UNIVERSAL AMERICAN FINANCIAL CORP. / 2000 Annual Report

UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. INCOME TAXES:

The Company files a consolidated return for Federal income tax purposes, in which American Exchange and its subsidiaries and PennCorp Life of Canada are not currently permitted to be included. American Exchange and its subsidiaries file a separate consolidated Federal income tax return.

The Company's Federal income tax expense (benefit):

                                    2000      1999     1998 
                                        (In thousands)
Current - U.S.. ..............  $   (126)  $   127  $     -
Current - Canadian ...........     3,296     1,394        -
Deferred - U.S. ..............     7,281     4,078    1,324
Deferred - Canadian ..........      (270)      644        - 
Total tax expense ............  $ 10,181   $ 6,243  $ 1,324

A reconciliation of the "expected" tax expense at 35% (34% in 1998) with the Company's actual tax expense applicable to operating income before taxes reported in the Consolidated Statements of Operations is as follows:

                                       2000      1999     1998 
                                          (In thousands)
Expected tax expense............  $  11,573  $  5,619  $ 1,337
Change in
   valuation allowance..........     (1,343)        -        -
Canadian taxes .................       (390)      365        -
Other ..........................        341       259      (13)
Actual tax expense .............  $  10,181  $  6,243  $ 1,324

In addition to Federal income tax, the Company is subject to state premium and income taxes, which taxes are included in other operating costs and expenses in the accompanying statement of operations. Income taxes receivable for the years ended December 31, 2000 and 1999 totaled $0.2 million and $3.7 million, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying value of assets and liabilities for financial reporting purposes and the amount used for income tax purposes. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2000 and 1999 are as follows:

                                                        2000        1999 
                                                         (In thousands)
Deferred tax assets:
Reserves for future policy benefits..............  $  22,032   $  30,637
Deferred policy acquisition costs ...............     19,418      24,582
Net operating loss carryforwards.................     19,615      19,899
Unrealized losses on investments.................          -       3,873
Investment valuation differences ................     10,733       7,176
Deferred revenues ...............................      1,145           -
AMT credit carryforward..........................        389         262
Other (including restructuring)..................      4,652           - 
   Total gross deferred tax assets ..............     77,984      86,429
   Less valuation allowance......................    (10,385)    (11,343)
   Net deferred tax assets ......................     67,599      75,086 

Deferred revenues ...............................          -      (1,190)
Present value of future profits .................       (339)       (488)
Unrealized gains on investments .................     (2,246)          -
Other............................................          -      (2,440)
   Total gross deferred tax liabilities .........     (2,585)     (4,118)
   Net deferred tax asset .......................  $  65,014   $  70,968

At December 31, 2000, the Company (exclusive of American Exchange and its subsidiaries and PennCorp Life of Canada) had tax loss carryforwards of approximately $9.4 million that expire in the years 2005 to 2019. At December 31, 2000, the Company also had an Alternative Minimum Tax (AMT) credit carryforward for Federal income tax purposes of approximately $0.4 million that can be carried forward indefinitely. At December 31, 2000, American Exchange and its subsidiaries had tax loss carryforwards, most of which were incurred prior to their acquisition by the Company, of approximately $46.7 million that expire in the years 2007 to 2013. As a result of changes in ownership of the Company in July 1999, the use of most of the loss carryforwards of the Company are subject to annual limitations.

At December 31, 2000 and 1999, the Company carried valuation allowances of $10.4 million and $11.3 million, respectively, with respect to its deferred tax assets. The Company establishes a valuation allowance based upon an analysis of projected taxable income and its ability to implement prudent and feasible tax planning strategies. As a result of the increased profitability of the Administrative Services segment, valuation allowances on certain of the non-life tax loss carryforwards were considered not necessary at December 31, 2000. The amount of the valuation allowance released was $1.3 million and was recorded as a benefit in the deferred income tax expense. This decrease was offset by the establishment of a valuation allowance for the purchased net operating losses of CHCS, which are subject to limitations on their use. Management believes it is more likely than not that the Company will realize the recorded net deferred tax assets.