Humana Inc (HUM) 2004 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Your conference will begin in just a few short moments. Again, ladies and gentlemen, we do appreciate your patience, and thank you for standing by.

Good day, ladies and gentlemen, and welcome to the KMG America Corporation fourth quarter 2004 earnings conference call. My name is Rachel, and I'll be your coordinator today.

At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's conference. If at any time during the call you require assistance, please press star followed by zero and a coordinator will be happy to assist you.

As a reminder, ladies and gentlemen, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Kenneth Kuk, Chairman and CEO. Please proceed, sir.

Thank you. Welcome to KMG America's fourth quarter conference call. With me this morning are Scott DeLong, our CFO; Tom Sass, who is Senior VP of Operations; Jim Nelson, who is our recently hired General Counsel; and Bob Matthews, CFO of our subsidiary, Kanawha Insurance Company.

Before I begin, I want to remind you that certain comments made during this call relating to KMG America's future operations, performance, growth plans, and expectations of future development are forward-looking statements under the federal securities laws. These statements are based on various assumptions and estimates that are subject to a number of risks and uncertainties.

These risks are discussed in our fourth quarter earnings release, which was issued today, and our Form 10-K, which will be filed today. In light of these risks, our actual results may differ materially from those expressed in any forward-looking statements made during this call, and should be considered carefully.

During this call, we will also be discussing certain non-GAAP financial measures, such as operating income and pro forma financial information that we believe is useful for evaluating the performance of the business. This information should not be viewed in isolation, or considered as a substitute for the financial information prepared in accordance with GAAP. A reconciliation of the non-GAAP measures to the most comparable GAAP measures is contained in the earnings release.

It has been slightly over 90 days since KMG America's IPO. Scott DeLong will speak to the fourth quarter results in a few minutes. Because our near-term objective is to lay the groundwork for a successful national group and voluntary work set operation, I will not focus this morning on the traditional measurements of success, such as earnings per share, ROE, and so forth. Instead, I want to report on what I think is truly impressive progress in terms of building the sales organization; developing and filing applications to offer new insurance products; implementing a budgeting, re-forecasting and planning process; initiating control procedures for compliance of Sarbanes-Oxley; launching an internal as well as an external branding effort, and integrating the two organizations cultures. We are making organizational changes that should lead to more clearly defined objectives and individual responsibility. Additionally, we are studying the efficiency of our administrative platform. But I can say that all early signs are that it is a very well run operation. And we are very happy with the interaction between our new sales organization and the administrative staff. Finally, I will talk about our sales efforts, which are already producing results. I can say without question, KMG America has been very well received in the marketplace by perspective employees, brokers, and customers. I have personally interacted with many consultants, brokers, and enrollment firms. Everyone seems to know about us, and I think the brokerage community is excited to have a new high-quality participant.

So let me expand a bit on each of these areas. We were successful in concluding the recruiting and signing of Paul Moore and Paul Kraemer as our national sales managers. This occurred on the first day after listing on the New York Stock Exchange. They immediately went on a whirlwind recruiting effort during the last two weeks of December. This effort led to the hiring of seven highly skilled sales representatives during the first week of January. It's very satisfying to me that we were able to recruit such a high-quality group so quickly, and at compensation arrangements consistent with our plan. Our objective for 2005 is to recruit 25 reps, and we expected to have eight on average for the year. By hiring seven reps the first week of the year, and already adding others, we clearly have accomplished our objective. We now have 10 reps employed. To a certain extent we're suffering from our own success because we now face some cost overruns when measured against our initial plans. We're modeling various scenarios now regarding timing of hiring more reps to determine the best balance between costs, sales, 2005 objectives, and 2006 expectations. Because of the qualities of the reps that we've hired, and that we're currently recruiting, we believe we could hire fewer than 25 reps this year, and still achieve our 2006 sales objectives. We're not certain yet that this is a strategy we'll employ. My bias is to worry less about the bottom line in 2005, and position ourselves better for 2006. I'm quite confident that we could have 25 high-quality reps on board by mid summer. But this is a question we're still trying to answer. Partially offsetting these incremental costs are more sales in 2005 as a result of accelerated rep hiring.

Product development began immediately after closing the transaction. Our initial focus has been on a stop loss product, as well as a group life product. While our product filing always seems to take longer than expected, we will have the stop loss product available in many states in the second quarter, and the group life product by the end of the second quarter. We then will round out our offering in the last half of 2005 so that we have a reasonably robust set of products for January '06 renewals. Nothing too exciting here other than we're making good progress. And we do have existing Kanawha voluntary products that we are selling.

I think the key to any successful business is a rigid, disciplined budget and re-forecasting process. Well-run companies know what to expect before a quarter begins rather than after it ends. And that's what this product - process will do for KMG America. We're a little behind where I'd like to be with this effort because so much of our financial focus has been on the fourth quarter results, and producing our first 10-K. But we're moving quickly in this area, and I expect to have this project complete and functioning by the middle of the second quarter.

KMG America will be our brand, although we have no immediate plans to change the name of the life company. The external branding effort is under way, although this will not be an extensive costly effort. We will rely heavily on our distribution to lead this charge. Internally our marketing and HR departments have done an excellent job of spreading the word about KMG America's goal, and the expectations of our associates. The level of cooperation and support from Stan Johnson, Dale Vaughan and the management team at Kanawha has been exceptional. I have personally met with over 200 employees in very small groups in Lancaster. And it's obvious to me that the enthusiasm and support for KMG America is sincere.

We are taking a close look at the organizational structure at Kanawha. We're trying to determine which existing businesses can be material contributors over time, who is responsible for what, and so forth. We have reassigned responsibilities for some activities, and will continue this process. It's my observation that much of Kanawha, probably because of its size, tended not to have as much individual responsibility for bottom line performance as I find desirable. These initiatives are meant to deal with that issue.

While we have not had any large sales successes, the new distribution - with the new distribution organization, we've had enough success to know that KMG America is a name that we can sell. Sales have been restricted to existing Kanawha voluntary products. And during the first 60 days of 2005, we have sold six cases, total annualized new premium of over a million dollars. Not big, but a good early indicator. This is all incremental to our plan given that we did not expect any new sales from new activity in the first half of 2005. Sales from existing Kanawha distribution appear to be on plan as well.

On the challenges side, we have had over 20 percent of invested assets in very short duration investments, virtually in cash. We didn't think it was wise to fully invest with rates where they were most of the first quarter. And indeed we've been rewarded somewhat with the 10-year bond up about 60 basis points of yield from the low point in the quarter. We have recently moved about 20 percent of our cash into more permanent investments. But we continue to believe that there is a likelihood - more likelihood of rising rates than falling. With the yield curve reasonably flat, the give up in yield isn't excessive, and I don't think it's prudent to damage long-term ROEs to get a - to get a couple hundred basis points of yield immediately. Our most recent investment has been at a yield approaching six percent, which is consistent with expectations in our plan. So we'll continue to selectively invest throughout the second quarter, barring a change in interest rate levels. Also, while the duration of our assets is still shorter than our liabilities, we would expect to be looking for even shorter duration assets if the rates remain where they are or increase.

Finally, ING ReliaStar did file suit against KMG America and several individuals in February. The complaint relates to our hiring of several former ING employees. We expected that the hiring of several individuals would produce a strong response by ReliaStar, and it did. The complaint alleges misappropriation of trade secrets, interference with business and employment relationships, and breach of contract. We believe the allegations are totally without merit, and of course we'll defend the action vigorously. We have determined that this matter will not have a material adverse effect in our financial position or results of operations. A copy of the complaint and our response is publicly available. This suit will neither distract us nor deter us from achieving our objectives. Except for the costs of defending it, I view this suit almost as a non-event. That's all I'll say on this matter right now, but I'll be happy to answer any questions you may have during the Q&A session following Scott's review of fourth quarter results.

In summary, we've done what - we've done what we said we would do, and we've done it sooner than expected. The enthusiasm I've had for this concept in this company is greater today than ever. I think we're building something special that should produce positive results for years to come.

I will turn it over to Scott now for a review of the fourth quarter.

Our earnings release went out earlier this morning. That document, along with these remarks, will be filed shortly in an 8-K. Within 24 hours a complete transcript of this call, including the Q&A, will be available on the Thomson StreetEvents Web site. Because this is our first earnings report following the IPO last December, I will take a little extra time up front to comment on our reporting format.

The IPO closed on December 21, just 10 days before the end of the fourth quarter. Normally to account for a mid-period acquisition, we would decompose the fourth quarter into the predecessor and successor periods, and report separately on each with purchase accounting adjustments incorporated into the successor sub-period. However, because of a very short 10-day time period remaining before the end of the reporting period in our situation, we concluded that the effect of purchase accounting in a few days of holding company operations would be immaterial to fourth quarter financial results. Therefore we accounted for the acquisition of Kanawha Insurance Company, our predecessor, as if it occurred on December 31. This provided a more meaningful presentation to investors, we believe, and simplified the preparation of our financial statements and related audit. But as a result, we include two non-consolidated income statements for the fourth quarter rather than a single consolidated statement of operations. The first includes a full quarter for our predecessor prepared using its historical GAAP accounting basis. The second income statement includes a short stub period for KMG America Holding Company operations at the end of December. This stub period includes just under $300,000 of incentive comp expense accruals and base pay for Ken and me, offset by a little dab of investment income earned on the $58 million of excess IPO capital remaining after paying out financing costs and the cash portion of the Kanawha purchase price. Balance sheet preparation was also simplified by assuming the acquisition occurred on December 31. We did not prepare both an opening balance sheet as of December 21, and a closing balance sheet as of December 31. Instead we prepared just the one balance sheet as of December 31 adjusted for the effects of purchase accounting.

We will be filing our 10-K shortly following the conclusion of this conference call, and you will find a complete discussion of our predecessor's 2002 through 2004 financial results in that document. However, the focus of that document is the full year, and there is very little discussion of the fourth quarter. As is customary, we focus on the fourth quarter in the press release, so you will want to carefully review both documents to get the complete picture of 2004 and the comparison to 2003.

Next I want to talk briefly about our use of pro forma earnings. We are well aware of SEC and investor attitudes toward pro forma earnings that are designed to direct attention away from GAAP defined earnings. Our use in this case is primarily to incorporate pro forma PGAAP adjustments to Kanawha's 2003 and 2004 historical GAAP earnings, just as we did in the IPO prospectus last year. The logic of this treatment is that Kanawha's earnings will be adjusted to PGAAP starting in 2005, and you will have year-over-year earnings comparisons on a consistent accounting basis. Kanawha's HGAAP, or historical GAAP net income for 2003 and 2004 is also available, of course, if you prefer that earnings measurement basis. Our use of pro forma here also excludes the KMG America Holding Company operations during the last few days of 2004 on the grounds that net income during that short period is not indicative of anything going forward as it includes primarily some miscellaneous, non-recurring expense accruals. We present pro forma earnings on both a net and operating income basis, the latter excluding after tax, net realized capital gains on investments in both 2003 and 2004. The press release contains a reconciliation of pro forma earnings back to GAAP.

With all this said, I'm not suggesting that Kanawha's pro forma income for 2004 is fully indicative of 2005 expected income for KMG America. As you would expect, we do believe that our early activities related to recruiting sales reps for the new large employer distribution channel will result in expenses outpacing the new revenues produced by these new efforts during 2005. Therefore please keep in mind that Kanawha's pro forma earnings in 2004 do not reflect these startup costs during 2005.

With this preparation, I'm now ready to discuss our financial results.

My earnings commentary will be directed to the 2004 financial performance of Kanawha Insurance Company, our predecessor. I don't plan to say anything further about the short stub period for KMG America, you can refer to the narrative and tables in the 10-K and press release.

For the full year, GAAP net income for Kanawha in 2004 was $6.2 million, compared to $7.8 million in 2003. Most of the earnings in both years were made up of realized investment gains. After tax operating income in 2004 was $1.1 million, compared to $2.8 million in 2003. 2004 operating income excludes realized investment gains and in March a non-recurring expense relating to an incentive payment to one of Kanawha's former outside investment managers. The decline in operating income in 2004 is due to two primary factors - adverse claims development, which contributed to the benefits ratio increase from 83.9 percent in 2003 to 87.7 percent in 2004; and 2) a decline in investment income due in large part to the downward trend in market interest rates, and the related portfolio yield which fell about 20 basis points. This yield decline, which was also affected by the increase in cash during the last part of the year, reduced after tax operating income in 2004 by about $500,000 after taking into account the increase investable funds during the year. Looking back, the year-over-year increase in the benefits ratio I mentioned a moment ago, approximately half of that was expected due to normal aging in Kanawha's book of business, most of which is long-term level premium policies. Adjusting for that, we estimate that adverse claims development during 2004 reduced after tax operating income by about $1.5 million, but a third of that was offset by lower expenses.

Pro forma net income for 2004 was $16.3 million, or 73 cents per diluted share, compared to $14.4 million, or 65 cents in 2003. Full year pro forma operating income was $11.2 million, or 50 cents per share in 2004, compared to $9.5 million, or 43 cents in 2003. There are two primary contributors to the significant PGAAP earnings accretion. First, the benefit expense is reduced as a result of the 44 million, or nine percent overall reserve strengthening. This results from revaluing the reserves using a lower discount rate, and selectively increasing expected claims costs. The second contributor is lower amortization of the newly established VOBA, compared or value of business acquired asset, compared to the amortization of Kanawha's historical back, which was eliminated on the purchase date. Amortization is lower for two reasons. First, the asset being amortized has been reduced by 35 percent from $113 million to $74 million, which is a direct result of the 30 percent discount to book value we paid for Kanawha. Second, the new VOBA has been allocated to the blocks of business in proportion to the expected profitability of those blocks, which differs from the historical DAC, which was allocated in proportion to actual commissions paid when the business was originally put on Kanawha's books. This reallocation of the asset based on expected profitability slows down the amortization in the early years.

I would like to speak next to the share counts used in the diluted earnings per share calculations, because we get asked about our plans for adopting the new option expensing rules. The diluted shares outstanding on our financial statements are determined using the treasury stock method. In other words, diluted EPS is calculating - is calculated using the existing rules, and we have not expensed the 1.2 million options that have already been granted. There is a small difference between basic and diluted shares outstanding in 2004 year end because our stock was trading above the $9.50 IPO and option exercise price. The intrinsic value of the unexercised options is taking into account under the current rules, but only to the extent that share counts are adjusted. Under the new rules, we will have to expense the economic value of these options over the vesting period, which is four years for most of the options. We plan to adopt the new rules in the third quarter of 2005, along with most of corporate America. We do have a footnote in the 10-K illustrating the effect on a pro forma basis. We did evaluation of the options as December 31 based on the $11 per share closing price of our stock. The value at that time was $3.44 per share using the Black Scholes model, or about 4.3 million for all outstanding options. This implies we will have to reduce pretax earnings by about 1.1 million per year over the four year vesting period, or under five cents per share per year pretax. Clearly this will not be a big deal.

Returning now to the earnings discussion, and looking at just the fourth quarter, Kanawha's net income was $0.9 million, compared to $1.5 million in the fourth quarter of 2003. Kanawha had significant realized investment gains in both years. Therefore on an operating income basis, Kanawha had a loss of $1.2 million in 2004, compared to operating income of $0.8 million in the fourth quarter of 2003. The fourth quarter operating loss was caused by three factors. First, one-time expenses relating primarily to new hires reduced after-tax earnings by over $700,000. Second, investment income fell year-over-year as the average portfolio yield on investments went from six percent in the fourth quarter of 2003, to 4.9 percent in the fourth quarter of 2004. This yield decline reduced after-tax earnings by about $800,000, and was due to the effect of the low interest rate environment generally, as well as an increase in cash resulting from our decision to reconfigure our investment portfolio starting at the end of the third quarter. The third factor was unfavorable claims experience as the benefit ratio increased from 84 percent in 2003, to 86 percent in 2004. And this reduced after-tax earnings in the fourth quarter by about $300,000 year-over-year.

As was the case for the full year, the purchase accounting adjustments were very accretive of the fourth quarter. On an operating income basis, and without any adjustments for the one-time expenses noted above, fourth quarter pro forma operating income in 2004 was $1.4 million, or six cents per diluted share, compared to $2.4 million, or 11 cents per diluted share in 2003.

Next I have a few comments regarding operating results in our five reporting segments. Note that the tables in the press release are pretax.

Our work site insurance segment has historically included life and health products marketed at the worksite to small employers in the southeastern United States. We also include products sold through Kanawha's career agency force in this segment, along with miscellaneous other activities that will not be material to our business plan. We reported a pretax loss of $700,000 in this segment in the fourth quarter of 2004, compared to income of $0.6 million in 2003. Lower investment income and higher claims contributed about equally to this $1.1 million pretax decline. Higher claims arose from two disability worksite cases which were written in 2003 in which new enrollments have been discontinued, and rate increases have been put in place.

Our senior market insurance segment includes long-term care products sold primarily to senior citizens. Pretax operating income in the fourth quarter of 2004 was one million, compared to $900,000 in 2003. While new sales were down in 2004, renewal premiums will continue to generate significant growth in invested assets and benefit reserves over the next few years.

Third party administration segment provides insurance administration and claims processing services internally, as well as to other insurance companies and large employers self funding their employee health plans. While fee income and earnings were down slightly in the fourth quarter, both were up for the year with earnings more than doubling. Keep in mind that for segment reporting purposes we include unaffiliated activities only.

The acquired business segment is composed of a number of closed blocks of business acquired over more than 10 years. It is in runoff as no material transactions have been completed since 1999. As a result, earnings are in long-term decline. A pretax loss of $1.7 million was reported in the fourth quarter of 2004, compared to a loss of $1.2 million in 2003. Reduced investment income contributed to this decline, along with higher claims, particularly in one health insurance block. The 251 percent benefit ratio in the fourth quarter of 2004 is indicative of aging in closed blocks of level premium policies, as well as the fact that about 70 percent of the acquired business is paid up as measured by reserves.

The corporate and other segment includes primarily investment income on capital and surplus, certain unallocated expenses, and all realized investment gains and losses. A pretax operating loss of $200,000 was reported in the fourth quarter of 2004, compared to operating income of $400,000 in 2003. Lower investment income contributed to this decline, as well as the one-time hiring expenses I mentioned earlier.

I will conclude with a report on our progress to date with Sarbanes-Oxley Section 404 compliance. We put together a steering committee of financial, actuarial, IT and operations leaders at Kanawha shortly after the IPO closed. I engaged the firm of Jefferson Wells in early January to help us with the initial assessment and documentation of all processes critical to financial reporting. We now have a well-defined work plan, which we have reviewed with our board and the external auditors, and we are well under way. We expect to have the documentation and remediation work done by early in the third quarter, and expect to be testing controls in connection with the third quarter close. It's going to take a lot of our internal resources to get this completed, and it's going to cost about twice what I thought originally. But the important thing is we have a good process involving our best people, and we will be done in time for certification in our 2005 10-K.

Finally, let me say how pleased I've been with the quality and effort of the people we have at Kanawha. It's been a very exciting but challenging time for all of us during the first three months since the IPO. I have been spending most of my time with the financial and actuarial staff, and I've been extremely impressed with the quality of the work they have produced, and their efforts. The fact that we are able to get our first 10-K filed on time today and report to you now on our inaugural conference call is quite a testament to them.

With that, let me turn the call back to the conference call operator for the Q and A session.

And before we do that, I would like to correct one statement that Scott made. The yield on the portfolio - investment portfolio from 2003 to 2004 dropped by 20 basis points rather then 200. It went from seven – 5.73 to about 5.55.

Thank you, Ken.

So now we're ready to take any questions that you may have.

Thank you, sir. Ladies and gentlemen, if you do wish to ask a question, please key star followed by one on your touch-tone telephone. If your question has been answered and you wish to withdraw that question, please press star followed by two. Again, ladies and gentlemen, it is star one for your questions.

Our first question comes from the line of David Lewis of SunTrust Robinson Humphrey.

Thank you, and good morning.

Good morning.

That was a lot of detail, Scott, and I think that's helpful. But I guess from my prospect is really it's kind of looking forward in how we use those numbers to kind of get to our forecast looking out. So if I can maybe kind of focus on a couple of things which you may or may not be prepared to talk about, but let's have a discussion on the investment income.

Investment income was a little lower than I anticipated in the quarter, but also the claims were a little lower than I anticipated. So actually beat my expectations on the bottom line. But if we look at kind of the pro forma investment income, tell us how much you had, you know, at the beginning of the quarter in cash. I think it started you said $58 million, and how much of that to date you've already kind of reinvested, and I think you indicated six percent. And how quickly we might guess that we move that up over the next two quarters.

Our cash position between the insurance company and KMG America was in the range of 125 million throughout most of the first quarter of '05. We have invested now a little bit over 20 percent of that, and yields have been just under six percent, the quality has been triple B type quality.

OK. And you had guessed that the majority of this cash would be invested assuming rates continued their slow advance by early third quarter?

I would suspect before then. Our instructions to the investment manager is to continue to actively pursue investments that meet the investment yields that we have. Obviously we have paid constraints on individual issuer limits so we can’t go out and get fully invest immediately. But with the rates where they are today, I would guess that by the end of the second quarter, beginning of the third quarter, unless there was a change, I would guess that we will be very close to 100 percent invested by the end of the second quarter.

OK, that's helpful. And, Scott, you indicated that SOX costs might be double your original assumptions. What kind of level do you think those might be for 2005? And should we expect a reduction in 2006?

Well right now the overall cost is looking like it'll be around a million and a half dollars, including not just the Jefferson Wells costs, but the incremental audit activity on the part of our independent audit firm.

Now looking to 2006 and beyond, there is ongoing compliance activity and related testing, but the costs are largely front ended, and going forward would be a small fraction of the million and a half that we expect to incur this year.

OK, and then finally on sales, if I heard correctly you - that you placed six large cases for two million of annualized premium?

No. between a million and two million, closer to a million.

And where does that show up? Is that under the work site marketing segment of the schedule on the last page of the release?

This is for first quarter '05.

That sure - so where is that going to show up though as we look at it though?

We will have a segment I am sure for the new large case activity.

OK, so you'll break it out separately?

I would guess that's right.

Well, we'll have the breakout available whether we break it out into a separate reporting segment remains to be seen. But we intend to account for the new activity separate from the legacy activity, so we'll have that information.

OK. And just a little more detail on those six large cases, was that - give us the idea of what the average case size was. Maybe was it more of a group life product, was it a disability product? Give us some details, if you would, so we can kind of get an idea of what you targeted.

The only product that we have available to sell today is Kanawha's existing voluntary product, and they have an array of critical illness and disability and other products. The average case size would have been substantially lower on those cases than we would expect to going forward when we have our group products in place.

Great. Thanks very much.

Thank you. Our next question comes from the line of Kevin Feder of Credit Suisse First Boston.

How are you? My question relates to how does after one quarter under you belt, how would you say this changes your outlook about 2005, 2006?

Kevin, let me take a shot at that. As Ken talked or mentioned in his remarks, you know, we've been focused almost entirely on the activity associated with the 10-K, and getting our arms around the fourth quarter so that we could talk about it intelligently this morning. That means that we've not completed the next generation of our business planning process, and I would - I would prefer not to speculate on how things are looking today versus where they were looking for us last fall during the IPO preparation process until we've completed that.

Now we've promised our board that we would provide that update to them when we meet with them in May. So our thoughts on that score we'll defer until after we report our first quarter.

Sure. Second question related to the disability in the work site business. Could you talk about exactly what went wrong there, and the size of the block, and kind of what's - a little more detail as to what's going on there?

I think you're referring to the two claims or two cases that had excess claims.

Sure.

I think that - I think that in retrospect I think that these were underwriting errors. Obviously claims flow at various levels in all cases, and it's never exactly what you expect. But I think on these two cases in particular I think that the decisions that were made at time of underwriting were probably not very appropriate.

We have - you know, we've dealt with that to the extent we can relative to price increases and so forth, and obviously we have a - we're implementing a more disciplined underwriting process associated with this new activity. So - and we haven't seen other cases emerge in the last half of '04 other than those two, so I don't think we think there's likely to be more of those kinds of underwriting errors.

All right.

Yes, but I would just say, you know, to your first question I would say, and this is more anecdotally, it's very apparent to me that the quality of the sales force that we're recruiting is even better than I had hoped. I have to be more confident about our ability to produce $3 million per rep on a normalized basis than I was before. We are incurring more costs, as I said, sooner than our original plan, but I think this all bodes well for 2006. I would be more confident now about our ability to achieve our sales numbers in '06 than I would have been 60 days ago.

Great. Thanks a lot.

Thank you. Our next question comes from the line of Stewart Johnson of FBR.

Hi, good morning. I have a follow-up question regarding the claims in the work site business, and you had said that you put rate increases in place or had planned to. Are there any multi-year guarantees that may delay the higher premium levels coming in, or is this something that will be in place immediately?

It's in place immediately.

OK, great. That's good news. And then I guess the second area of higher than expected claims was in the acquired business, they were health insurance related claims. Can you give us some more detail on that and how you're addressing it?

Well, the specific situation that emerged in the fourth quarter was related to health insurance in one reinsurance treaty. And we are in discussions with the company who underwrites that - underwrote that business, the policies are still in their name. We expect that we will be able to impose the underwriting actions that we want to take, which involved in some cases re-rating the business, and other cases exiting - well actually this is all in force, so re-rating cases that are already on the books. We can't go forward with those plans until we have the cooperation and agreement from the ceding carrier, and we've been - we've been pursuing that for the last three months.

OK. Is another few months expected, or do you feel like you're getting somewhere there?

I hope so. I wouldn't expect another few months.

OK.

We probably would have had this taken care of had we not had so many other things on our minds.

OK, understand. I guess the second question is bigger picture. It sounds like you're trying to work out a little bit of a balancing between success in recruiting and getting these sales guys on board, yet not having the products you really want available until the second quarter. Stop loss, you said you're going to have available in the second quarter, and then group life towards the end of the second quarter. Is that a proper assessment? In other words, you're incurring expenses, but you don't have the products you want for the guys to sell yet.

That's right. In a perfect world we would hire everybody on June 22nd, or something like that, but it just doesn't work that way and we're - we couldn't be happier about having the reps on board that we have on board. We just want to manage the costs as prudent as we can. And we've actually slowed down hiring a bit, we could be farther down the line than we are, but it just makes sense I think to be prudent about the 2005 expenses, 2005 sales, and 2006 sales.

OK. And then my last question has to do with the complaint filed by ReliaStar. Have you heard anything in terms of filing since the initial? In other words - you said ...

The initial complaint was filed - we filed a response probably 10 days ago or so. Our litigation firm, Dorsey and Whitney in Minneapolis, has spent a significant amount of time on it, and we have had no additional interaction other than discussions with their law firm about timing of depositions, discovery and so forth.

OK. And they - have they filed any sort of a restraining order, or any follow-up or anything since the initial suit?

They have not.

OK. Thank you.

Thank you, sir. Ladies and gentlemen, as a reminder, it is star one if you have any questions at this time. Our next question comes from the line of Lisa Jelman of Sunova (ph) Capital.

I just wanted you to - have you reiterate for me, I think I missed it, what you had said about purchase accounting. Did I understand you correctly to say that it - you had not applied it in the - at the - at the time of the close?

That's right. In consultation with our audit firm, we considered the options relative to accounting for that 10-day stub period after the IPO closed. And concluded that it would be both more meaningful to investors and considerably simpler to prepare the financial statements and audit them if we for accounting purposes assumed that the transaction closed on December 31 rather than December 21. With that said, you know, we have prepared and provided pro forma earnings for the fourth quarter and year as well as 2003. So that at least for the full quarter you could see what earnings would have looked like had we followed a purchase accounting for Kanawha ...

OK.

... fourth quarter.

So if I were to - so let's see. Now the way I understand that is that the - this isn't simple - is that the pro forma statements account for the purchase as if it occurred - as if it occurred on the day it did occur, 12/21?

No.

It occurred for the entire first - entire quarter?

There is no purchase accounting in our - in our GAAP income statement.

OK.

There is purchase accounting reflected on the GAAP balance sheet as of 12/31/04 as if the acquisition occurred on that date. The acquisition date that's hypothetically assumed for purposes of the pro forma earnings that I've provided is consistent with how it was done per SX (ph) rules in our prospectus for the IPO, i.e. we assume that the acquisition for this purpose occurred on January 1, 2003.

OK. So - all right, let me just try to sum this up then. So it's reasonable to say that any impact of purchase accounting on your - in your income is reflected in the pro forma statements?

Yes, it is.

OK fine, thank you.

And the reason we did that as I said was we think that now that we will be presenting income statements starting with the first quarter of '05 on purchase accounting, you'll have a more comparable historical period to relate that to if we - you know, if you have pro forma income statements adjusted to purchase accounting for '03 and '04.

OK. All right.

Thank you. Our next question comes as a follow-up from the line of David Lewis.

Yes, couple of follow-ups. But I guess one thing, Scott, I want to make sure I'm clear on to Lisa's question, you did not get any benefit from the investment income on the excess proceeds included in that pro forma statement, which would have a favorable benefit on say $58 million of excess capital from the proceeds as we go into the first quarter, correct?

That is correct. Under - you know, and I guess we could have done this as we chose, but we did it pretty much consistent with the rules applicable to the S-1, and that is to say you can - you can only reflect things that you know with certainty. And since we didn't know what we might have invested those assets or those excess capital funds in, we couldn't estimate that in the pro forma calculation.

Understand. Can you give us an idea of what to expect the tax rate - do you still insist say roughly a 35 percent tax rate for '05?

Yes, we do.

Straight across the board on a quarterly basis?

I think so.

OK. And do you by chance have the pre FAS115 book value, or know what the unrealized gains were after tax in the year end period?

Well the unrealized gains and the fixed income portfolio were about $18 million. Of course they went away with the mark to market on the - on the purchase date, which as I said for accounting purposes is year end 2004. So they're in effect realized, but the - under Kanawha's historical GAAP, they were about $18 million on 12/31/04. And under purchase accounting we also have to include mark to market adjustments for all other invested assets, so there's about a million and a half additional adjustment for the small mortgage loan portfolio.

So on an ongoing basis then the $8.44 of diluted earnings - I mean diluted book value would be basically the same on a reported pre FAS115 basis?

Well we - the pro forma earnings were adjusted for the amortization of that premium over the cost basis. And, you know, similarly going forward, the investment income reported will be adjusted for the realized gain that will have to be amortized against future earnings to the ultimate maturity value. So P-GAAP investment income going forward will be lower than historic GAAP income would have been had we not had purchase accounting.

OK, I understand. And then finally litigation expenses I assume are expenses that are developed, Ken, I think you indicated that you spent a good amount of time on this. Does that mean that we have higher front-end litigation expenses in the first and maybe even second quarters?

I'd say throughout the year I think that, you know, the discovery that will go on in the second and third quarters would lead to some incremental increases in litigation expense for the entire year.

Do you care to share any guesstimate of what that level might be? Is it a half million dollars? Or ...

I don't think it'll be that high, I think it probably will be less than half of that.

OK, great. Thanks very much.

Thank you, sir. And at this time there are no further questions on the line. I'd like to turn it back to our management team for any closing remarks.

Well, thank you for joining us this morning. I'll reiterate that we couldn't be happier about the progress we've made, and we look forward to talking to you on a quarterly basis, and updating you on the progress that we're making. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude your presentation, and you may now disconnect. Have a wonderful day.