accident & health insurance 9,723,549 232,926 --- 9,490,623 0.0%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
Total $ 39,700,693 $ 1,243,439 $ 21,896 $ 38,479,150 0.1%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
2001:
Life insurance in force: $812,515,000 $109,227,000 $6,768,604 $710,056,604 1.0%
Premiums:
Life insurance $ 20,387,653 $ 1,051,574 $ 26,915 $ 19,362,994 0.1%
Accident & health insurance 9,555,188 173,806 --- 9,381,382 0.0%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
Total $ 29,942,841 $ 1,225,380 $ 26,915 $ 28,744,376 0.1%
------------------------------------- ---------------- ----------------- ---------------- ----------------- ----------------
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
OF THE REGISTRANT
The information required by this Item is set forth under the captions: "Election
of Directors", "Executive Officers", and "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Board of Director's Proxy Statement for the Annual
Meeting of Shareholders of the Company now scheduled for June 30, 2004, and such
information is here incorporated by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is set forth under the captions:
"Executive Compensation", "Board of Directors Report on Executive Compensation",
"Performance Graph" and "Compensation Committee Interlocks and Insider
Participation" of the Board of Directors' Proxy Statement for the Annual Meeting
of Shareholders of the Company now scheduled for June 30, 2004, and such
information is here incorporated by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this Item is set forth under the caption: "Security
Ownership of Certain Beneficial Owners and Management" in the Board of
Directors' Proxy Statement for the Annual Meeting of Shareholders of the Company
now scheduled for June 30, 2004, and such information is here incorporated by
reference.
ITEM 13. CERTAIN RELATIONSHIPS
AND RELATED TRANSACTIONS
The information required by this Item is set forth under the caption: "Certain
Transactions Involving Directors and Executive Officers" in the Board of
Directors' Proxy Statement for the Annual Meeting of Shareholders of the Company
now scheduled for June 30, 2004, and such information is here incorporated by
reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item is set forth under the caption:
"Independent Public Accountants" in the Board of Director's Proxy Statement for
the Annual Meeting of Shareholders of the Company now scheduled for June 30,
2004, and such information is here incorporated by reference.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
The following documents are filed as part of this Form 10-K:
(a) Financial Statements and Financial Statement Schedules.
Schedule II - Condensed Financial Information of Registrant........49
Schedule III - Supplementary Insurance Information..................52
Schedule IV - Reinsurance...........................................53
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable and
therefore have been omitted or the information is presented in the
consolidated financial statements or related notes
(b) Reports on Form 8-K.
December 23, 2003 Item 5 Other Events. The Company disclosed borrowing
$1,000,000 from its chairman.
November 8, 2003 Item 12 Results of Operations and Financial Condition.
The Company furnished a press release announcing our financial results
for the fiscal quarter ended September 30, 2003.
(c) Exhibits.
The exhibits listed in the Index to Exhibits appearing on page 57.
Pursuant to paragraph (b)(4)(iii) of Item 601 of Regulation S-K, the Company
agrees to furnish to the Commission upon request copies of instruments defining
the rights of holders of the Company's long term debt.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
CITIZENS FINANCIAL CORPORATION
March 25, 2004 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 registrant and
in the capacities and on the dates indicated.
/s/ Darrell R. Wells
---------------------------------------
Darrell R. Wells
Director and President March 25, 2004
(principal executive officer)
/s/ Len E. Schweitzer
---------------------------------------
Len E. Schweitzer
Vice President, Accounting, March 25, 2004
and Treasurer (principal financial
and accounting officer)
/s/ John H. Harralson, Jr.
---------------------------------------
John H. Harralson, Jr.
Director March 25, 2004
/s/ Frank T. Kiley
---------------------------------------
Frank T. Kiley
Director March 25, 2004
/s/ Thomas G. Ward
---------------------------------------
Thomas G. Ward
Director March 25, 2004
/s/ Margaret A. Wells
---------------------------------------
Margaret A. Wells
Director March 25, 2004
INDEX TO EXHIBITS
(Item 15(c))
The documents listed in the following table are filed as Exhibits in response to
Item 15(c). Exhibits listed that are not filed herewith are incorporated herein
by reference.
Exhibit No. Description
3.1 Restated Articles of Incorporation of the Company dated
August 12, 1996 (filed as Exhibit 3.1 to the Company's
Form 10-KSB dated March 31, 1999)
3.2 Amended and Restated Bylaws of the Company adopted
November 19, 2003 (filed herewith)
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, Inc. (filed as Exhibit 10.1 to the Company's
Form 10-K dated March 29, 1995)
10.1B Investment Management Agreement dated June 1, 1998
between United Liberty and SMC Advisors, Inc. (filed as
Exhibit 10.1B to the Company's Form 10-KSB dated
March 31, 1999)
10.1C Investment Management Agreement dated February 6, 2000
between Citizens Insurance and SMC Advisors, Inc. (filed
as Exhibit 10.1C to the Company's Form 10-KSB dated
March 29, 2000)
10.10 1999 Stock Option Plan (filed as exhibit to the Company's
proxy statement for annual meeting of shareholders held
on May 20, 1999)*
10.11 2002 Promissory Note to Darrrell R. Wells and related
Subordination Agreement (filed as Exhibit 10.11 to the
Company's Form 10-K dated April 7, 2003)
10.12 Executive Severance Plan* (filed as Exhibit 10.12 to the
Company's Form 10-K dated April 11, 2003)
10.13 2003 Promissory Note to Darrell R. Wells and related
Subordination Agreement (filed herewith)
10.14 Employment Agreement dated as of February 6, 2004 between
the Company and Frank C. Jones (field herewith)
21.2 Subsidiaries of the registrant (filed as Exhibit 21.2 to
the Company's Form 10-K dated March 30, 2002)
23.3 Consent of Independent Auditors (filed herewith)
31.1 Rule 13a-14(a) /15d-14 (a) Certification -- Principal
Executive Officer (filed herewith)
31.2 Rule 13a-14(a) /15d-14(a) Certification -- Principal
Financial Officer (filed herewith)
32.1 Section 1350 Certification - Principal Executive Officer
(filed herewith)
32.2 Section 1350 Certification - Principal Financial Officer
(filed herewith)
---------- -----------------------------------------------------------
* Management contract or compensatory plan or arrangement.