MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
OVERVIEW
Independence Holding Company, a Delaware corporation (NYSE: IHC), is a holding
company principally engaged in the life and health insurance business through:
(i) its insurance companies, Standard Security Life Insurance Company of New
York ("Standard Security Life"), Madison National Life Insurance Company, Inc.
("Madison National Life"), Independence American Insurance Company
("Independence American"); and (iii) its marketing and administrative companies,
including IHC Risk Solutions, LLC ("Risk Solutions"), IHC Health Solutions,
Inc., IHC Specialty Benefits, Inc. and Actuarial Management Corporation. These
companies are sometimes collectively referred to as the "Insurance Group", and
IHC and its subsidiaries (including the Insurance Group) are sometimes
collectively referred to as the "Company." IHC also owns a significant equity
interest in a managing general underwriter ("MGU") that writes medical stop-loss
for Standard Security Life.
IHC's health insurance products serve niche sectors of the commercial market
through multiple classes of business and varied distribution channels. Medical
Stop-Loss is marketed to large employer groups that self-insure their medical
risks; in 2012 the Company's average case size was 250 covered employee lives.
This niche is expected to grow as result of federal health care reform. The
small-group major medical product is purchased by employers with between two and
50 covered lives. With regard to those persons in the growing individual
market, IHC's products offer major medical coverage for individuals and families
and persons with short-term medical needs, and limited medical and scheduled
benefit plans through select distribution partners. Beginning in 2012,
Independence American entered the pet insurance market through a national
distributor with a long history in this niche. Standard Security Life's limited
medical product is primarily purchased by hourly workers and others who are
generally not eligible for coverage under their employer's group medical plan.
Madison National Life and Independence American offer limited and scheduled
benefit plans primarily to uninsured consumers. The dental and vision products
are marketed to large and small groups as well as individuals. With respect to
IHC's life and disability business, Madison National Life has historically sold
almost all of this business through one distribution source specializing in
serving school districts and municipalities.
While management considers a wide range of factors in its strategic planning and
decision-making, underwriting profit is consistently emphasized as the primary
goal in all decisions as to whether or not to increase our retention in a core
line, expand into new products, acquire an entity or a block of business, or
otherwise change our business model. Management's assessment of trends in
healthcare and morbidity, with respect to medical stop-loss, fully insured
medical, disability and DBL; mortality rates with respect to life insurance; and
changes in market conditions in general play a significant role in determining
the rates charged, deductibles and attachment points quoted, and the percentage
of business retained. IHC also seeks transactions that permit it to leverage its
vertically integrated organizational structure by generating fee income from
production and administrative operating companies as well as risk income for its
carriers and profit commissions. Management has always focused on managing
costs of its operations and providing its insureds with the best cost
containment tools available.
The following is a summary of key performance information and events:
The results of operations for the years ended December 31, 2012, 2011 and 2010,
are summarized as follows (in thousands):
2012 2011 2010
Revenues $ 428,061 $ 417,996 $ 435,368
Expenses 403,447 399,498 399,116
Income from continuing operations before 24,614 18,498
36,252
income taxes
Income taxes 2,003 3,732 12,583
Income from continuing operations 22,611 14,766
23,669
Discontinued operations:
Loss from discontinued operations - -
(256)
Net income 22,611 14,766
23,413
Less income from noncontrolling interests in (2,950) (1,763)
(1,676)
subsidiaries
Net income attributable to IHC $ 19,661 $ 13,003 $
21,737
·
Declared a special 10% stock dividend to IHC shareholders of record on February
17, 2012 with a distribution date of March 5, 2012. As a result, IHC issued 1.6
million shares of its common stock, net of treasury shares, with a fair value of
$15.8 million and paid cash in-lieu of fractional shares. All references to
number of common shares and earnings per share amounts have been adjusted
retroactively for all periods presented to reflect the change in capital
structure;
·
Income from continuing operations of $1.09 per share, diluted, for the year
ended December 31, 2012, compared to $.74 per share, diluted, for the year ended
December 31, 2011. Net income for 2010 includes a $16.7 million after-tax gain
on the bargain purchase of AMIC;
·
Consolidated investment yield (on an annualized basis) of 4.1% in 2012 compared
to 4.3% in 2011;
·
Announced an increase to IHC's annual dividend from $.045 to $.07 per share
·
In the fourth quarter of 2011, Standard Security Life entered into a coinsurance
agreement effective in January 2012 and transferred approximately $143 million
of group annuity reserves in the first quarter of 2012. For the year ended
December 31, 2011, net realized investment gains were $8.7 million of which a
significant portion resulted from sales of invested assets in anticipation of
the transfer of assets in accordance with the terms of such agreement in the
first quarter of 2012. As a result of such agreement, the Company wrote-off $4.6
million of deferred acquisition costs at December 31, 2011, which was more than
offset by these net realized investment gains.
·
Book value of $15.93 per common share, an increase of 10% from December 31,
2011.
The following is a summary of key performance information by segment:
·
The Medical Stop-Loss segment reported income from continuing operations before
taxes of $15.8 million and $9.0 million for the years ended December 31, 2012
and 2011, respectively. The increase is primarily due to increased volume and
improved loss ratios in 2012;
o
Premiums earned increased $25.2 million for the year ended December 31, 2012
when compared to 2011. The increase in premiums earned is primarily due to
increased volume and retention on business underwritten by Risk Solutions;
o
Underwriting experience, as indicated by its GAAP Combined Ratios, for the
Medical Stop-Loss segment is as follows (in thousands):
2012 2011 2010
Premiums Earned $ 139,724 $ 114,478 $ 121,156
Insurance Benefits, Claims & Reserves 90,406 75,490 89,968
Expenses 38,350 34,047 32,404
Loss Ratio(A) 64.7% 65.9% 74.3%
Expense Ratio (B) 27.4% 29.8% 26.7%
Combined Ratio (C) 92.1% 95.7% 101.0%
o
Loss ratios for the year ended December 31, 2012 decreased due to improved
underwriting results in business produced by both Risk Solutions and by
independent MGUs.
o
The expense ratio decreased for the year ended December 31, 2012 primarily due
to a decrease in profit commission expense as a result of poor performance on
certain business written through one program at AMIC.
(A)
Loss ratio represents insurance benefits claims and reserves divided by premiums
earned.
(B)
Expense ratio represents net commissions, administrative fees, premium taxes and
other underwriting expenses divided by premiums earned.
(C)
The combined ratio is equal to the sum of the loss ratio and the expenses ratio.
·
The Fully Insured Health segment reported $4.4 million of income from continuing
operations before taxes for the year ended December 31, 2012 as compared to $7.7
million for the year ended December 31, 2011;
o
Premiums earned increased $0.2 million year ended December 31, 2012 over the
comparable period in 2011. An increase in premiums during the year from the new
pet insurance line of business at AMIC was offset by decreases in volume and
retentions in certain other lines of the business;
o
Underwriting experience as indicated by its GAAP Combined Ratios, for the Fully
Insured segment is as follows (in thousands):
2012 2011 2010
Premiums Earned $ 141,546 $ 141,322 $ 120,818
Insurance Benefits, Claims & Reserves 94,700 89,040 81,676
Expenses 43,639 44,535 35,192
Loss Ratio 66.9% 63.0% 67.6%
Expense Ratio 30.8% 31.5% 29.1%
Combined Ratio 97.7% 94.5% 96.7%
o
The increase in the loss ratio was primarily attributable to an increase in the
claims experience on major medical business for groups and individuals not
administered by Health Solutions and dental.
o
The underwriting expense ratio decreased primarily as a result of a decrease in
general expenses.
·
Income before taxes from the Group disability, life, annuities and DBL segment
increased $6.9 million for the year ended December 31, 2012 compared to 2011
primarily as a result of the write-off of deferred acquisition costs in
connection with the sale of group annuity contracts in 2011, in addition to
better loss ratios in the group term life line;
·
Income before taxes from the Individual life, annuities and other segment
increased $0.5 million for the year ended December 31, 2012 compared to the
prior year primarily due to new business written;
·
Income before taxes from the Corporate segment decreased $1.9 million for the
year ended December 31, 2012 compared to the prior year primarily due to an
increase in corporate expenses and a decrease in investment income due to the
redemption of a partnership interest;
·
Net realized investment gains were $5.1 million for the year ended December 31,
2012 compared to $8.7 million in 2011. A significant portion of the net realized
investment gains in 2011 resulted from sales of invested assets in anticipation
of a transfer of assets in the first quarter of 2012 in accordance with the
terms of a coinsurance agreement.
·
Other-than-temporary impairment losses recognized in earnings for the years
ended December 31, 2012 and 2011 were $0.7 million and $1.5 million,
respectively; and
·
Premiums by principal product for the years indicated are as follows (in
thousands):
Gross Direct and Assumed
Earned Premiums: 2012 2011 2010
Medical Stop-Loss $ 168,596 $ 146,209 $ 161,530
Fully Insured Health 224,377 209,174 207,409
Group disability; life, annuities and DBL 90,935 94,688 102,986
Individual life, annuities and other
31,728 35,470 34,549
$ 515,636 $ 485,541 $ 506,474
Net Premiums Earned: 2012 2011 2010
Medical Stop-Loss $ 139,724 $ 114,478 $ 121,156
Fully Insured Health 141,546 141,322 120,818Group disability; life, annuities and DBL 49,315 50,698 55,828
Individual life, annuities and other
25,482 29,916 28,344
$ 356,067 $ 336,414 $ 326,146
Information pertaining to the Company's business segments is provided in Note 21
of Notes to Consolidated Financial Statements included in Item 8.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies of the Company conform to U.S. GAAP. The
preparation of the Consolidated Financial Statements in conformity with GAAP
requires the Company's 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. A summary of the Company's
significant accounting policies and practices is provided in Note 1 of the Notes
to the Consolidated Financial Statements included in Item 8 of this report.
Management has identified the accounting policies described below as those that,
due to the judgments, estimates and assumptions inherent in those policies, are
critical to an understanding of the Company's Consolidated Financial Statements
and this Management's Discussion and Analysis.
Insurance Premium Revenue Recognition and Policy Charges
Health
Premiums for short-duration medical insurance contracts are intended to cover
expected claim costs resulting from insured events that occur during a fixed
period of short duration. The Company has the ability to not renew the contract
or to revise the premium rates at the end of each annual contract period to
cover future insured events. Insurance premiums from annual health contracts are
collected monthly and are recognized as revenue evenly as insurance protection
is provided.
Premiums related to long-term and short-term disability contracts are recognized
on a pro rata basis over the applicable contract term.
Life
Traditional life insurance products consist principally of products with fixed
and guaranteed premiums and benefits, primarily term and whole life insurance
products. Premiums from these products are recognized as revenue when due.
Annuities and interest-sensitive life contracts, such as universal life and
interest-sensitive whole life, are contracts whose terms are not fixed and
guaranteed. Premiums from these policies are reported as funds on deposit.
Policy charges consist of fees assessed against the policyholder for cost of
insurance (mortality risk), policy administration and early surrender. These
revenues are recognized when assessed against the policyholder account balance.
Policies that do not subject the Company to significant risk arising from
mortality or morbidity are considered investment contracts. Deposits received
from such contracts are reported as other policyholder funds. Policy charges for
investment contracts consist of fees assessed against the policyholder account
for maintenance, administration and surrender of the policy prior to
contractually specified dates, and are recognized when assessed against the
policyholder account balance.
Insurance Reserves
The Company maintains loss reserves to cover its estimated liability for unpaid
losses and loss adjustment expenses, where material, (including legal, other
fees, and costs not associated with specific claims but related to the claims
payment function) for reported and unreported claims incurred as of the end of
each accounting period. These loss reserves are based on actuarial assumptions
and are maintained at levels that are in accordance with U.S. generally accepted
accounting principles. Many factors could affect these reserves, including
economic and social conditions, frequency and severity of claims, medical trend
resulting from the influences of underlying cost inflation, changes in
utilization and demand for medical services, and changes in doctrines of legal
liability and damage awards in litigation. Therefore, the Company's reserves are
necessarily based on estimates, assumptions and analysis of historical
experience. The Company's results depend upon the variation between actual
claims experience and the assumptions used in determining reserves and pricing
products. Reserve assumptions and estimates require significant judgment and,
therefore, are inherently uncertain. The Company cannot determine with precision
the ultimate amounts that will be paid for actual claims or the timing of those
payments. The Company's estimate of loss represents management's best estimate
of the Company's liability at the balance sheet date.
Loss reserves differ for short-duration and long-duration insurance policies,
including annuities. Reserves are based on approved actuarial methods, but
necessarily include assumptions about expenses, mortality, morbidity, lapse
rates and future yield on related investments.
All of the Company's short-duration contracts are generated from its accident
and health business, and are accounted for based on actuarial estimates of the
amount of loss inherent in that period's claims, including losses incurred for
which claims have not been reported. Short-duration contract loss estimates rely
on actuarial observations of ultimate loss experience for similar historical
events.
Management believes that the Company's methods of estimating the liabilities for
insurance reserves provided appropriate levels of reserves at December 31, 2012.
Changes in the Company's reserve estimates are recorded through a charge or
credit to its earnings.
Health
The Company believes that its recorded insurance reserves are reasonable and
adequate to satisfy its ultimate liability. The Company primarily uses its own
loss development experience, but will also supplement that with data from its
outside actuaries, reinsurers and industry loss experience as warranted.
To illustrate the impact that Loss Ratios have on the Company's loss reserves
and related expenses, each hypothetical 1% change in the Loss Ratio for the
health business (i.e., the ratio of insurance benefits, claims and settlement
expenses to earned health premiums) for the year ended December 31, 2012, would
increase reserves (in the case of a higher ratio) or decrease reserves (in the
case of a lower ratio) by approximately $3.2 million with a corresponding
increase or decrease in the pre-tax expense for insurance benefits, claims and
reserves in the Consolidated Statement of Operations. Depending on the
circumstances surrounding a change in the Loss Ratio, other pre-tax amounts
reported in the Consolidated Statement of Operations could also be affected,
such as amortization of deferred acquisition costs and commission expense.
The Company's health reserves by segment are as follows (in thousands):
December 31, 2012
Claim Policy Total Health
Reserves Claims Reserves
Medical Stop-Loss $ 59,029 $ - $ 59,029
Fully Insured Health 40,747 - 40,747
Group Disability 76,109 11,062 87,171Individual Accident and Health
and Other 7,278 255 7,533
$ 183,163 $ 11,317 $ 194,480
December 31, 2011
Claim Policy Total Health
Reserves Claims Reserves
Medical Stop-Loss $ 58,741 $ - $ 58,741
Fully Insured Health 32,508 - 32,508
Group Disability 79,571 13,707 93,278Individual Accident and Health
and Other 8,222 238 8,460
$ 179,042 $ 13,945 $ 192,987
Medical Stop-Loss
All of the Company's Medical Stop-Loss policies are short-duration and are
accounted for based on actuarial estimates of the amount of loss inherent in
that period's claims or open claims from prior periods, including losses
incurred for claims that have not been reported ("IBNR"). Short-duration
contract loss estimates rely on actuarial observations of ultimate loss
experience for similar historical events.
The two "primary" assumptions underlying the calculation of loss reserves for
Medical Stop-Loss business are (i) projected Net Loss Ratio, and (ii) claim
development patterns. The projected Net Loss Ratio is set at expected levels
consistent with the underlying assumptions ("Projected Net Loss Ratio"). Claim
development patterns are set quarterly as reserve estimates are developed and
are based on recent claim development history ("Claim Development Patterns").
The Company uses the Projected Net Loss Ratio to establish reserves until
developing losses provide a better indication of ultimate results and it is
feasible to set reserves based on Claim Development Patterns. The Company has
concluded that a reasonably likely change in the Projected Net Loss Ratio
assumption could have a material effect on the
Company's financial condition, results of operations, or liquidity ("Material
Effect") but a reasonably likely change in the Claim Development Pattern would
not have a Material Effect.
Projected Net Loss Ratio
Generally, during the first twelve months of an underwriting year, reserves for
Medical Stop-Loss are first set at the Projected Net Loss Ratio, which is set
using assumptions developed using completed prior experience trended forward.
The Projected Net Loss Ratio is the Company's best estimate of future
performance until such time as developing losses provide a better indication of
ultimate results.
While the Company establishes a best estimate of the Projected Net Loss Ratio,
actual experience may deviate from this estimate. This was the case with the
2009, 2010 and 2011 underwriting years which deviated by 1.5, (1.3) and 0.8 Net
Loss Ratio points, respectively. After the recorded reserve estimate, it is
reasonably likely that the actual experience will fall within a range up to five
Net Loss Ratio points above or below the expected Projected Net Loss Ratio for
the 2012 underwriting year at December 31, 2012. The impact of these reasonably
likely changes at December 31, 2012, would be an increase in net reserves (in
the case of a higher ratio) or a decrease in net reserves (in the case of a
lower ratio) of up to approximately $3.3 million with a corresponding increase
or decrease in the pre-tax expense for insurance benefits, claims and reserves
in the 2012 Consolidated Statement of Operations.
Major factors that affect the Projected Net Loss Ratio assumption in reserving
for Medical Stop-Loss relate to: (i) frequency and severity of claims; (ii)
changes in medical trend resulting from the influences of underlying cost
inflation, changes in utilization and demand for medical services, the impact of
new medical technology and changes in medical treatment protocols; and (iii) the
adherence to the Company's underwriting guidelines. Changes in these underlying
factors are what determine the reasonably likely changes in the Projected Net
Loss Ratio as discussed above.
Claim Development Patterns
Subsequent to the first twelve months of an underwriting year, the Company's
developing losses provide a better indication of ultimate losses. At this point,
claims have developed to a level where Claim Development Patterns can be applied
to generate reasonably reliable estimates of ultimate claim levels. Development
factors based on historical patterns are applied to paid and reported claims to
estimate fully developed claims. Claim Development Patterns are reviewed
quarterly as reserve estimates are developed and are based on recent claim
development history. The Company must determine whether changes in development
represent true indications of emerging experience or are simply due to random
claim fluctuations.
The Company also establishes its best estimates of claim development factors to
be applied to more developed treaty year experience. While these factors are
based on historical Claim Development Patterns, actual claim development may
vary from these estimates. The Company does not believe that reasonably likely
changes in its actual claim development patterns would have a Material Effect.
Predicting ultimate claims and estimating reserves in Medical Stop-Loss is more
complex than fully insured medical and disability business due to the "excess of
loss" nature of these products with very high deductibles applying to specific
claims on any individual claimant and in the aggregate for a given group. The
level of these deductibles makes it more difficult to predict the amount and
payment pattern of such claims. Fluctuations in results for specific coverage
are primarily due to the severity and frequency of individual claims, whereas
fluctuations in aggregate coverage are largely attributable to frequency of
underlying claims rather than severity. Liabilities for first dollar medical
reserves and disability coverages are computed using completion factors and
expected Net Loss Ratios derived from actual historical premium and claim data.
Due to the short-term nature of Medical Stop-Loss, redundancies or deficiencies
will typically emerge during the course of the following year rather than over a
number of years. For Employer Stop-Loss, as noted above, the Company maintains
its reserves based on underlying assumptions until it determines that an
adjustment is appropriate based on emerging experience from all of its MGUs
for
prior underwriting years.
Fully Insured Health
Reserves for fully insured medical and dental business are established using
historical claim development patterns. Claim development by number of months
elapsed from the incurred month is studied each month and development factors
are calculated. These claim development factors are then applied to the amount
of claims paid to date for each incurred month to estimate fully complete
claims. The difference between fully complete claims and the claims paid to date
is the estimated reserve. Total reserves are the sum of the reserves for all
incurred months.
The primary assumption in the determination of fully insured reserves is that
historical claim development patterns tend to be representative of future claim
development patterns. Factors which may affect this assumption include changes
in claim payment processing times and procedures, changes in product design,
changes in time delay in submission of claims, and the incidence of unusually
large claims. The reserving analysis includes a review of claim processing
statistical measures and large claim early notifications; the potential impacts
of any changes in these factors are minimal. The time delay in submission of
claims tends to be stable over time and not subject to significant volatility.
Since our analysis considered a variety of outcomes related to these factors,
the Company does not believe that any reasonably likely change in these factors
will have a Material Effect.
Group Disability
The Company's Group Disability segment is comprised of Long Term Disability
("LTD") and Disability Benefits Law ("DBL"). The two "primary" assumptions on
which Group Disability reserves are based are: (i) morbidity levels; and (ii)
recovery rates. If morbidity levels increase, for example due to an epidemic or
a recessionary environment, the Company would increase reserves because there
would be more new claims than expected. In regard to the assumed recovery rate,
if disabled lives recover more quickly than anticipated then the existing claims
reserves would be reduced; if less quickly, the existing claims reserves would
be increased. Advancements in medical treatments could affect future recovery,
termination, and mortality rates. With respect to LTD only, other assumptions
are: (i) changes in market interest rates; (ii) changes in offsets; (iii)
advancements in medical treatments; and (iv) cost of living. Changes in market
interest rates could change reserve assumptions since the payout period could be
as long as 40 years. Changes in offsets such as Social Security benefits,
retirement plans and state disability plans also impact reserving. As a result
of the forgoing assumptions, it is possible that the historical trend may not be
an accurate predictor of the future development of the block. As with most long
term insurance reserves that require judgment, the reserving process is subject
to uncertainty and volatility and fluctuations may not be indicative of the
claim development overall.
While the Company believes that larger variations are possible, the Company does
not believe that reasonably likely changes in its "primary" assumptions would
have a Material Effect.
Individual Accident and Health and Other
This segment is a combination of closed lines of business as well as certain
small existing lines. While the assumptions used in setting reserves vary
between these different lines of business, the assumptions would generally
relate to the following: (i) the rate of disability; (ii) the morbidity rates on
specific diseases; and (iii) accident rates. The reported reserves are based on
management's best estimate for each line within this segment. General
uncertainties that surround all insurance reserving methodologies would apply.
However, since the Company has so few policies of this type, volatility may
occur due to the small number of claims.
Life
For traditional life insurance products, the Company computes insurance reserves
primarily using the net premium method based on anticipated investment yield,
mortality, and withdrawals. These methods are widely used in the life insurance
industry to estimate the liabilities for insurance reserves. Inherent in these
calculations are management and actuarial judgments and estimates that could
significantly impact the ending reserve liabilities and, consequently, operating
results. Actual results may differ, and these estimates are subject to
interpretation and change.
Policyholder funds represent interest-bearing liabilities arising from the sale
of products, such as universal life, interest-sensitive life and annuities.
Policyholder funds are comprised primarily of deposits received and interest
credited to the benefit of the policyholder less surrenders and withdrawals,
mortality charges and administrative expenses.
Interest Credited
Interest credited to policyholder funds represents interest accrued or paid on
interest-sensitive life policies and investment policies. Amounts charged to
operations (including interest credited and benefit claims incurred in excess of
related policyholder account balances) are reported as insurance benefits,
claims and reserves-life and annuity. Credit rates for certain annuities and
interest-sensitive life policies are adjusted periodically by the Company to
reflect current market conditions, subject to contractually guaranteed minimum
rates.
Deferred Acquisition Costs
Costs that vary with and are primarily related to acquiring insurance policies
and investment type contracts are deferred and recorded as deferred policy
acquisition costs ("DAC"). These costs are principally broker fees, agent
commissions, and the purchase prices of the acquired blocks of insurance
policies and investment type policies. DAC is amortized to expense and reported
separately in the Consolidated Statements of Operations. All DAC within a
particular product type is amortized on the same basis using the following
methods:
For traditional life insurance and other premium paying policies, amortization
of DAC is charged to expense over the related premium revenue recognition
period. Assumptions used in the amortization of DAC are determined based upon
the conditions as of the date of policy issue or assumption and are not
generally revised during the life of the policy.
For long duration type contracts, such as annuities and universal life business,
amortization of DAC is charged to expense over the life of the underlying
contracts based on the present value of the estimated gross profits ("EGPs")
expected to be realized over the life of the book of contracts. EGPs consist of
margins based on expected mortality rates, persistency rates, interest rate
spreads, and other revenues and expenses. The Company regularly evaluates its
EGPs to determine if actual experience or other evidence suggests that earlier
estimates should be revised. If the Company determines that the current
assumptions underlying the EGPs are no longer the best estimate for the future
due to changes in actual versus expected mortality rates, persistency rates,
interest rate spreads, or other revenues and expenses, the future EGPs are
updated using the new assumptions and prospective unlocking occurs. These
updated EGPs are utilized for future amortization calculations. The total
amortization recorded to date is adjusted through a current charge or credit to
the Consolidated Statements of Operations.
Internal replacements of insurance and investment contracts determined to result
in a replacement contract that is substantially changed from the original
contract will be accounted for as an extinguishment of the original contract,
resulting in a release of the unamortized deferred acquisition costs, unearned
revenue, and deferral of sales inducements associated with the replaced
contract.
Investments
The Company has classified all of its investments as either available-for-sale
or trading securities. These investments are carried at fair value with
unrealized gains and losses reported through other comprehensive income for
available-for-sale securities or as unrealized gains or losses in the
Consolidated Statements of Operations for trading securities. Fixed maturities
and equity securities available-for-sale totaled $735.2 million and $880.4
million at December 31, 2012 and 2011, respectively. Premiums and discounts on
debt securities purchased at other than par value are amortized and accreted,
respectively, to interest income in the Consolidated Statements of Operations,
using the constant yield method over the period to maturity. Net realized gains
and losses on investments are computed using the specific identification method
and are reported in the Consolidated Statements of Operations.
Fair value is determined using quoted market prices when available. In some
cases, we use quoted market prices for similar instruments in active markets
and/or model-derived valuations where inputs are observable in active markets.
When there are limited or inactive trading markets, we use industry-standard
pricing methodologies, including discounted cash flow models, whose inputs are
based on management assumptions and available current market information.
Further, we retain independent pricing vendors to assist in valuing certain
instruments. Most of the securities in our portfolio are classified in either
Level 1 or Level 2 of the Fair Value Hierarchy.
The Company periodically reviews and assesses the vendor's qualifications and
the design and appropriateness of its pricing methodologies. Management will on
occasion challenge pricing information on certain individual securities and,
through communications with the vendor, obtain information about the
assumptions, inputs and methodologies used in pricing those securities, and
corroborate it against documented pricing methodologies. Validation procedures
are in place to determine completeness and accuracy of pricing information,
including, but not limited to: (i) review of exception reports that (a) identify
any zero or un-priced securities; (b) identify securities with no price change;
and (c) identify securities with significant price changes; (ii) performance of
trend analyses; (iii) periodic comparison of pricing to alternative pricing
sources; and (iv) comparison of pricing changes to expectations based on rating
changes, benchmarks or control groups. In certain circumstances, pricing is
unavailable from the vendor and broker pricing information is used to determine
fair value. In these instances, management will assess the quality of the data
sources, the underlying assumptions and the reasonableness of the broker quotes
based on the current market information available. To determine if an exception
represents an error, management will often have to exercise judgment. Procedures
to resolve an exception vary depending on the significance of the security and
its related class, the frequency of the exception, the risk of material
misstatement, and the availability of information for the security. These
procedures include, but are not limited to; (i) a price challenge process with
the vendor; (ii) pricing from a different vendor; (iii) a reasonableness review;
(iv) a change in price based on better information, such as an actual market
trade, among other things. Management considers all facts and relevant
information obtained during the above procedures to determine the proper
classification of each security in the Fair Value Hierarchy.
Declines in value of securities available-for-sale that are judged to be
other-than-temporary are determined based on the specific identification method.
The Company reviews its investment securities regularly and determines whether
other-than-temporary impairments have occurred. The factors considered by
management in its regular review to identify and recognize other-than-temporary
impairment losses on fixed maturities include, but are not limited to: the
length of time and extent to which the fair value has been less than cost; the
Company's intent to sell, or be required to sell, the debt security before the
anticipated recovery of its remaining amortized cost basis; the financial
condition and near-term prospects of the issuer; adverse changes in ratings
announced by one or more rating agencies; subordinated credit support; whether
the issuer of a debt security has remained current on principal and interest
payments; current expected cash flows; whether the decline in fair value appears
to be issuer specific or, alternatively, a reflection of general market or
industry conditions including the effect of
changes in market interest rates. If the Company intends to sell a debt
security, or it is more likely than not that it would be required to sell a debt
security before the recovery of its amortized cost basis, the entire difference
between the security's amortized cost basis and its fair value at the balance
sheet date would be recognized by a charge to total other-than-temporary
impairment losses in the Consolidated Statement of Operations. If a decline in
fair value of a debt security is judged by management to be other-than-temporary
and; (i) the Company does not intend to sell the security; and (ii) it is not
more likely than not that it will be required to sell the security prior to
recovery of the security's amortized cost, the Company assesses whether the
present value of the cash flows to be collected from the security is less than
its amortized cost basis. To the extent that the present value of the cash flows
generated by a debt security is less than the amortized cost basis, a credit
loss exists. For any such security, the impairment is bifurcated into (a) the
amount of the total impairment related to the credit loss, and (b) the amount of
the total impairment related to all other factors. The amount of the
other-than-temporary impairment related to the credit loss is recognized by a
charge to total other-than-temporary impairment losses in the Consolidated
Statement of Operations, establishing a new cost basis for the security. The
amount of the other-than-temporary impairment related to all other factors is
recognized in other comprehensive income in the Consolidated Balance Sheet. It
is reasonably possible that further declines in estimated fair values of such
investments, or changes in assumptions or estimates of anticipated recoveries
and/or cash flows, may cause further other-than-temporary impairments in the
near term, which could be significant.
In assessing corporate debt securities for other-than-temporary impairment, the
Company evaluates the ability of the issuer to meet its debt obligations and the
value of the company or specific collateral securing the debt position. For
mortgage-backed securities where loan level data is not available, the Company
uses a cash flow model based on the collateral characteristics. Assumptions
about loss severity and defaults used in the model are primarily based on actual
losses experienced and defaults in the collateral pool. Prepayment speeds, both
actual and estimated, are also considered. The cash flows generated by the
collateral securing these securities are then determined with these default,
loss severity and prepayment assumptions. These collateral cash flows are then
utilized, along with consideration for the issue's position in the overall
structure, to determine the cash flows associated with the mortgage-backed
security held by the Company. In addition, the Company evaluates other
asset-backed securities for other-than-temporary impairment by examining similar
characteristics referenced above for mortgage-backed securities. The Company
evaluates U.S. Treasury securities and obligations of U.S. Government
corporations, U.S. Government agencies, and obligations of states and political
subdivisions for other-than-temporary impairment by examining the terms and
collateral of the security.
Equity securities may experience other-than-temporary impairment in the future
based on the prospects for full recovery in value in a reasonable period of time
and the Company's ability and intent to hold the security to recovery. If a
decline in fair value is judged by management to be other-than-temporary or
management does not have the intent or ability to hold a security, a loss is
recognized by a charge to total other-than-temporary impairment losses in the
Consolidated Statement of Operations. For the purpose of other-than-temporary
impairment evaluations, preferred stocks with maturities are treated in a manner
similar to debt securities. Declines in the creditworthiness of the issuer of
debt securities with both debt and equity-like features requires the use of the
equity model in analyzing the security for other-than-temporary impairment.Goodwill and Other Intangible Assets
Goodwill carrying amounts are evaluated for impairment, at least annually, at
the reporting unit level which is equivalent to an operating segment. If the
fair value of a reporting unit is less than its carrying amount, further
evaluation is required to determine if a write-down of goodwill is required. In
determining the fair value of each reporting unit, we used an income approach,
applying a discounted cash flow method which included a residual value. Based
on historical experience, we make assumptions as to: (i) expected future
performance and future economic conditions, (ii) projected operating earnings,
(iii) projected new and renewal business as well as profit margins on such
business, and (iv) a discount
rate that incorporated an appropriate risk level for the reporting unit. Any
impairment of goodwill would be charged to expense. No impairment charge for
goodwill was required in 2012, 2011 or 2010.
Other intangible assets are amortized to expense over their estimated useful
lives and are subject to impairment testing. Any impairment write-down of other
intangible assets would be charged to expense. No impairment charges for
intangible assets were required in 2012, 2011 or 2010.
At December 31, 2012, the Company's market capitalization was less than its book
value indicating a potential impairment of goodwill. As a result, the Company
assessed the factors contributing to the performance of IHC stock in 2012. The
Company does not believe that an impairment of goodwill exists at this time.
If we experience a sustained decline in our results of operations and cash
flows, or other indicators of impairment exist, we may incur a material non-cash
charge to earnings relating to impairment of our goodwill, which could have a
material adverse effect on our results.
Deferred Income Taxes
The provision for deferred income taxes is based on the asset and liability
method of accounting for income taxes. Under this method, deferred income taxes
are recognized by applying enacted statutory tax rates to temporary differences
between amounts reported in the Consolidated Financial Statements and the tax
bases of existing assets and liabilities. A valuation allowance is recognized
for the portion of deferred tax assets that, in management's judgment, is not
likely to be realized. The effect on deferred income taxes of a change in tax
rates or laws is recognized in income tax expense in the period that includes
the enactment date. The Company has certain tax-planning strategies that were
used in determining that a valuation allowance was not necessary on its deferred
taxes.
RESULTS OF OPERATIONS
Results of Operations for the Year Ended December 31, 2012 Compared to the Year
Ended December 31, 2011
Information by business segment for the year ended December 31, 2012 and 2011 is
as follows:
Benefits, Amortization Selling,
December 31, Net Fee and Claims of Deferred General
2012 Premiums Investment Other and Acquisition and
(In thousands) Earned Income Income Reserves Costs Administrative Total
Medical stop-loss $ 139,724 4,990 1,664 90,406 - 40,154 $ 15,818
Fully Insured 141,546 1,733 28,213 94,700 17 72,415 4,360
Group disability,
life, annuities
and DBL 49,315 2,618 116 27,663 - 15,779 8,607
Individual life,
annuities
and other 25,482 23,475 4,250 32,022 6,549 13,731 905
Corporate - 540 - - - 7,920 (7,380)
Sub total $ 356,067 $ 33,356 $ 34,243 $ 244,791 $ 6,566 $ 149,999 22,310
Net realized investment gains 5,099
Other-than-temporary impairment losses (704)
Interest expense (2,091)
Income from continuing operations before income taxes 24,614
Income taxes 2,003
Income from continuing operations
$ 22,611
Benefits, Amortization Selling,
December 31, Net Fee and Claims of Deferred General
2011 Premiums Investment Other and Acquisition and
(In thousands) Earned Income Income Reserves Costs Administrative Total
Medical stop-loss $ 114,478 4,399 4,620 75,490 - 39,024 $ 8,983
Fully Insured 141,322 1,429 25,149 89,040 21 71,147 7,692
Group disability,
life, annuities
and DBL 50,698 9,495 183 37,946 5,099 15,598 1,733
Individual life,
annuities
and other 29,916 23,492 4,695 36,386 6,449 14,879 389
Corporate - 973 - - - 6,454 (5,481)
Sub total $ 336,414 $ 39,788 $ 34,647 $ 238,862 $ 11,569 $ 147,102 13,316
Net realized investment gains 8,670
Other-than-temporary impairment losses (1,523)
Interest expense (1,965)
Income from continuing operations before income taxes 18,498
Income taxes 3,732
Income from continuing operations
$ 14,766
Premiums Earned
In 2012, premiums earned increased $19.7 million over the comparable period of
2011. The increase is primarily due to: (i) an $25.2 million increase in the
Medical Stop-Loss segment due to increased volume and retention of business in
2012; and (ii) a $0.2 million increase in the Fully Insured Health segment
primarily as a result of premiums from the new pet and international lines of
business, partially offset by decreased retentions and premium volume in the
short term medical business, major medical business for groups and individuals,
limited medical and dental lines of business; partially offset by (iii) a
decrease of $4.4 million of earned premiums in the Individual life, annuities
and other segment primarily as a result of the transfer of certain annuity
contracts in the fourth quarter of 2011and decreased premium volume from other
lines in run-off; and (iv) a $1.4 million decrease in the Group disability,
life, annuities and DBL segment primarily due to decreased premiums from the
group term life and LTD lines
due in part to reduced production sources, partially offset by premiums
generated by a new line of international LTD and life business.
Net Investment Income
Total net investment income decreased $6.4 million. The overall annualized
investment yields were 4.1% and 4.3% (approximately 4.2% and 4.4%, on a tax
advantaged basis) for 2012 and 2011, respectively. The overall decrease was
primarily a result of a decrease in investment income on bonds, equities and
short-term investments due to the transfer of $143.5 million of assets in the
first quarter of 2012 related to a coinsurance treaty. The annualized
investment yields on bonds, equities and short-term investments were 3.8% and
4.1% in 2012 and 2011, respectively. IHC has approximately $197.5 million in
highly rated shorter duration securities earning on average 1.6%. A portfolio
that is shorter in duration enables us, if we deem prudent, the flexibility to
reinvest in much higher yielding longer-term securities, which would
significantly increase investment income.
Net Realized Investment Gains and Other-Than-Temporary Impairment Losses, Net
The Company had net realized investment gains of $5.1 million in 2012 compared
to $8.7 million in 2011. These amounts include gains and losses from sales of
fixed maturities and equity securities available-for-sale and other investments.
Decisions to sell securities are based on management's ongoing evaluation of
investment opportunities and economic and market conditions, thus creating
fluctuations in gains and losses from period to period. A significant portion of
the net realized investment gains in 2011 resulted from sales of invested assets
in anticipation of a transfer of assets in the first quarter of 2012 in
accordance with the terms of a coinsurance agreement.
For the year ended December 31, 2012 and 2011, the Company recorded $0.7 million
and $1.5 million, respectively, of other-than-temporary impairment losses in
earnings. The other-than-temporary impairment losses in 2012 consist of credit
losses resulting from expected cash flows of debt securities that are less than
their amortized cost. In 2011, other-than-temporary impairment losses recognized
in earnings consist of $1.3 million of credit losses resulting from expected
cash flows of debt securities that are less than the debt securities' amortized
cost and $0.2 million of losses resulting from the Company's intent to sell
certain corporate debt securities prior to the recovery of their amortized
cost
bases.
Fee Income and Other Income
Fee income increased $0.7 million for the year ended December 31, 2012 compared
to the year ended December 31, 2011 primarily as a result of the increased
volume of gross business in certain lines of the Fully Insured Health segment
offset by decreased fee income from the Medical Stop-Loss segment due to
increased retentions.
Total other income decreased $1.0 million in the year ended December 31, 2012 to
$5.0 million from $6.0 million in the year ended December 31, 2011 primarily due
to business in run-off.
Insurance Benefits, Claims and Reserves
In 2012, insurance, benefits, claims and reserves increased $5.9 million over
the comparable period in 2011. The decrease is primarily attributable to: (i) an
increase of $14.9 million in the Medical Stop-Loss segment as a result of an
increase in premium volume by Risk Solutions, offset by improved loss ratios;
and (ii) an increase of $5.7 million in the Fully Insured Health segment,
principally due to increases arising from the new pet and international lines of
business offset by volume decreases in the short term medical and dental lines
of business; partially offset by (iii) a $10.3 million decrease in the Group
disability, life, annuities and DBL segment as a result of lower production
coupled with lower loss ratios in the LTD line and the transfer of certain
annuity contracts in the fourth quarter of 2011; (iv) a $4.4 million decrease in
the Individual life, annuity and other segment primarily resulting from the
transfer of certain group annuity contracts in the fourth quarter of 2011 and
decreased premium volume from other lines in run-off.
Amortization of Deferred Acquisition Costs
Amortization of deferred acquisition costs in 2011 includes the write-off of
$4.6 million of deferred acquisition costs that were recorded in connection with
a coinsurance agreement. Excluding this write-off in 2011, amortization of
deferred acquisition costs decreased $0.3 million.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased $2.9 million. The
increase is primarily due to: (i) a $1.2 million increase in commissions and
other general expenses in the Medical Stop-Loss segment as a result of increased
production; (ii) a $1.3 million increase in the Fully Insured Health segment
largely due to commissions and other general expenses related to the new pet and
international lines of business partially offset by decreases in expenses
resulting from the decreased retentions and premium volume in the short term
medical business, major medical business for groups and individuals, limited
medical and dental lines of business; and (iii) an increase of $1.5 million in
corporate overhead expenses due to employee, option, SAR and benefit related
expenses; partially offset by (iv) a $1.1 million decrease in the individual
life, annuities and other segment primarily a result of decreases in volume from
the transfer of certain group annuity contracts in the fourth quarter of 2011
and decreased volume from other lines in run-off.
Income Taxes
In 2012, the Company recorded a $5.9 million credit to federal income taxes as a
result of the reduction in AMIC's valuation allowance related to its deferred
tax asset at December 31, 2012. Excluding this transaction, the effective tax
rate for the year ended December 31, 2012 was 32.1%. In 2011, IHC eliminated
$2.3 million of previously recorded deferred income taxes due to management's
intention to adopt tax planning strategies to recover its investment in AMIC in
a tax-free manner. Excluding this transaction, the effective tax rate for the
year ended December 31, 2011 was 32.4%. The lower effective tax rate in 2012 was
due to a higher benefit from tax advantaged securities as a percentage of income
in 2012.
Results of Operations for the Year Ended December 31, 2011 Compared to the Year
Ended December 31, 2010
Acquisition of AMIC
On March 5, 2010, IHC acquired a controlling interest in AMIC as a result of the
purchase of AMIC common stock in the open market. In determining the bargain
purchase gain with regard to the acquisition of the controlling interest in
AMIC, IHC first recognized a gain of $2.2 million as a result of re-measuring
its equity interest in AMIC to its fair value of $22.0 million immediately
before the acquisition based on the closing market price of AMIC's common stock.
Then, upon the acquisition of a controlling interest on March 5, 2010, the
Company consolidated the net assets of AMIC. Accordingly, the Company determined
the fair value of the identifiable assets acquired and liabilities assumed from
AMIC on such date. The fair value of the net assets acquired exceeded the sum
of: (i) the fair value of the consideration paid; (ii) the fair value of IHC's
equity investment prior to the acquisition; and (iii) the fair value of the
noncontrolling interests in AMIC, resulting in a bargain purchase gain of $25.6
million. The total gain, amounting to $27.8 million pre-tax, is included in gain
on bargain purchase of AMIC on the Company's Consolidated Statement of
Operations. This gain is a result of the quoted market price of AMIC being
significantly less than the fair value of the net assets of AMIC. This
disparity is due to the low trading volume in AMIC shares, and a discount on the
shares traded due to a lack of control by
minority shareholders. The fair value of the noncontrolling interests in AMIC
was based on the closing market price of AMIC's common stock.
Prior to obtaining control, IHC recorded its investment in AMIC using the equity
method. IHC recorded changes in its investment in AMIC in the "Equity income
from AMIC" line in the Consolidated Statements of Operations. Upon achieving
control, on March 5, 2010, AMIC's income and expense amounts became consolidated
with IHC's results. Accordingly, the individual line items on the Consolidated
Statement of Operations for 2010 reflect approximately ten months of the
operations of AMIC.
Information by business segment for the year ended December 31, 2011 and 2010 is
as follows:
Equity Benefits, Amortization Selling,
December 31, Net Income Fee and Claims of Deferred General
2011 Premiums Investment From Other and Acquisition and
(In thousands) Earned Income AMIC Income Reserves Costs Administrative Total
Medical stop-loss $ 114,478 4,399 - 4,620 75,490 - 39,024 $ 8,983
Fully Insured 141,322 1,429 - 25,149 89,040 21 71,147 7,692
Group disability,
life, annuities
and DBL 50,698 9,495 - 183 37,946 5,099 15,598 1,733
Individual life,
annuities
and other 29,916 23,492 - 4,695 36,386 6,449 14,879 389
Corporate - 973 - - - - 6,454 (5,481)
Sub total $ 336,414 $ 39,788 $ - $ 34,647 $ 238,862 $ 11,569 $ 147,102 13,316
Net realized investment gains 8,670
Other-than-temporary impairment losses (1,523)
Interest expense (1,965)
Income from continuing operations before income taxes 18,498
Income taxes 3,732
Income from continuing operations
$ 14,766
Equity Benefits, Amortization Selling,
December 31, Net Income Fee and Claims of Deferred General
2010 Premiums Investment From Other and Acquisition and
(In thousands) Earned Income AMIC Income Reserves Costs Administrative Total
Medical stop-loss $ 121,156 4,080 14 5,404 89,968 - 38,808 $ 1,878
Fully Insured 120,818 1,454 244 28,168 81,676 28 65,854 3,126
Group disability,
life, annuities
and DBL 55,828 9,668 22 454 41,440 497 17,389 6,646
Individual life,
annuities
and other 28,344 25,839 - 4,458 38,234 5,718 12,472 2,217
Corporate - 760 - 27,830 - - 5,120 23,470
Sub total $ 326,146 $ 41,801 $ 280 $ 66,314 $ 251,318 $ 6,243 $ 139,643 37,337
Net realized investment losses 4,646
Other-than-temporary impairment losses (3,819)
Interest expense (1,912)
Income from continuing operations before income taxes 36,252
Income taxes 12,583
Income from continuing operations
$ 23,669
Premiums Earned
Premiums in 2011 include twelve months of earned premiums from AMIC of $72.4
million compared to ten months of earned premiums from AMIC of $61.6 million in
2010. Excluding these amounts, earned premiums decreased $.5 million. The
decrease is primarily due to: (i) a $15.6 million net increase of premiums
earned in the Fully Insured Health segment in 2011 primarily as a result of
increased retentions in the major medical business for groups and individuals,
short term medical and
limited medical lines of business and increased volume in the major medical
business for groups and individuals and limited medical lines, partially offset
by a decrease in the student accident line as a result of the cancellation of a
producer of this product; (ii) an increase of $1.6 million of earned premiums in
the Individual life, annuities and other segment primarily as a result of the
ceding of certain ordinary life and annuity business during 2010, in part offset
by reduced production of annuity contracts; more than offset by (iii) a $12.3
million decrease in the Medical Stop-Loss segment primarily due to the
cancellation of non-owned managing general underwriters in 2010; and (iv) a $5.4
million decrease in the Group disability, life, annuities and DBL segment
primarily due to lower production and reduced rates in the DBL line and the
discontinuance of the point of service line.
Net Investment Income
Total net investment income decreased $2.0 million. The overall annualized
investment yields were 4.3% and 4.6% (approximately 4.4% and 4.8%, on a tax
advantaged basis) for 2011 and 2010, respectively. The overall decrease was
primarily a result of a decrease in investment income on bonds, equities and
short-term investments due to lower yields and the shorter duration of our
portfolio. IHC has approximately $273.3 million in highly rated shorter
duration securities earning on average 1.5%. A portfolio that is shorter in
duration enables us, if we deem prudent, the flexibility to reinvest in much
higher yielding longer-term securities, which would significantly increase
investment income.
Net Realized Investment Gains and Other-Than-Temporary Impairment Losses, Net
The Company had net realized investment gains of $8.7 million in 2011 compared
to $4.6 million in 2010. These amounts include gains and losses from sales of
fixed maturities and equity securities available-for-sale and other investments.
Decisions to sell securities are based on management's ongoing evaluation of
investment opportunities and economic and market conditions, thus creating
fluctuations in gains and losses from period to period. A significant portion of
the net realized investment gains in 2011 resulted from sales of invested assets
in anticipation of a transfer of assets in the first quarter of 2012 in
accordance with the terms of a coinsurance agreement at December 31, 2011. Net
realized investment gains in 2010 were reduced by an additional loss of $3.3
million resulting from discussions in the fourth quarter of 2010 with the
trustee in bankruptcy pertaining to the resolution of claims related to the
non-affiliate broker-dealer that managed the trading accounts of the Company in
2008. The $3.3 million pre-tax loss consisted of: (i) the reversal of $0.5
million of anticipated SIPC recoveries initially recorded by a subsidiary of
IHC; (ii) the reversal of $0.5 million of anticipated SIPC recoveries initially
recorded by AMIC; and (iii) an additional $2.3 million of withdrawals by IHC and
AMIC deemed subject to return. See Note 8 in the Notes to Consolidated Financial
Statements included in the Item 8 of this report for more information about net
realized investment gains and losses.
For the year ended December 31, 2011 and 2010, the Company recorded $1.5
million and $3.8 million, respectively, of other-than-temporary impairment
losses in earnings, pre-tax. In 2011, other-than-temporary impairment losses
recognized in earnings consist of $1.3 million of credit losses resulting from
expected cash flows of debt securities that are less than the debt securities'
amortized cost and $0.2 million of losses resulting from the Company's intent to
sell certain corporate debt securities prior to the recovery of their amortized
cost bases. In 2010, other-than-temporary impairment losses recognized in
earnings consist of $3.1million of credit losses resulting from expected cash
flows of debt securities that are less than the debt securities' amortized cost
and $0.7 million resulting from the Company's intent to sell certain municipal
debt securities prior to the recovery of their amortized cost bases.
Fee Income and Other Income
Fee income decreased $4.1 million primarily as a result of the lower volume of
business in the Medical Stop-Loss segment and certain lines of the Fully Insured
Health segment.
Total other income for 2011 remained comparable to other income for 2010.
Insurance Benefits, Claims and Reserves
Benefits, claims and reserves in 2011 includes twelve months of benefits, claims
and reserves from AMIC of $47.8 million compared to ten months of benefits,
claims and reserves from AMIC of $42.0 million in 2010. Excluding these
amounts, benefits, claims and reserves decreased $18.2 million. The decrease is
primarily attributable to: (i) a decrease of $16.4 million in the Medical
Stop-Loss segment, largely resulting from a decrease in premiums earned and
improved loss ratios; (ii) a $3.7 million decrease in the Group disability,
life, annuities and DBL segment largely as a result of lower loss ratios on the
GTL line of business and a decrease in the point of service line which has been
discontinued; and (iii) a $1.8 million decrease in the Individual life, annuity
and other segment primarily resulting from a decrease in individual annuity
contracts in 2011; partially offset by (iv) an increase of $3.7 million in the
Fully Insured Health segment, principally due to the increase in premiums on the
major medical business for groups and individuals and the limited medical line
of business, partially offset by a decrease in short term medical business due
to improved experience and a decrease in the student accident line resulting
from a lower volume of business due to the cancellation of a producer of this
product.
Amortization of Deferred Acquisition Costs
On December 31, 2011, the Company wrote-off $4.6 million of deferred acquisition
costs in connection with a coinsurance agreement that is effective in the first
quarter of 2012. Excluding this write-off, amortization of deferred acquisition
costs increased $0.8 million.
Selling, General and Administrative Expenses
Selling, general and administrative expenses in 2011 include twelve months of
expenses from AMIC of $28.0 million compared to ten months of expenses from AMIC
of $23.1 million in 2010. Excluding these amounts, selling, general and
administrative expenses increased $2.6 million. The increase is primarily due
to: (i) a $3.2 million decrease in commissions and other general expenses in the
Medical Stop-Loss segment due to a decrease in volume as a result of reduced
production; (ii) a $1.9 million decrease in the Group disability, life,
annuities and DBL segment; more than offset by (iii) a $4.5 million increase in
the Fully Insured Health segment largely due to an increase in commissions as a
result of increased retentions in the major medical business for groups and
individuals, short term medical and limited medical lines of business in 2011
combined with administrative expenses resulting from the increased volume of
major medical business for groups and individuals and limited medical business;
(iv) a $2.4 million increase in the Individual life, annuity and other segment
related to the increase in premium volume of the ordinary life and annuity
business; and (v) a net increase of $.8 million in corporate selling, general
and administrative expenses.
Income Taxes
In 2011, IHC eliminated $2.3 million of previously recorded deferred income
taxes due to management's intention to adopt tax planning strategies to recover
its investment in AMIC in a tax-free manner. In addition, under the above
assumptions, IHC did not record deferred taxes in 2011 relative to its share of
earnings from its investment in AMIC, as it had in prior years, also resulting
in a lower effective tax rate in the current year. Excluding this transaction,
the effective tax rate for the year ended December 31, 2011 was 32.4% compared
to 34.8% in 2010. The high effective tax rate in 2010 is primarily attributable
to higher jurisdictional tax rates on the gain related to the AMIC acquisition
in 2010.
LIQUIDITY
Insurance Group
The Insurance Group normally provides cash flow from: (i) operations; (ii) the
receipt of scheduled principal payments on its portfolio of fixed maturities;
and (iii) earnings on investments. Such cash flow is partially used to fund
liabilities for insurance policy benefits. These liabilities represent long-term
and short-term obligations.
Corporate
Corporate derives its funds principally from: (i) dividends from the Insurance
Group; (ii) management fees from its subsidiaries; and (iii) investment income
from Corporate liquidity. Regulatory constraints historically have not affected
the Company's consolidated liquidity, although state insurance laws have
provisions relating to the ability of the parent company to use cash generated
by the Insurance Group. In the fourth quarter of 2011, the Insurance Group was
reorganized such that Madison National Life and Standard Security Life became
sister companies under a common Corporate parent company, whereas prior Standard
Security Life was a wholly owned subsidiary of Madison National Life. The
Insurance Group declared and paid $11,430,000, $2,000,000 and $3,450,000 of cash
dividends to Corporate in 2012, 2011 and 2010, respectively.
In July 2012, the Company made a $2.0 million principal debt repayment in
accordance with the terms of its amortizing term loan.
Corporate utilizes cash primarily for the payment of general overhead expenses,
common stock dividends, common stock repurchases and debt repayment.
Cash Flows
As of December 31, 2012, the Company had $23.9 million of cash and cash
equivalents compared with $18.2 million as of December 31, 2011.
The decrease in cash from operating activities of $115.4 million is primarily
the result of $143.5 million cash that Standard Security Life transferred to an
unaffiliated reinsurer in connection with a coinsurance agreement in February
2012, partially offset by net income of $22.6 million. Cash provided by
investing activities of $122.9 million consists primarily of proceeds from the
net sales of investments in preparation for such transfer of funds by Standard
Security Life.
The Company has $460.7 million of insurance reserves that it expects to
ultimately pay out of current assets and cash flows from future business. If
necessary, the Company could utilize the cash received from maturities and
repayments of its fixed maturity investments if the timing of claim payments
associated with the Company's insurance resources does not coincide with future
cash flows. For the year ended December 31, 2012, cash received from the
maturities and other repayments of fixed maturities was $74.4 million.
Financing activities for the year ended December 31, 2012 used $1.8 million,
primarily consisting of dividends paid, the repayment of debt and repurchases of
common stock, net of proceeds from investment-type insurance contracts.
The Company believes it has sufficient cash to meet its currently anticipated
business requirements over the next twelve months including working capital
requirements and capital investments.
BALANCE SHEET
Total investments decreased $121.6 million during the year ended December 31,
2012 largely due to net sales of investments in the first quarter of 2012 in
connection with the transfer of $143.5 cash in connection with a coinsurance
agreement, partially offset by $13.8 million in pre-tax unrealized gains on
available-for-sale securities.
The Company had net receivables from reinsurers of $118.7 million at December
31, 2012. All of such reinsurance receivables are either due from highly rated
companies or are adequately secured. No allowance for doubtful accounts was
necessary at December 31, 2012.
The Company made a $2.0 million principal debt repayment in July 2012 in
accordance the terms of its amortizing term loan.
The $24.6 million increase in IHC's stockholders' equity in 2012 is primarily
due to $19.7 million of net income attributable to IHC and $7.2 million of other
comprehensive income, partially offset by $1.3 million of treasury share
purchases and $1.3 million of cash declared.
Asset Quality and Investment Impairments
The nature and quality of insurance company investments must comply with all
applicable statutes and regulations, which have been promulgated primarily for
the protection of policyholders. Although the Company's gross unrealized losses
on available-for-sale securities totaled $2.5 million at December 31, 2012,
approximately 98.1% of the Company's fixed maturities were investment grade and
continue to be rated on average AA. The Company marks all of its
available-for-sale securities to fair value through accumulated other
comprehensive income or loss. These investments tend to carry less default risk
and, therefore, lower interest rates than other types of fixed maturity
investments. At December 31, 2012, approximately 1.9% (or $13.5 million) of the
carrying value of fixed maturities was invested in non-investment grade fixed
maturities (primarily mortgage securities). Investments in such securities have
different risks than investment grade securities, including greater risk of loss
upon default, and thinner trading markets. The Company does not have any
non-performing fixed maturity investments at December 31, 2012.
Approximately 1.2% of fixed maturities, primarily municipal obligations, in our
investment portfolio are insured by financial guaranty insurance companies. The
purpose of this insurance is to increase the credit quality of the fixed
maturities and their credit ratings. If the obligations of these financial
guarantors ceased to be valuable, either through a credit rating downgrade or
default, these debt securities would likely receive lower credit ratings by the
rating agencies that would reflect the creditworthiness of the various obligors
as if the fixed maturities were uninsured. The following table summarizes the
credit quality of our fixed maturity portfolio as rated, and as rated if the
fixed maturities were uninsured, at December 31, 2012:
As Rated
Bond Ratings As Rated If Uninsured
AAA 20.2% 20.2%
AA 47.0% 46.6%
A 30.1% 29.6%
BBB 0.8% 1.7%
Total Investment Grade 98.1% 98.1%
BB or lower 1.9% 1.9%
Total Fixed Maturities 100.0% 100.0%
Changes in interest rates, credit spreads, and investment quality ratings may
cause the market value of the Company's investments to fluctuate. The Company
does not have the intent to sell nor is it more likely than not that the Company
will have to sell debt securities in unrealized loss positions that are not
other-than-temporarily impaired before recovery. In the event that the
Company's liquidity needs require the sale of fixed maturity securities in
unfavorable interest rate, liquidity or credit spread environments, the Company
may realize investment losses.
The Company reviews its investments regularly and monitors its investments
continually for impairments, as discussed in Note 1(E) (vi) of the Notes to
Consolidated Financial Statements in Item 8 of this report. For the years ended
December 31, 2012 and 2011 the Company recorded losses of $1.0 million and $2.5
million, respectively, for other-than-temporary impairments on
available-for-sale securities. Of those impairment losses, credit losses of $0.7
million and $1.5 million, respectively, were recognized in earnings for the
years ended December 31, 2012 and 2011, and the remaining non-credit losses were
recognized in other comprehensive income. The following table summarizes the
carrying value of securities with fair values less than 80% of their amortized
cost at December 31, 2012 by the length of time the fair values of those
securities were below 80% of their amortized cost (in thousands):
Greater than Greater than
3 months, 6 months,
Less than less than less than Greater than
3 months 6 months 12 months 12 months Total
Fixed maturities $ - $ - $ - $ 409 $ 409
Equity securities - - - - -
Total $ - $ - $ - $ 409 $ 409
The unrealized losses on all available-for-sale securities have been evaluated
in accordance with the Company's impairment policy and were determined to be
temporary in nature at December 31, 2012. In 2012, the Company recorded $10.8
million of net unrealized gains on available-for sale securities in other
comprehensive income, pre-tax. Related deferred tax benefits were $3.6 million.
From time to time, as warranted, the Company may employ investment strategies to
mitigate interest rate and other market exposures. Further deterioration in
credit quality of the companies backing the securities, further deterioration in
the condition of the financial services industry, a continuation of the current
imbalances in liquidity that exist in the marketplace, a continuation or
worsening of the current economic recession, or additional declines in real
estate values may further affect the fair value of these securities and increase
the potential that certain unrealized losses be designated as
other-than-temporary in future periods and the Company may incur additional
write-downs.
Goodwill
Goodwill represents the excess of the amount we paid to acquire subsidiaries and
other businesses over the fair value of their net assets at the date of
acquisition. The Company tests goodwill for impairment at least annually and
between annual tests if an event or circumstances change that would more likely
than not reduce the fair value of a reporting unit below its carrying amount.
Goodwill is considered impaired when the carrying amount of goodwill exceeds its
implied fair value.
All goodwill carrying amounts are evaluated for impairment at the reporting unit
level which is equivalent to an operating segment. Goodwill was allocated to
each reporting unit or operating segment at the time of acquisition. At
December 31, 2012, total goodwill was $50.3 million, of which $44.6 million was
attributable to the Fully Insured Health segment and $5.7 million to the Medical
Stop Loss segment.
Based upon the goodwill impairment testing performed at December 31, 2012, the
fair value of each reporting unit exceeded its carrying value and no impairment
charge was required. Fair value exceeded carrying value by 10% or more in both
the Fully Insured Health and the Medical Stop Loss segments.
In determining the fair value of each reporting unit, we used an income
approach, applying a discounted cash flow method which included a residual
value. Based on historical experience, we made assumptions as to: (i) expected
future performance and future economic conditions, (ii) projected operating
earnings, (iii) projected new and renewal business as well as profit margins on
such business, and (iv) a discount rate that incorporated an appropriate risk
level for the reporting unit.
Management uses a significant amount of judgment in estimating the fair value of
the Company's reporting units. The key assumptions underlying the fair value
process are subject to uncertainty and change. The following represent some of
the potential risks that could impact these assumptions and the related expected
future cash flows: (i) increased competition; (ii) an adverse change in the
insurance industry and overall business climate; (iii) changes in state and
federal regulations; (iv) rating agency downgrades of our insurance companies;
and (v) a sustained and significant decrease in our share price and market
capitalization. As a result of the global economic crisis that began in 2008,
we experienced a significant decline in our stock price. Due to this significant
decline, our market capitalization as of December 31, 2012 was significantly
below the sum of our reporting units' fair values. As a result, the Company
assessed the factors contributing to the performance of IHC stock in 2012, and
concluded that the market capitalization does not represent the fair value of
the Company. The Company noted several factors that have led to a difference
between the market capitalization and the fair value of the Company, including
(i) the Company's stock is thinly traded and a sale of even a small number of
shares can have a large percentage impact on the price of the stock, (ii) Geneve
Corporation and insiders own approximately 56% of the outstanding shares, which
has had a significant adverse impact on the number of shares available for sale
and therefore the trading potential of IHC stock, and (iii) lack of analyst
coverage of the Company. If we experience a sustained decline in our results of
operations and cash flows, or other indicators of impairment exist, we may incur
a material non-cash charge to earnings relating to impairment of our goodwill,
which could have a material adverse effect on our results.
Health Reserves
The following table summarizes the prior year net favorable amount incurred in
2012 according to the year to which it relates, together with the opening
reserve balance (net of reinsurance recoverable) to which it relates (in
thousands):
Reserves at Prior Year Amount
January 1, 2012 Incurred in 2012
Total Reserves
2011 $ 74,356 $ (2,888)
2010 11,730 (3,668)
2009 5,352 (800)
2008 and Prior 18,411 (1,552)
Total $ 109,849 $ (8,908)
The following sections describe, for each segment, the unfavorable (favorable)
development experienced in 2012, together with the key assumptions and changes
therein affecting the reserve estimates.
Medical Stop-Loss
The Company experienced net favorable development of $3.0 million in the Medical
Stop-Loss segment. The favorable development was the result of on-going analysis
of recent loss development trends primarily attributable to improvements on the
direct written business in the 2010 year.
Fully Insured HealthThe Fully Insured Health segment had a favorable development of $0.4 million.
The Company experienced a $0.8 million favorable variance related to 2010
reserves primarily on the vision line of business offset by additional expense
incurred related to 2011 reserves primarily due to group major medical business.
Group Disability
The Group Disability segment had a favorable development of $4.5 million. This
amount consists of favorable developments of $2.7 million and $1.3 million on
the 2011 and 2010 reserves, respectively, primarily due to LTD business from
those years and, in part, to DBL business from the 2011 year.
Due to the long-term nature of LTD, in establishing loss reserves the Company
must make estimates for case reserves, IBNR, and reserves for Loss Adjustment
Expenses ("LAE"). Case reserves generally equal the actuarial present value of
the liability for future benefits to be paid on claims incurred as of the
balance sheet date. The IBNR reserve is established based upon historical trends
of existing incurred claims that were reported after the balance sheet date. The
LAE reserve is calculated based on an actuarial expense study. Since the LTD
block of policies is relatively small, with the potential for very large claims
on individual policies, results can vary from year to year. If a small number of
claimants with large claim reserves were to recover or several very large claims
were incurred, the results could distort the Company's reserve estimates from
year to year. High termination rates and offsets caused favorable development
in LTD prior year reserves. With respect to DBL, reserves for the most recent
quarter of earned premium are established using a Net Loss Ratio methodology.
The Net Loss Ratio is determined by applying the completed prior four quarters
of historical Net Loss Ratios to the last quarter of earned premium. Reserves
associated with the premium earned prior to the last quarter are established
using a completion factor methodology. The completion factors are developed
using the historical payment patterns for DBL. The favorable development in the
DBL line is due to lower than expected claims.
There were normal fluctuations to the Company's experience factor. The IBNR
factors were updated to reflect the current experience. The reserving process
used by management was consistent from 2011 to 2012.
Individual Life, Annuities and Other
All other lines, primarily due to the blanket and other individual health
products, experienced a favorable development of $1.0 million.
CAPITAL RESOURCES
Due to its strong capital ratios, broad licensing and excellent asset quality
and credit-worthiness, the Insurance Group remains well positioned to increase
or diversify its current activities. It is anticipated that future acquisitions
or other expansion of operations will be funded internally from existing capital
and surplus and parent company liquidity. In the event additional funds are
required, it is expected that they would be borrowed or raised in the public or
private capital markets to the extent determined to be necessary or desirable.
In November 2004, December 2003 and March 2003, the Company borrowed $15.0
million, $12.0 million and $10.0 million, respectively, through pooled trust
preferred issuances by unconsolidated subsidiary trusts. In August 2009, the
outstanding line of credit was cancelled and converted into an amortizing term
loan. In 2011 the term loan was amended and increased from $7.5 million to $10.0
million. See Note 13 of the Notes to Consolidated Financial Statements in Item 8
of this report.
IHC enters into a variety of contractual obligations with third parties in the
ordinary course of its operations, including liabilities for insurance reserves,
funds on deposit, debt and operating lease obligations. However, IHC does not
believe that its cash flow requirements can be fully assessed based solely upon
an analysis of these obligations. Future cash outflows, whether they are
contractual obligations or not, also will vary based upon IHC's future needs.
Although some outflows are fixed, others depend on future events.
The chart below reflects the maturity distribution of IHC's contractual
obligations at December 31, 2012 (in thousands):
Junior Funds
Subordinated Interest Insurance on
Debt Debt On Debt Leases Reserves Deposit Total
2013 $ 2,000 $ - $ 1,900 $ 2,981 $ 147,537 $ 28,864 $ 183,282
2014 2,000 - 1,800 2,696 43,279 26,896 76,671
2015 2,000 - 1,701 2,576 34,876 24,863 66,016
2016 2,000 - 1,602 2,070 30,574 23,133 59,379
2017 - - 1,553 784 28,529 21,638 52,504
2018 and
Thereafter - 38,146 25,102 462 175,890 152,690 392,290
Totals $ 8,000 $ 38,146 $ 33,658 $ 11,569 $ 460,685 $ 278,084 $ 830,142
OUTLOOK
For 2013, we will emphasize:
·
Continued growth in our medical stop-loss segment as the demand for this product
continues to grow and Risk Solutions continues to build its reputation as a
direct writer and provider of captive solutions;
·
Adapting to health care reform by continuing to proactively adjust our
distribution strategies and mix of Fully Insured Health products to take
advantage of changing market demands;
·
Continued growth in pet insurance;
·
Increasing emphasis on direct-to-consumer distribution initiatives as we believe
this will be a growing means for selling health insurance in the coming years;
·
Growth in small group major medical premiums in 2013, but a decline in this line
of business in 2014 as we cease writing new business in certain states and as
employers may choose to drop group health coverage or self-fund;
·
Increasing sales of short-term, limited medical and supplemental health
products, such as dental, hospital indemnity and critical illness and
international products to offset the reduction in major medical premiums in
2014;
·
Selling non-subscriber occupational accident insurance in Texas;
·
Increasing sales in our DBL line of business; and
·
Continued focus on administrative efficiencies.
The Company remained highly liquid in 2012 with a shorter duration portfolio. As
a result, the yields on our investment portfolio were, and continue to remain,
lower than in prior years and investment income may continue to be depressed for
the balance of the year. IHC has approximately $197.5 million in highly rated
shorter maturity securities earning on average 1.6%; our portfolio as a whole is
rated, on average, AA. The low duration of our portfolio enables us, if we deem
prudent, the flexibility to reinvest in much higher yielding longer-term
securities, which would significantly increase investment income. A low
duration portfolio such as ours also mitigates the adverse impact of potential
inflation. IHC will continue to monitor the financial markets and invest
accordingly.
At December 31, 2012, IHC owned 78.6% of AMIC's outstanding common stock. In
January 2013, as a result of AMIC's share repurchases, IHC's ownership interest
increased to 80.6%.
We had a significant increase in the profitability and growth of our stop-loss
business in 2012, our largest core business, which we attribute to the more
efficient and controlled model of writing the majority of our medical stop-loss
on a direct basis. At present, all indicators point to a continuation of this
growth and higher level of profitability. There are a number of market forces
that support this expectation. We have observed a trend on the part of our
producers of stop-loss to consolidate their business with a smaller number of
stop-loss carriers. The direct writing model employed by Risk Solutions is well
suited to take advantage of this trend. There is an increased interest in
self-funded options to address concerns about cost and regulatory burdens and we
have developed targeted programs to address these needs. Finally there appears
to be a market recognition that stop loss buying decisions need to be more about
price. Service and fair claims payment practices are also important
considerations and the partnership model under which Risk Solutions operates is
increasingly recognized as addressing those issues.
We will continue to focus on our strategic objectives, including expanding our
distribution network. However, the success of a portion of our Fully Insured
Health business may be affected by the passage of the Patient Protection and
Affordable Care Act of 2010, as amended, signed by President Obama in March 2010
and its subsequent interpretations by state and federal regulators. The
appropriate regulatory agencies have now issued their proposed regulations. The
regulations proposed to-date (including those mandating minimum loss ratios)
seem to have validated our strategy of pursuing niche lines of business across
many states utilizing multiple carriers. We have begun a comprehensive review of
all the options for IHC and we are continuing a thorough evaluation of our
options for those health insurance products that may be affected. Although the
law will generally require insurers to operate with a lower expense structure
for major medical essential health benefit ("EHB") plans in the small employer
and individual markets, the law appears to make exceptions for carriers, such as
ours, that have a minimal presence in any one state. Non-EHB lines of business
and Medical Stop-Loss have been impacted by health care reform minimally or not
at all.
Our results depend on the adequacy of our product pricing, our underwriting, the
accuracy of our reserving methodology, returns on our invested assets, and our
ability to manage expenses. We will also need to be diligent with the increased
rate review scrutiny to effect timely rate changes and will need to stay focused
on the management of medical cost drivers as medical trend levels have reversed
direction in 2012 causing some margin pressures. Therefore, factors affecting
these items, as well as unemployment and global financial markets, may have a
material adverse effect on our results of operations and financial condition.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
The Company manages interest rate risk by seeking to maintain an investment
portfolio with a duration and average life that falls within the band of the
duration and average life of the applicable liabilities. Options may be utilized
to modify the duration and average life of such assets.
The following summarizes the estimated pre-tax change in fair value (based upon
hypothetical parallel shifts in the U.S. Treasury yield curve) of the fixed
income portfolio (excluding redeemable preferred stocks) assuming immediate
changes in interest rates at specified levels at December 31, 2012:
Change in Interest Rates
200 100 basis Base scenario 100 basis 200 basis
basis point point point
point rise decline decline
rise
Corporate securities $ 316,424$ 334,185 $ 353,823 $ 373,990 $
388,143
CMO's 19,261 19,939 20,664 21,336 21,447
U.S. Government 18,165 18,512 18,866 19,012 19,012
obligations
Agency MBSs 405 416 428 433 434
GSEs 42,388 45,756 49,606 54,025 59,115
State & Political 230,808 248,994 268,225 284,078 293,144
Subdivisions
Total estimated fair $ 627,451$ 667,802 $ 711,612 $ 752,874 $
781,295
value
Estimated change in $ (84,161) $ (43,810) $ 41,262 $
69,683
value
The Company monitors its investment portfolio on a continuous basis and believes
that the liquidity of the Insurance Group will not be adversely affected by its
current investments. This monitoring includes the maintenance of an
asset-liability model that matches current insurance liability cash flows with
current investment cash flows. This is accomplished by first creating an
insurance model of the Company's in-force policies using current assumptions on
mortality, lapses and expenses. Then, current investments are assigned to
specific insurance blocks in the model using appropriate prepayment schedules
and future reinvestment patterns.
The results of the model specify whether the investments and their related cash
flows can support the related current insurance cash flows. Additionally,
various scenarios are developed changing interest rates and other related
assumptions. These scenarios help evaluate the market risk due to changing
interest rates in relation to the business of the Insurance Group.
In the Company's analysis of the asset-liability model, a 100 to 200 basis point
change in interest rates on the Insurance Group's liabilities would not be
expected to have a material adverse effect on the
Company. With respect to its liabilities, if interest rates were to increase,
the risk to the Company is that policies would be surrendered and assets would
need to be sold. This is not a material exposure to the Company since a large
portion of the Insurance Group's interest sensitive policies are burial policies
that are not subject to the typical surrender patterns of other interest
sensitive policies, and many of the Insurance Group's universal life and annuity
policies were acquired from liquidated companies which tend to exhibit lower
surrender rates than such policies of continuing companies. Additionally, there
are charges to help offset the benefits being surrendered. If interest rates
were to decrease substantially, the risk to the Company is that some of its
investment assets would be subject to early redemption. This is not a material
exposure because the Company would have additional unrealized gains in its
investment portfolio to help offset the future reduction of investment income.
With respect to its investments, the Company employs (from time to time as
warranted) investment strategies to mitigate interest rate and other market
exposures.
ITEM 8.
