UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FOR            ANNUAL AND TRANSITION REPORTS

 

**FORM 10-K**

 

| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE                            SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] |
|---|--------------------------------------------------------------------------------------------------------------------------------|

|   | For the Fiscal Year ended December 31, 2007                            or |
|--------|---------------------------------------------------------------------------|

| [ ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE                            SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] |
|-----|---------------------------------------------------------------------------------------------------------------------------------------|

|   | For the Transition Period from______ | to_______ |
|--------|--------------------------------------|-----------|

Commission File Number 2-40764

 

**KANSAS CITY LIFE INSURANCE COMPANY**

(Exact Name of Registrant as Specified in its Charter)

 

|   | Missouri | 44-0308260 |
|--------|----------|------------|

|   | (State or Other Jurisdiction of | (I.R.S. Employer |
|--------|---------------------------------|------------------|

|   | Incorporation or Organization) | Identification Number) |
|--------|--------------------------------|------------------------|

 

|   | 3520 Broadway, Kansas City, Missouri | 64111-2565   |
|--------|--------------------------------------|-------------------|

|   | (Address of Principal Executive Offices) | (Zip Code) |
|--------|------------------------------------------|------------|

 

Registrant's Telephone Number, including Area Code:            816-753-7000

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

|   | Name of Each Exchange on |
|--------|--------------------------|

|   | Title of Each Class | Which Registered |
|--------|---------------------|------------------|

|   | $1.25 par value common stock | NASDAQ Capital Market LLC |
|--------|------------------------------|---------------------------|

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

(Title of Class)

 

**-1-** 

 

 

Indicate by check mark if the Registrant is a well-known seasoned            issuer, as defined in Rule 405 of the Securities Act.

|   | Yeso | Nox |
|--------|------|-----|

 

Indicate by check mark if the Registrant is not required to file reports            pursuant to Section 13 or Section 15(d) of the Act.

|   | Yeso | Nox |
|--------|------|-----|

 

Indicate by check mark whether the Registrant (1) has filed all reports            required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934            during the preceding 12 months (or for such shorter period that the Registrant was            required to file such reports), and (2) has been subject to such filing requirements            for the past 90 days.

             

|   | Yesx | Noo |
|--------|------|-----|

 

Indicate by check mark if disclosure of delinquent filers pursuant to            Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will            not be contained, to the best of Registrant's knowledge, in definitive proxy or            information statements incorporated by reference in Part III of this Form 10-K or any            amendment to this Form 10-K.x

 

Indicate by check mark whether the Registrant is a large accelerated            filer, an accelerated filer, or a non-accelerated filer, See definition of            “accelerated filer and large accelerated filer” in Rule 12b-2 of the            Exchange Act. (Check one):

             

|   | Large accelerated filero | Accelerated filerx | Non-accelerated filero |
|--------|--------------------------|--------------------|------------------------|

             

Indicate by check mark whether the Registrant is a shell company (as            defined in Rule 12b-2 of the Act).

             

|   | Yeso | Nox |
|--------|------|-----|

 

As of December 31, 2007, 11,765,037 shares of the Company's capital            stock par value $1.25 were outstanding, and the aggregate market value of the common            stock (based upon the average of bid and ask price according to Company records) on            June 30, 2007 of Kansas City Life Insurance Company held by non-affiliates was            approximately $182,745,010.

 

**-2-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**TABLE OF CONTENTS**

 

 

| PART                            I.................................................................................................................................                                                                                                                 | 4      |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                                                               |   |
| Item 1.                            Business......................................................................................................................                                                                                                                  | 4      |
| Item 1A. Risk Factors and Cautionary Factors that may                            Affect Future                            Results...............................................                                                                                                   | 5      |
| Item 1B. Unresolved Staff                            Comments..............................................................................................                                                                                                                        | 11     |
| Item 2.                            Properties.....................................................................................................................                                                                                                                 | 11     |
| Item 3. Legal                            Proceedings............................................................................................................                                                                                                                   | 12     |
| Item 4. Submission of Matters to a Vote of Security                            Holders..................................................................                                                                                                                           | 12     |
|                                                                                                                                                                                                                                                                               |   |
| PART                            II.................................................................................................................................                                                                                                                | 13     |
|                                                                                                                                                                                                                                                                               |   |
| Item 5. Market for Registrant’s Common Equity,                            Related Stockholder Matters and Issuer Purchases of Equity

Securities............................................................................................................................ | 13     |
| Item 6. Selected Consolidated Financial                            Data......................................................................................                                                                                                                      | 15     |
| Item 7. Management’s Discussion and Analysis of                            Financial Condition and Results of                            Operations.......................                                                                                                   | 16     |
| Item 7A. Quantitative and Qualitative Disclosures About                            Market                            Risk.......................................................                                                                                                   | 37     |
| Item 8. Financial Statements and Supplementary                            Data...........................................................................                                                                                                                          | 40     |
| Consolidated Balance                            Sheets......................................................................................................                                                                                                                       | 40     |
| Consolidated Statements of                            Income..............................................................................................                                                                                                                         | 41     |
| Consolidated Statements of Stockholders’                            Equity.............................................................................                                                                                                                      | 42     |
| Consolidated Statements of Cash                            Flows........................................................................................                                                                                                                           | 43     |
| Notes to Consolidated Financial                            Statements....................................................................................                                                                                                                          | 44     |
| Schedule I – Summary of Investments – Other                            Than Investments in Related                            Parties....................................                                                                                              | 75     |
| Schedule II – Condensed Financial Information of                            Registrant...............................................................                                                                                                                        | 76     |
| Schedule III – Supplementary Insurance                            Information........................................................................                                                                                                                        | 79     |
| Schedule IV – Reinsurance                            Information........................................................................................                                                                                                                     | 80     |
| Schedule V – Valuation and Qualifying                            Accounts............................................................................                                                                                                                        | 82     |
| Report of Independent Registered Public Accounting                            Firm..................................................................                                                                                                                               | 83     |
| Item 9. Changes in and Disagreements with Accountants                            on Accounting and Financial Disclosure.....................                                                                                                                                       | 85     |
| Item 9A. Controls and                            Procedures..................................................................................................                                                                                                                      | 85     |
| Item 9B. Other                            Information..........................................................................................................                                                                                                                    | 85     |
|                                                                                                                                                                                                                                                                               |   |
| PART                            III.................................................................................................................................                                                                                                               | 86     |
| The information required by Items 10 through 14 is                            incorporated by reference from our definitive proxy

statement to be filed with the Commission pursuant to                            Regulation 14A within 120 days after December 31, 2007.        |   |
|                                                                                                                                                                                                                                                                               |   |
| PART                            IV.................................................................................................................................                                                                                                                | 86     |
|                                                                                                                                                                                                                                                                               |   |
| Item 15. Exhibits, Financial Statement                            Schedules................................................................................                                                                                                                        | 86     |
|                                                                                                                                                                                                                                                                               |   |
| Signatures................................................................................................................................                                                                                                                                         | 88     |
|                                                                                                                                                                                                                                                                               |   |

 

 

**-3-** 

 

**PART I**

 

**Item 1****.****BUSINESS**

 

Kansas City Life Insurance Company (the Company) was incorporated under            the assessment laws of Missouri in 1895 as the Bankers Life Association. In 1900, its            present corporate title was adopted and it was reorganized as a legal reserve company            in 1903.

 

The            Company primarily consists of three insurance companies: Kansas City Life Insurance            Company (Kansas City Life) the parent company, and wholly owned subsidiaries Sunset            Life Insurance Company of America (Sunset Life) and Old American Insurance Company (Old            American). The Company also has several non-insurance subsidiaries that individually            are not material.

 

Kansas City Life markets its individual insurance products, including            traditional, interest sensitive and variable products through a nationwide sales force            of independent general agents and third-party marketing arrangements. Kansas City Life            also markets group insurance products, which include life, dental, vision and            disability products through a nationwide sales force of independent general agents,            group brokers and third-party marketing arrangements. Kansas City Life operates in 48            states and the District of Columbia.

 

Sunset Life’s individual insurance products include traditional            and interest sensitive products. Sunset Life’s marketing, administrative and            accounting operations have been integrated with Kansas City Life’s to improve            efficiency and effectiveness. Sunset Life continues as a life insurance company with            its current block of business, but without new sales. Sunset Life operates in 43 states            and the District of Columbia.

 

Old            American sells final expense insurance products nationwide through its general agency            system, with exclusive territories, using direct response marketing to supply agents            with leads. Old American operates and maintains a separate and independent field force.            To support the unique needs of this field force, Old American maintains a separate and            distinct sales and marketing function, while other operational activities have been            integrated with Kansas City Life’s to improve efficiency and effectiveness. Old            American operates in 46 states and the District of Columbia.

 

The            Company has three reportable business segments: Individual Insurance, Group Insurance            and Old American. The Individual Insurance segment consists of individual insurance            products for both Kansas City Life and Sunset Life. For the year ended December 31,            2007, the Individual segment generated approximately 55% of consolidated customer            revenues. Also during 2007, the Group Insurance segment and the Old American segment            accounted for 19% and 26% of consolidated revenues from customers,            respectively.

 

The            Company and its subsidiaries are subject to state regulations in their states of            domicile and in the states in which they do business. Although the federal government            generally does not regulate the business of insurance, federal initiatives often have            an impact on the business in a variety of ways, including the taxation of insurance            companies and the tax treatment of insurance products. In addition, the Company is a            stock life insurance company and is subject to the rules and regulations of the            Securities and Exchange Commission (SEC).

 

The            Company and its subsidiaries had 527 full-time employees as of December 31, 2007. The            Company considers relations with its employees to be good.

 

The            Company operates in the life insurance sector of the financial services industry in the            United States. The industry is highly competitive with respect to pricing, selection of            products and quality of service. No single competitor or any small group of competitors            dominate any of the markets in which the Company operates.

 

*Access to Public Filings*

 

The            Company provides access to its annual report on Form 10-K, and will provide access as            they become available during the year for all quarterly reports on Form 10-Q, current            reports on Form 8-K, and amendments to these reports filed with the Securities and            Exchange Commission (SEC) under the 1934 Act, free of charge. These documents may be            accessed on the Company’s website at the following address:http://www.kclife.comand will be provided            as soon as is practicable after filing with the SEC, although not always on the same            day. They may also be found on the SEC’s website athttp://www.sec.gov.

 

 

**-4-** 

**Item 1A.****RISK FACTORS AND            CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS**

             

The            operating results of life insurance companies have historically been subject to            significant fluctuations. The factors which could affect the Company’s future            results include, but are not limited to, general economic conditions and the known            trends and uncertainties which are discussed more fully below.

 

*The Company operates in a mature, highly competitive industry, which            could limit its ability to grow sales or maintain its position in the industry and            negatively affect profitability.*

 

Life            insurance is a mature and highly competitive industry. In recent years, the industry            has experienced little growth in life insurance sales, though the aging population has            increased the demand for retirement savings products. The Company encounters            significant competition in all lines of business from other insurance companies, many            of which have greater financial resources, a greater market share, a broader range of            products, lower product prices, better name recognition, policyholder service,            perceived financial strength, claims-paying ratings, the ability to assume a greater            level of risk, lower operating or financing costs, or lower profitability            expectations.

 

*Changes in the business environment and competition could negatively            affect the Company’s ability to maintain or increase its            profitability.*

 

In            recent years, there has been substantial consolidation and convergence among companies            in the financial services industry, resulting in increased competition from large,            well-capitalized financial services firms. Furthermore, many of these larger            competitors may have lower operating costs and an ability to absorb greater risk while            maintaining their financial strength ratings, thereby allowing them to price their            products more competitively. The Company expects consolidation to continue, thereby            increasing competitive pressures.

 

Changes in demographics, particularly the aging of the population and            the decline in the number of agents in the industry, affect the demand for life            insurance products. Also, as technology evolves, customers and agents may be able to            compare products of any particular company with any other, which could lead to            increased competition as well as changes in agent or customer behavior, including            persistency that differs from past behavior.

 

*The Company may be unable to attract agencies and sales            representatives.*

 

The            Company sells insurance and annuity products through independent agents and agencies.            These agencies and sales representatives are not captive and may sell products of the            Company’s competitors.The Company’s ability to compete is dependent upon,            among other things, its ability to attract and retain agents and agencies to market its            insurance products, its ability to develop competitive and profitable products, its            ability to maintain low unit costs, and its maintenance of strong ratings from rating            agencies. Sales and the results of operations and financial condition could be            adversely affected if the Company is unsuccessful in attracting and retaining agencies            and sales representatives.

 

*The Company’s ability to maintain competitive unit costs is            dependent upon the level of new sales.*

 

The            Company’s ability to maintain competitive unit costs is dependent upon a number            of factors, such as the level of new sales, persistency (continuation or renewal) of            existing business, and expense management. A decrease in sales or the amount of total            existing business without a corresponding reduction in expenses may result in higher            unit costs, which would affect the Company’s operating results.

 

*The Company’s ability to grow depends in large part upon the            continued availability of capital.*

 

The            Company deploys significant amounts of capital to support its sales and acquisitions            efforts. Although the Company believes it has sufficient capital to fund its immediate            growth and capital needs, the amount of capital available could vary in the future due            to a variety of circumstances, some of which are neither predictable nor foreseeable,            nor within the Company’s control. A lack of sufficient capital could impair the            Company’s ability to grow.

 

 

 

 

**-5-** 

*The            Company may be unable to complete additional acquisitions.*

 

One            of the Company’s growth strategies is to acquire other life insurance companies            and/or blocks of business. The Company’s acquisitions have increased its earnings            by allowing the Company to position itself to realize certain operating efficiencies or            increase sales. There can be no assurance, however, that suitable acquisitions that            present opportunities for continued growth and operating efficiencies will continue to            be available to the Company. Further, sufficient capital to fund acquisitions may not            be available at the time opportunities become available.

 

*The Company may not realize its anticipated financial results from            its acquisitions.*

 

The            completion of an acquisition may be more costly or take longer than expected. There may            be unforeseen liabilities that arise in connection with businesses that the Company            acquires. Additionally, in connection with its acquisitions, the Company assumes or            otherwise becomes responsible for the obligations of policies and other liabilities of            other insurers. Any regulatory, legal, financial, or other adverse development            affecting the other insurer could also have an adverse effect on the            Company.

 

*The Company’s policy claims fluctuate from period to period,            resulting in earnings volatility.*

 

The            Company’s financial results may fluctuate from period to period due to            fluctuations in policy claims incurred by the Company. The Company reinsures a            significant amount of the mortality risk on fully underwritten and newly issued,            individual life insurance contracts. The Company regularly reviews retention limits for            continued appropriateness and they may be changed in the future. If the Company was to            experience adverse mortality or morbidity experience, a significant portion of that            expense would be reimbursed by reinsurers.

 

*Significant adverse mortality experience may result in the loss of,            or higher prices for, reinsurance.*

 

Prolonged or severe adverse mortality or morbidity experience could            result in increased reinsurance costs, and ultimately, reinsurers not willing to offer            coverage. If the Company was unable to maintain its current level of reinsurance or            purchase new reinsurance protection in amounts that are considered sufficient, the            Company would either have to be willing to accept an increase in net exposures or            revise pricing to reflect higher reinsurance premiums. If this were to occur, the            Company may be exposed to reduced profitability and cash flow strain or may not be able            to price new business at competitive rates.

 

*The Company’s results may be negatively affected should actual            experience differ from management’s assumptions and estimates.*

 

In            the conduct of business, the Company makes certain assumptions regarding the mortality,            persistency, expenses, interest rates, tax liability, business mix, or other factors            appropriate to the type of business it expects to experience in future periods. These            assumptions are also used to estimate the amounts of deferred policy acquisition costs,            policy reserves and accruals, future earnings, and various components of the            Company’s balance sheet. These assumptions are used in the operations of the            Company’s business in making decisions crucial to the success of the Company,            including the pricing of products and expense structures relating to products. The            Company’s actual experience, as well as changes in estimates are used to prepare            the Company’s income statements. To the extent the Company’s actual            experience varies from period to period, deviations in our financial statement will            result.

 

*The Company’s reserves for future policy benefits may prove to            be inadequate.*

 

The            Company establishes and carries, as a liability, reserves based on estimates of how            much will be needed to pay for future benefits and claims. The assumptions and            estimates used in connection with establishing and carrying reserves are inherently            uncertain. If actual experience is significantly different from assumptions or            estimates, reserves may prove to be inadequate in relation to estimated future benefits            and claims. As a result, a charge to earnings would be incurred in the quarter in which            the Company increases reserves.

 

*Assumptions and estimates involve judgment and are subject to changes            and revision over time.*

 

The            calculations the Company uses to estimate various components of its balance sheet and            statements of income are necessarily complex and involve analyzing and interpreting            large quantities of data. The Company currently employs various techniques for such            calculations and it from time to time will develop and implement more sophisticated            systems and procedures capable of facilitating the calculation of more precise            estimates. Accordingly, the Company’s results may be affected, positively or            negatively, from time to time, by actual

 

**-6-** 

results            differing from assumptions, by changes in estimates, and by changes resulting from            implementing more sophisticated administrative systems and procedures that facilitate            the calculation of more precise estimates.

 

*The Company’s reinsurers could fail to meet assumed            obligations, increase rates or be subject to adverse*

*developments that could affect the Company.*

 

The            Company follows the insurance practice of reinsuring a portion of the risks under the            policies written by the Company (known as ceding). The Company cedes material amounts            of insurance to other insurance companies through reinsurance. This reinsurance makes            the assuming reinsurer liable to the Company for the reinsured portion of the risk.            However, reinsurance does not discharge the Company from its primary obligation to pay            policyholders for losses insured under the policies that are issued. Therefore, the            failure of one or more of the Company’s reinsurers could negatively impact the            Company’s earnings and financial position.

 

*The Company’s ability to compete is dependent on the            availability of reinsurance or other substitute capital market            solutions.*

 

Premium rates charged by the Company are based, in part, on the            assumption that reinsurance will be available at a certain cost. Under certain            reinsurance agreements, the reinsurer may increase the rate it charges the Company for            the reinsurance. Therefore, if the cost of reinsurance were to increase or if            reinsurance were to become unavailable or if alternatives to reinsurance were not            available to the Company, the Company could be adversely affected.

 

Recently, access to reinsurance has become more costly for the Company,            as well as the insurance industry in general. In recent years, the number of life            reinsurers has decreased as the reinsurance industry has consolidated. The decreased            number of participants in the life reinsurance market results in increased            concentration risk for insurers, including the Company. If the reinsurance market            further contracts, the Company’s ability to continue to offer its products on            terms favorable to the Company could be adversely impacted.

 

*The use of reinsurance introduces variability in the Company’s            income statements.*

 

The            timing of premium payments to and receipt of expense allowances from reinsurers may            differ from the Company’s receipt of customer premium payments and incurrence of            expenses. These timing differences introduce variability in certain components of the            Company’s income statements.

 

*The Company’s investments are subject to market and credit            risks.*

 

The            Company’s invested assets, primarily including fixed income securities, are            subject to customary risks of credit defaults and changes in market values. The value            of the Company’s commercial mortgage loan and real estate portfolios also depend            on the financial condition of the tenants occupying the properties which the Company            has financed. Factors that may affect the overall default rate on, and market value of,            the Company’s invested assets includes interest rate levels, financial market            performance, and general economic conditions, as well as particular circumstances            affecting the businesses of individual borrowers and tenants.

 

*Interest rate fluctuations could negatively affect the            Company’s spread income or otherwise impact its business.*

 

Because the profitability of fixed annuity and interest-sensitive whole            life, universal life and fixed portion of variable universal life insurance business            depends in part on interest rate spreads, interest rate fluctuations could negatively            affect profitability. Changes in interest rates may reduce both the profitability from            spread businesses and the return on invested capital.

 

Some            of the Company’s products, principally fixed annuities and interest-sensitive            whole life, universal life and the fixed portion of variable universal life insurance,            have interest rate guarantees that expose the Company to the risk that changes in            interest rates will reduce the “spread,” or the difference between the            amounts the Company is required to credit to policyholders under contracts and the            amounts earned by the Company on general account investments. Declines in spread or            instances where the returns on the general account investments are not sufficient to            support the interest rate guarantees on these products could have a material adverse            effect on the results of operations. In periods of increasing interest rates, the            Company may not be able to replace the assets in the general account with higher            yielding assets needed to fund the higher crediting rates that may be necessary to keep            interest sensitive products competitive. The Company, therefore, may have to accept a            lower spread and profitability or face a decline in sales and loss of existing            contracts from non-renewed maturities or early withdrawals or surrenders. In periods of            declining interest rates, the Company has to reinvest the cash received from interest            or return of principal on investments in lower yielding

**                                                                                                     -7-** 

instruments then available. Moreover, issuers of fixed-income securities            and borrowers may prepay these obligations in order to borrow at lower market rates,            which exacerbates the risk for the Company of having to reinvest at lower            rates.

 

The            Company is entitled to reset the interest rates on fixed-rate annuities but only at            limited, pre-established intervals. Because many of the Company’s policies have            guaranteed minimum interest or crediting rates. Because many of the Company’s            policies have guaranteed minimum interest or credit rates, spreads could decrease and            potentially become negative. Increases in interest rates may cause increased surrenders            and withdrawals of insurance products. In periods of increasing interest rates, policy            loans and surrenders and withdrawals of life insurance policies and annuity contracts            may increase as policyholders seek to buy products with higher returns. These outflows            may require investment assets to be sold at a time when the prices of those assets are            lower because of the increase in market interest rates, which may result in realized            investment losses.

 

Changes in interest rates may also impact the business in other ways.            Lower interest rates may result in lower sales of certain of the Company’s            insurance products. Higher interest rates may create a less favorable environment for            the origination of mortgage loans. Higher interest rates may also result in lower sales            of variable products.

 

While the Company develops and maintains asset/liability management            programs and procedures designed to mitigate the effect on spread income in rising or            falling interest rate environments, no assurance can be given that changes in interest            rates will not affect such spreads. Additionally, the Company’s asset/liability            management programs incorporate assumptions about the relationship between short-term            and long-term interest rates (i.e., the slope of the yield curve) and relationships            between risk-adjusted and risk-free interest rates, market liquidity, policyholder            behavior in periods of changing interest rates and other factors. The effectiveness of            the Company’s asset/liability management programs and procedures may be            negatively affected whenever actual results differ from these assumptions.

 

*The Company could be forced to sell investments at a loss to cover            policyholder withdrawals.*

 

Many            of the products offered by the Company allow policyholders and contract holders to            withdraw their funds under defined circumstances. The Company manages liabilities and            configures the investment portfolio so as to provide and maintain sufficient liquidity            to support anticipated withdrawal demands and contract benefits and maturities. While            the Company owns a significant amount of liquid assets, a certain portion of investment            assets are relatively illiquid. If the Company experiences unanticipated withdrawal or            surrender activity, the Company could exhaust all other sources of liquidity and be            forced to liquidate other assets, perhaps on unfavorable terms. If the Company is            forced to dispose of assets on unfavorable terms, it could have an adverse effect on            the Company’s financial condition.

 

*Equity market volatility could negatively impact the Company’s            business.*

 

The            amount of policy fees received from variable products is affected by the performance of            the equity markets, increasing or decreasing as markets rise or fall. Equity market            volatility can also affect the profitability of variable products in other ways, in            particular as a result of options embedded in these products.

 

The            amortization of deferred policy acquisition costs relating to variable products and the            estimated cost of providing guaranteed minimum death benefits incorporate various            assumptions about the overall performance of equity markets over certain time periods.            The rate of amortization of deferred policy acquisition costs and the estimated cost of            providing guaranteed minimum death benefits could increase if equity market performance            is worse than assumed.

 

*Computer viruses or network security breaches could affect the data            processing systems of the Company or its business partners and could damage business            and adversely affect financial condition and results of operations.*

 

A            computer virus could affect the data processing systems of the Company or its business            partners, destroying valuable data or making it difficult to conduct business. In            addition, despite the Company’s implementation of network security measures, its            servers could be subject to physical and electronic break-ins, and similar disruptions            from unauthorized tampering with its computer systems. The Company retains confidential            information in its computer systems, and relies on sophisticated commercial            technologies to maintain the security of those systems. Anyone who is able to            circumvent the Company’s security measures and penetrate the Company’s            computer systems could access, view, misappropriate, alter, or delete any information            in the systems, including personally identifiable customer information and proprietary            business information. In addition, an increasing number of states require that            customers be notified if a security breach results in the disclosure of personally            identifiable customer information. Any compromise of the security of the            Company’s

**-8-** 

computer systems that results in inappropriate disclosure of personally            identifiable customer information could damage the Company’s reputation in the            marketplace, deter people from purchasing the Company’s products, subject the            Company to significant civil and criminal liability and require the Company to incur            significant technical, legal and other expenses.

 

*Insurance companies are highly regulated and subject to numerous            legal restrictions and regulations.*

 

The            Company is subject to government regulation in each of the states in which business is            conducted. Such regulation is vested in state agencies having broad administrative and            in, some instances, discretionary power dealing with many aspects of the            Company’s business. This may include, among other things, premium rates and            increases thereto, reserve requirements, marketing practices, advertising, privacy,            policy forms, reinsurance reserve requirements, acquisitions, mergers, and capital            adequacy. Government regulation of insurers is concerned primarily with the protection            of policyholders and other customers rather than share owners. Interpretations of            regulations by regulators may change and statutes, regulations and interpretations may            be applied with retroactive impact, particularly in areas such as accounting or reserve            requirements.

 

At            the federal level, bills have been introduced in the U. S. Senate and the U. S. House            of Representatives that would provide for an optional federal charter for life and            property and casualty insurers, and another bill has been introduced in the U. S. House            of Representatives that would pre-empt state law in certain respects with regard to the            regulation of reinsurance. Still another bill has been introduced in the House and            Senate that would remove the federal antitrust exemption from the insurance industry.            The Company cannot predict whether or in what manner reforms will be enacted and, if            so, whether the enacted reforms will positively or negatively affect the Company or            whether any effects will be material. Moreover, although with respect to some financial            regulations and guidelines, states defer to the interpretation of the insurance            department of the state of domicile, neither the action of the domiciliary state nor            action of the National Association of Insurance Commissioners (NAIC) is binding on a            state. Accordingly, a state could choose to follow a different            interpretation.

 

Other types of regulation that could affect the Company include            insurance company investment laws and regulations, state statutory accounting            practices, anti-trust laws, minimum solvency requirements, state securities laws,            federal privacy laws, insurable interest laws, federal money laundering and            anti-terrorism laws. Further, because the Company owns and operates real property,            state, federal, and local environmental laws could affect the Company. The Company            cannot predict what form any future changes in these or other areas of regulation            affecting the insurance industry might take or what effect, if any, such proposals            might have on the Company if enacted into law.

 

*Publicly held companies in general and the financial services            industry, in particular, are sometimes the target of law enforcement investigations and            the focus of increased regulatory scrutiny.*

 

The            financial services industry has become the focus of increased scrutiny by regulatory            and law enforcement authorities relating to allegations of improper special payments,            price-fixing, bid-rigging and other alleged misconduct, including payments made by            insurers and other financial services providers to brokers and the practices            surrounding the placement of insurance business and sales of other financial            products.

 

*New accounting rules or changes to existing accounting rules could            negatively impact the Company.*

 

Like            all publicly traded companies, the Company is required to comply with accounting            principles generally accepted in the United States of America (GAAP). A number of            organizations are instrumental in the development and interpretation of GAAP, such as            the SEC, the Public Company Accounting Oversight Board (PCAOB), the Financial            Accounting Standards Board (FASB), and the American Institute of Certified Public            Accountants (AICPA).

 

GAAP            is subject to constant review by these organizations and others in an effort to address            emerging accounting rules and issue interpretative accounting guidance on a continual            basis. The Company can give no assurance that future changes to GAAP will not have a            negative impact on the Company.

 

In            addition, the Company is required to comply with statutory accounting principles (SAP).            SAP and various components of SAP (such as statutory actuarial reserving methodology)            are subject to constant review by the NAIC and its taskforces and committees as well as            state insurance departments to address emerging issues and otherwise improve or alter            financial reporting. Various proposals are currently pending before committees and            taskforces of the NAIC, some of which, if enacted, would negatively affect the Company,            and some of which could positively impact the Company. The NAIC is also currently            working to reform state regulation in various areas, including comprehensive reforms            relating to life insurance reserves and the accounting for such reserves. The Company            cannot predict whether or in what manner reforms will be enacted and, if so, whether            the enacted reforms will positively or negatively affect the Company. Although, states            generally defer to the interpretation of the insurance department of the state of            domicile with regards to

**                                                                                                             -9-** 

regulations and guidelines, neither the action of the domiciliary state            nor action of the NAIC is binding on a state. Accordingly, a state could choose to            follow a different interpretation. The Company can give no assurance that future            changes to SAP or components of SAP will not have a negative impact on the            Company.

 

*Changes to tax law or interpretations of existing tax law could            adversely affect the Company and its ability to compete with non-insurance products or            reduce the demand for certain insurance products.*

 

Under the Internal Revenue Code of 1986, as amended (the Code), income            tax payable by policyholders on investment earnings is deferred during the accumulation            period of certain life insurance and annuity products. This favorable tax treatment may            give certain of the Company’s products a competitive advantage over other            non-insurance products. To the extent that the Code is revised to reduce the            tax-deferred status of life insurance and annuity products, or to increase the            tax-deferred status of competing products, all life insurance companies, including the            Company, would be adversely affected with respect to their ability to sell such            products. Further, depending upon grandfathering provisions, life companies would be            affected by the surrenders of existing annuity contracts and life insurance policies.            Changes in tax law, which have reduced the federal income tax rates on corporate            dividends in certain circumstances, could make the tax advantages of investing in            certain life insurance or annuity products less attractive. Additionally, changes in            tax law based on proposals to establish new tax advantaged retirement and life savings            plans, if enacted, could reduce the tax advantage of investing in certain life            insurance or annuity products. The Company cannot predict what changes to tax law or            interpretations of existing tax law may ultimately be enacted or adopted or whether            such changes could adversely affect the Company.

 

*A            ratings downgrade could adversely affect the Company’s ability to compete and            increase the number or value of policies surrendered.*

 

The            Company’s financial strength ratings, which are intended to measure its ability            to meet policyholder obligations, are an important factor affecting public confidence            in most of the Company’s products and, as a result, the Company’s            competitiveness. Rating organizations periodically review the financial performance and            condition of insurers, including the Company. In recent years, downgrades of insurance            companies have occurred with increasing frequency.

 

A            downgrade in the Company’s rating could adversely affect the Company’s            ability to sell its products, retain existing business, and compete for attractive            acquisition opportunities. Rating organizations assign ratings based upon several            factors. While most of the factors relate to the rated company, some of the factors            relate to the views of the rating organization, general economic conditions and            circumstances outside the rated company’s control. In addition, rating            organizations use various models and formulas to assess the strength of a rated            company, and from time to time rating organizations have, in their discretion, altered            the models. Changes to the models could impact the rating organizations’ judgment            of the rating to be assigned to the rated company. The Company cannot predict what            actions the rating organizations may take, or what actions the Company may be required            to take in response to the actions of the rating organizations, which could adversely            affect the Company.

 

*Financial services companies are frequently the targets of            litigation, including class action litigation, which could result in substantial            judgments.*

 

A            number of civil jury verdicts have been returned against insurers, broker-dealers, and            other providers of financial services involving sales or claims practices, alleged            agent misconduct, failure to properly supervise representatives, relationships with            agents or other persons with whom the insurer does business, and other matters. Often            these lawsuits have resulted in the award of substantial judgments that are            disproportionate to the actual damages, including material amounts of punitive            non-economic compensatory damages. In some states, juries, judges, and arbitrators have            substantial discretion in awarding punitive and non-economic compensatory damages,            which creates the potential for unpredictable material adverse judgments or awards in            any given lawsuit or arbitration. Arbitration awards are subject to very limited            appellate review. In addition, in some class actions and other lawsuits, companies have            made material settlement payments.

 

The            Company, like other financial services companies, in the ordinary course of business is            involved in litigation and arbitration. Although the Company cannot predict the outcome            of any litigation or arbitration, the Company does not believe that any such outcome            will have a material impact on the financial condition or results of operations of the            Company.

 

 

 

**-10-** 

*The            Company is exposed to the risks of natural disasters, pandemics, malicious and            terrorist acts that could adversely affect the Company’s            operations.*

 

While the Company has implemented risk management and contingency plans,            and taken preventive measures and other precautions, no predictions of specific            scenarios can be made nor can assurance be given that there are not scenarios that            could have an adverse effect on the Company. A natural disaster, pandemic, or an            outbreak of an easily communicable disease could adversely affect the mortality or            morbidity experience of the Company or its reinsurers. A pandemic could also have an            adverse effect on lapses and surrenders of existing policies, as well as sales of new            policies. In addition, a pandemic could result in large areas being subject to            quarantine, with the result that economic activity slows or ceases, adversely affecting            the marketing or administration of the Company’s business within such area and/or            the general economic climate. This, in turn, could have an adverse affect on the            Company. The possible macroeconomic effects of a pandemic could also adversely affect            the Company’s asset portfolio, as well as many other variables.

 

*The Company is dependent on the performance of others.*

 

The            Company’s results may be affected by the performance of others because the            Company has entered into various arrangements involving other parties. For example,            most of the Company’s products are sold through independent distribution            channels, and variable annuity deposits are invested in funds managed by third parties.            Additionally, the Company’s operations are dependent on various technologies,            some of which are provided by other parties.

 

As            with all financial services companies, the Company’s ability to conduct business            is dependent upon consumer confidence in the industry and its products. Actions of            competitors and financial difficulties of other companies in the industry could            undermine consumer confidence and adversely affect retention of existing business and            future sales of the Company’s insurance and investment products.

 

*Risk management policies and procedures may leave the Company exposed            to unidentified or unanticipated risk, which could negatively affect business or result            in losses.*

 

The            Company has devoted significant resources to develop risk management policies and            procedures and expects to continue to do so in the future. Nonetheless, the            Company’s policies and procedures used to identify, monitor and manage risks may            not be fully effective. Many of the methods of managing risk and exposures are based            upon the use of observed historical market behavior or statistics based on historical            models. As a result, these methods may not predict future exposures, which could be            significantly greater than the historical measures indicate, such as the risk of            pandemics causing a large number of deaths. Other risk management methods depend upon            the evaluation of information regarding markets, clients, catastrophe occurrence or            other matters that are publicly available or otherwise accessible to us, which may not            always be accurate, complete, up-to-date or properly evaluated. Management of            operational, legal and regulatory risks requires, among other things, policies and            procedures to record properly and verify a large number of transactions and events, and            these policies and procedures may not be fully effective. Additional risks and            uncertainties not currently known, or that the Company currently deems to be            immaterial, may adversely affect the business, financial condition and/or operating            results.

 

**Item 1B.****UNRESOLVED STAFF            COMMENTS**

 

None.

 

**Item 2****.****PROPERTIES**

 

The            Company’s home office is located at 3520 Broadway in Kansas City, Missouri. The            Company owns and wholly occupies two five-story buildings on an eight-acre            site.

 

The            Company owns various other properties held for investment.

 

 

 

 

**-11-** 

**Item 3****.****LEGAL PROCEEDINGS**

 

The            life insurance industry, including the Company and its subsidiaries, has been subject            to an increase in litigation in recent years. Such litigation has been pursued on            behalf of purported classes of insurance purchasers, often questioning the conduct of            insurers in the marketing of their products.

 

In            addition to the above, the Company and its subsidiaries are defendants in, or subject            to, other claims or legal actions. Some of these claims and legal actions are in            jurisdictions where juries are given substantial latitude in assessing damages,            including punitive damages. Although no assurances can be given and no determinations            can be made at this time, management believes that the ultimate liability, if any, with            respect to these other claims and legal actions would have no material effect on the            Company’s business, results of operations or financial position.

 

**Item 4****.****SUBMISSION OF MATTERS TO A VOTE OF SECURITY            HOLDERS**

 

None.

 

 

**-12-** 

 

**PART II**

 

**Item 5****.****MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS            AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

**STOCKHOLDER INFORMATION**

             

**CORPORATE HEADQUARTERS**

Kansas City Life Insurance Company

3520 Broadway

Post Office Box 219139

Kansas City, Missouri 64121-9139

Telephone: (816) 753-7000

Fax: (816) 753-4902

Internet: http://www.kclife.com

E-mail: kclife@kclife.com

 

**NOTICE OF ANNUAL MEETING**

The annual meeting of stockholders will be held at 9 a.m. on Thursday,            April 24, 2008 at Kansas City Life's corporate headquarters.

 

**TRANSFER AGENT**

Cheryl Keefer, Assistant Secretary

Kansas City Life Insurance Company

Post Office Box 219139

Kansas City, Missouri 64121-9139

 

**10-K            REQUEST**

Stockholders may request a free copy of Kansas City Life's Form 10-K, as            filed with the Securities and Exchange Commission, by writing to Secretary, Kansas City            Life Insurance Company.

 

**SECURITY HOLDERS**

As of January 31, 2008, Kansas City Life had approximately 2,500            security holders, including individual participants in security position            listings.

 

**-13-** 

 

**STOCK AND DIVIDEND INFORMATION**

**Stock Quotation Symbol**

NASDAQ—KCLI

 

The            following table presents the high and low prices for the Company’s common stock            for the periods indicated and the dividends declared per share during such            periods.

 

|           |   | Bid    |   |   | Dividend |
|----------------|--------|--------|--------|--------|----------|
|           |   | High   |   |   | Low      |   |   | Paid |
|           |   |
| **2007:**      |   |   |   |   |     |   |   |   |
| First quarter  | $      | 52.28  |   | $      | 44.35    |   | $ | 2.27 |
| Second quarter |   | 47.95  |   |   | 44.61    |   |   | 0.27 |
| Third quarter  |   | 50.79  |   |   | 38.18    |   |   | 0.27 |
| Fourth quarter |   | 50.48  |   |   | 40.00    |   |   | 0.27 |
|           |   |   |   |   | $        | 3.08 |
| **2006:**      |   |   |   |   |     |   |   |   |
| First quarter  | $      | 53.04  |   | $      | 48.75    |   | $ | 0.27 |
| Second quarter |   | 51.27  |   |   | 41.57    |   |   | 0.27 |
| Third quarter  |   | 46.08  |   |   | 41.82    |   |   | 0.27 |
| Fourth quarter |   | 58.97  |   |   | 44.36    |   |   | 0.27 |
|           |   |   |   |   | $        | 1.08 |
|           |   |   |   |   |     |   |   |   |

 

 

A            quarterly dividend of $0.27 per share was paid February 12, 2008.

             

NASDAQ            market quotations are compiled according to Company records and may reflect            inter-dealer prices, without markup, markdown or commission and may not necessarily            represent actual            transactions.                

**-14-** 

 

**Item 6****.****SELECTED CONSOLIDATED FINANCIAL DATA**

 

 

| **SELECTED CONSOLIDATED FINANCIAL DATA**  |
|-------------------------------------------|
| (amounts in thousands, except share data) |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                      |   |   | 2007 |   | 2006 |   | 2005 |   | 2004 |   | 2003 |
| Revenues:                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                      | Insurance revenues | $ | 231,894 |   | $ | 235,264 |   | $ | 238,503 |   | $ | 250,111 |   | $ | 272,664 |
|                                      | Net investment income |   | 190,405 |   |   | 196,280 |   |   | 194,608 |   |   | 197,975 |   |   | 194,763 |
|                                      | Realized investment gains (losses) |   | 5,426 |   |   | 5,621 |   |   | 6,113 |   |   | 45,929 |   |   | (29,280) |
|                                      | Other revenues |   | 11,499 |   |   | 11,349 |   |   | 10,312 |   |   | 8,468 |   |   | 9,387 |
|                                      |   | Total revenues | $ | 439,224 |   | $ | 448,514 |   | $ | 449,536 |   | $ |  502,483 |   | $ | 447,534 |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                | $ | 35,661 |   | $ | 36,918 |   | $ | 36,184 |   | $ | 57,687 |   | $ | 14,793 |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Per common share:                         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                      | Net income, basic and diluted | $ | 3.01 |   | $ | 3.11 |   | $ | 3.03 |   | $ | 4.83 |   | $ | 1.24 |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                      | Cash dividends to stockholders | $ | 3.08 |   | $ | 1.08 |   | $ | 1.08 |   | $ | 1.08 |   | $ | 1.08 |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                      | Stockholders' equity | $ | 58.17 |   | $ | 57.72 |   | $ | 57.07 |   | $ | 58.00 |   | $ | 54.04 |
|                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Assets                                    | $ |  4,352,108 |   | $ |  4,457,795 |   | $ | 4,555,379 |   | $ | 4,662,724 |   | $ | 4,544,669 |
| Notes payable                             |   | 10,400 |   |   | 14,700 |   |   | 27,282 |   |   | 92,220 |   |   | 133,670 |
| Stockholders' equity                      |   | 684,401 |   |   | 684,304 |   |   | 680,219 |   |   | 692,896 |   |   | 644,438 |
| Life insurance in force                   | $ |      31,135,142 |   | $ |       31,261,016 |   | $ |       30,949,501 |   | $ |       30,980,928 |   | $ | 32,216,624 |

 

 

**-15-** 

**Item 7****:****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION            AND RESULTS OF OPERATIONS**

 

Management’s Discussion and Analysis of Financial Condition and            Results of Operations analyzes the consolidated financial condition, changes in            financial position and results of operations for the three years ended December 31,            2007 of Kansas City Life Insurance Company and its consolidated subsidiaries. The            discussion should be read in conjunction with the Consolidated Financial Statements and            Notes. All dollar amounts are in thousands except share data.

 

**Overview**

 

Kansas City Life Insurance Company (the Company) is a financial services            company. The Company primarily consists of three life insurance companies: Kansas City            Life Insurance Company (Kansas City Life) the parent company, and wholly owned            subsidiaries Sunset Life Insurance Company of America (Sunset Life) and Old American            Insurance Company (Old American).

 

Kansas City Life markets its individual insurance products, including            traditional, interest sensitive and variable products through a nationwide sales force            of independent general agents and third-party marketing arrangements. Kansas City Life            also markets group insurance products, which include life, dental, vision and            disability products through a nationwide sales force of independent general agents,            group brokers and third-party marketing arrangements. Kansas City Life operates in 48            states and the District of Columbia.

 

Sunset Life’s individual insurance products include traditional            and interest sensitive products. Sunset Life’s marketing, administrative and            accounting operations have been integrated with Kansas City Life’s to improve            efficiency and effectiveness. Sunset Life continues as a life insurance company with            its current block of business, but without new sales. Sunset Life operates in 43 states            and the District of Columbia.

 

Old            American sells final expense insurance products nationwide through its general agency            system, with exclusive territories, using direct response marketing to supply agents            with leads. Old American operates and maintains a separate and independent field force.            To support the unique needs of this field force, Old American maintains a separate and            distinct sales and marketing function, while other operational activities have been            integrated with Kansas City Life’s to improve efficiency and effectiveness. Old            American operates in 46 states and the District of Columbia.

 

The            Company offers investment products and broker dealer services through its subsidiary            Sunset Financial Services, Inc. (SFS) for both proprietary and non-proprietary variable            insurance products and mutual funds.

 

**Business Changes**

 

On            January 23, 2006 the Company entered into a definitive agreement to sell its bank            subsidiary, Generations Bank, for $10.1 million in cash to Brooke Corporation. On            January 8, 2007, the Company completed the sale of Generations Bank after receiving            regulatory approval from the Office of Thrift Supervision. The gain on the sale was            $1.9 million and is included in realized investment gains. The bank subsidiary and the            results of operations were not material to the financial statements of the Company and            are not disclosed separately.

 

In            2006 the Company entered into a Master General Agent and Marketing Agreement with            American Republic Insurance Company (American Republic) under which American Republic            agents market Kansas City Life’s insurance products. For segment reporting            purposes, sales under this agreement are reflected in the Individual Insurance            segment.

 

**Cautionary Statement on Forward-Looking Information**

 

This            report reviews the Company’s financial condition and results of operations, and            historical information is presented and discussed. Where appropriate, factors that may            affect future financial performance are also identified and discussed. Certain            statements made in this report include “forward-looking statements” that            fall within the meaning of the Private Securities Litigation Reform Act of 1995.            Forward-looking statements include any statement that may predict, forecast, indicate            or imply future results, performance or achievements rather than historical facts and            may contain words like “believe,” “expect,”            “estimate,” “project,” “forecast,”            “anticipate,” “plan,” “will,” “shall,”            and other words, phrases or expressions with similar meaning.

 

**-16-** 

Forward-looking statements are subject to known and unknown risks,            uncertainties and other factors that may cause actual results to differ materially from            those contemplated by the forward-looking statements. Factors that could cause the            Company’s future results to differ materially from expected results include, but            are not limited to:

 

 

|   | **•** | Changes in general economic conditions, including the                            performance of financial markets and interest rates; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Increasing competition and changes in consumer behavior,                            which may affect the Company’s ability to sell its products and                            retain business; |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Customer and agent response to new products,                            distribution channels and marketing initiatives; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Fluctuations in experience regarding current mortality,                            morbidity, persistency and interest rates relative to expected amounts                            used in pricing the Company’s products; |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Changes in assumptions related to deferred acquisition                            costs and the value of business acquired; |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Regulatory, accounting or tax changes that may affect                            the cost of, or the demand for, the Company’s products or                            services; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Unanticipated changes in industry trends and ratings                            assigned by nationally recognized rating organizations. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|

 

The            Company cannot give assurances that such statements will prove to be correct. Given            these risks and uncertainties, investors should not place undue reliance on            forward-looking statements as a prediction of actual results.

 

**Critical Accounting Policies and Estimates**

 

The            accounting policies below have been identified as critical to the understanding of the            results of operations and financial position. The application of these critical            accounting policies in preparing the financial statements requires management to use a            variety of assumptions and estimates, in particular expectations of current and future            mortality, morbidity, persistency, expenses, interest rates and equity market            performance. Actual results may differ from these estimates under different assumptions            or conditions. The profitability of life insurance and annuity products is dependent on            actual experience and differences between actual experience and pricing assumptions may            result in variability of net income in amounts which may be material. On an ongoing            basis, the Company evaluates the estimates, assumptions and judgments based on            historical experience and various other information that the Company believes to be            reasonable under the circumstances. A detailed discussion of other significant            accounting policies is provided in Note 1- Nature of Operations and Significant            Accounting Policies in the Notes to Consolidated Financial Statements.

 

***Recognition of Revenues***

Premiums are included in insurance revenues in the Consolidated            Statements of Income. Premiums for traditional life insurance products are reported as            revenue when due. Traditional insurance products include whole life, term life,            immediate annuities and supplementary contracts with life contingencies.

 

Premiums on accident and health, disability and dental insurance are            reported as earned ratably over the contract period in proportion to the amount of            insurance protection provided. A reserve is provided for the portion of premiums            written which relates to unexpired terms of coverage.

 

Deposits relate to insurance products that include universal life,            variable life, variable annuities, fixed deferred annuities, annuities and supplemental            contracts without life contingencies. The cash flows from deposits are credited to            policyholder account balances. Deposits are not recorded as revenue, but revenues from            such contracts consist of amounts assessed against policyholder account balances for            mortality, policy administration and surrender charges, and are recognized in the            period in which the services are provided. Deposits are shown as a Financing Activity            in the Consolidated Statements of Cash Flows.

 

The            Company measures its sales or new business production with two components: new premiums            recorded and new deposits received. Premiums and deposits are subdivided into two            categories: new and renewal. New premiums and deposits are measures of sales or new            business production. Renewal premiums and deposits occur as continuing business from            existing customers.

 

***Reinsurance***

Reinsurance is one of the tools that the Company uses to accomplish its            business objectives. A variety of reinsurance vehicles are currently in use, including            individual and bulk arrangements on both coinsurance and mortality/morbidity only            basis. Reinsurance supports a multitude of corporate objectives, including managing            statutory capital, reducing volatility and surplus strain. At the customer level,            reinsurance increases the

 

**-17-** 

Company’s capacity, provides access to additional underwriting            expertise, and generally makes it possible for the Company to offer products at            competitive levels that could not otherwise be made available. Reinsurance is an            actively managed tool that has increased in importance over recent years and will            continue to play a role in the Company’s future. Reinsurance receivables include            amounts related to paid benefits and estimated amounts related to unpaid policy and            contract claims, future policy benefits and policyholder account balances.

 

***Future Policy Benefits***

The            Company establishes liabilities for amounts payable under insurance policies, including            traditional life insurance, annuities and accident and health insurance. Generally,            amounts are payable over an extended period of time. Principal assumptions used in            pricing policies and in the establishment of liabilities for future policy benefits are            mortality, morbidity, expenses, persistency, investment returns and            inflation.

 

***Policyholder Account Balances***

Policyholder account balances include universal life insurance, fixed            deferred annuity contracts and investment-type contracts. The account balances for            universal life contracts are equal to cumulative premiums, less contract charges and            withdrawals, plus interest credited. The account balances for fixed deferred annuities            and investment-type contracts are equal to the cumulative deposits, less any applicable            contract charges and withdrawals, plus interest credited.

 

***Deferred Acquisition Costs (DAC) and Value of Business Acquired            (VOBA)***

Deferred acquisition costs (DAC), principally agent commissions and            other selling, selection and issue costs, which vary with and are directly related to            the production of new business, are capitalized as incurred. These deferred costs are            then amortized in proportion to future premium revenues or the expected future profits            of the business, depending upon the type of product.

 

When            a new block of business is acquired, a portion of the purchase price is allocated to a            separately identifiable intangible asset, called the value of business acquired (VOBA).            VOBA is established as the actuarially determined present value of future gross profits            of the business acquired and is amortized in proportion to future premium revenues or            the expected future profits, depending on the type of business acquired.

 

The            Company considers the following assumptions to be of significance when evaluating the            amortization of DAC and VOBA: expected mortality, interest spreads, surrender rates and            expense margins. Mortality relates to the occurrence of death. Interest spreads are the            difference between the investment returns earned and the crediting rates of interest            applied to policyholder account balances. Surrender rates relate to the relative volume            of policy terminations. Expense margins involve the expenses incurred for maintaining            and servicing in-force policies.

 

At            least annually, a review is performed of the models and the assumptions used to develop            expected future profits, based upon management’s current view of future events.            DAC is reviewed on an ongoing basis to determine that the unamortized portion does not            exceed the expected recoverable amounts. Management’s view primarily reflects            Company experience but can also reflect emerging trends within the industry. Short-term            deviations in experience affect the amortization of DAC and VOBA in the period, but do            not necessarily indicate that a change to the long-term assumptions of future            experience is warranted. If it is determined that it is appropriate to change the            long-term assumptions of future experience, then an unlocking adjustment is recognized            for the block of business being evaluated. Certain assumptions, such as interest            spreads and surrender rates, may be interrelated. As such, unlocking adjustments often            reflect revisions to multiple assumptions. The balances of DAC and VOBA are immediately            impacted by any assumption changes, with the change reflected through the income            statement as an unlocking adjustment in the amount of DAC or VOBA amortized. These            adjustments can be positive or negative. The impact of unlocking adjustments from the            changes in estimates for the periods reported are included in the sections*Consolidated Results of Operations*and*Operating Results by            Segment*.

 

The            following table reflects the estimated pre-tax impact to DAC and VOBA on universal            life, variable universal life, and fixed and variable deferred annuity products; that            could occur in a given year for an unlocking adjustment due to reasonably likely            changes in significant assumptions. Changes in assumptions of the same magnitude in the            opposite direction would have an impact of a similar magnitude but opposite direction            of the examples provided.

 

             

**-18-** 

| Critical Accounting Estimate | Determination Methodology                                                                                                                                                                                                                                               | Potential One-time Effect on DAC, VOBA and Related                        Items                                                                                                                                                          |
|------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Mortality Experience         | Based on Company mortality experience. Industry experience                        and trends are also considered.                                                                                                                                                       | A 2.5% increase in expected mortality experience for all                        future years would result in a reduction in DAC and VOBA, and an increase                        in current period amortization expense of $4.6 million. |
| Surrender Rates              | Based on Company surrender experience. Industry experience                        and trends are also considered.                                                                                                                                                       | A 10% increase in expected surrender rates for all future                        years would result in a reduction in DAC and VOBA, and an increase in                        current period amortization expense of $2.3 million.       |
| Interest Spreads             | Based on expected future investment returns and expected                        future crediting rates applied to policyholder account balances; future                        crediting rates include constraints imposed by policy                        guarantees. | A 10 basis point reduction in future interest rate spreads                        would result in a reduction in DAC and VOBA, and an increase in current                        period amortization expense of $3.9 million.            |
| Maintenance Expenses         | Based on Company experience using an internal expense                        allocation methodology.                                                                                                                                                                    | A 10% increase in future maintenance expenses would result                        in a reduction in DAC and VOBA, and an increase in current period                        amortization expense of $2.5 million.                         |

 

***Valuation of Investments***

The            Company’s principal investments are in fixed maturity securities, mortgage loans            and real estate; all of which are exposed to three primary sources of investment risk:            credit, interest rate and liquidity. The fixed maturity securities, which are all            classified as available for sale, are carried at their fair value in the            Company’s balance sheet, with unrealized gains or losses recorded in accumulated            other comprehensive loss net. The unrealized gains or losses are also recorded net of            the adjustment to policyholder account balances to reflect what would have been earned            had those gains been realized and the proceeds reinvested. The Company’s fair            value of fixed maturity and equity securities are derived from external pricing            sources, brokers, and internal matrices. Approximately 94% of these investments are            from external pricing services while 6% are derived from brokers and internal matrices.            The investment portfolio is monitored regularly to ensure that investments which may be            other than temporarily impaired are identified in a timely fashion and properly valued,            and that impairments are charged against earnings as realized investment losses. The            valuation of the investment portfolio involves a variety of assumptions and estimates,            especially for investments that are not actively traded. Fair values are obtained from            a variety of external sources.

 

The            Company has a policy and process in place to identify securities that could potentially            have an impairment that is other-than-temporary. This process involves monitoring            market events that could impact issuers’ credit ratings, business climate,            management changes, litigation and government actions, and other similar factors. This            process also involves monitoring late payments, downgrades by rating agencies, key            financial ratios, financial statements, revenue forecasts and cash flow projections as            indicators of credit issues.

 

At            the end of each quarter, all securities are reviewed to determine whether impairments            should be recorded. This quarterly process includes an assessment of the credit quality            of each investment in the entire securities portfolio. Additional reporting and review            procedures are conducted for those securities where fair value is less than 90% of            amortized cost. Further, detailed analysis is performed for each issue or issues having            experienced a formal restructuring or where the security has experienced material            deterioration in fair value.

 

The            Company considers relevant facts and circumstances in evaluating whether the impairment            of a security is other-than-temporary. Relevant facts and circumstances considered            include (1) the current fair value of the security as compared to cost, (2) the length            of time the fair value has been below cost, (3) the financial position of the issuer,            including the current and future impact of any specific events, and (4) the            Company’s ability and intent to hold the

 

**-19-** 

 

security to maturity or until it recovers in value. To the extent the            Company determines that a security is deemed to be other than temporarily impaired, the            difference between amortized cost and fair value would be charged to income as a            realized investment loss, resulting in a permanent reduction to the cost basis of the            underlying investment.

 

There are a number of significant risks and uncertainties inherent in            the process of monitoring impairments and determining if an impairment is            other-than-temporary. These risks and uncertainties include (1) the risk that the            Company’s assessment of an issuer’s ability to meet all of its contractual            obligations will change based on changes in the credit characteristics of that issuer,            (2) the risk that the economic outlook will be worse than expected or have more of an            impact on the issuer than anticipated, (3) the risk that fraudulent information could            be provided to the Company’s investment professionals who determine the fair            value estimates, and (4) the risk that new information obtained by the Company or            changes in other facts and circumstances lead the Company to change its intent to hold            the security to maturity or until it recovers in value. Any of these situations could            result in a charge to income in a future period.

 

***Income Taxes***

Deferred income taxes are recorded on the differences between the tax            bases of assets and liabilities and the amounts at which they are reported in the            consolidated financial statements. Recorded amounts are adjusted to reflect changes in            income tax rates and other tax law provisions as they become enacted. Deferred income            tax assets are subject to ongoing evaluation of whether such assets will be realized.            The ultimate realization of deferred income tax assets generally depends on generating            future taxable income during the periods in which temporary differences become            deductible and the reversal of deferred tax liabilities. A valuation allowance against            deferred income tax assets may be required if future taxable income is not expected.            The Company adopted the provisions of FASB Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,            on January 1, 2007. The Company did not change the liability for unrecognized tax            benefits as of January 1, 2007 as a result of implementing Interpretation 48. The total            amount of unrecognized tax benefits, if recognized, that would impact the effective tax            rate was $0.8 million as of December 31, 2007.

 

***Pensions and Other Postretirement Benefits***

The            measurement of pension and other postretirement benefit obligations and costs depends            on a variety of assumptions. Assumptions are made regarding the discount rate, expected            long-term rate of return on plan assets, employee turnover, expected compensation            increases, health care claim costs, heath care cost trends, retirement rates and            mortality. The discount rate and the expected return on plan assets have the most            significant impact on the level of cost. See Note 7 – Pensions and Other            Postretirement Benefits in the Notes to Consolidated Financial Statements for further            details.

 

**Consolidated Results of Operations**

 

***Summary***

The            Company’s net income decreased $1.3 million in 2007, versus the prior year, to a            total of $35.7 million. Net income increased $0.7 million in 2006 compared to 2005, to            a total of $36.9 million. Net income per share decreased 3% in 2007 to $3.01, compared            with $3.11 for 2006 and $3.03 in 2005. The decrease for the year ended 2007 included            declines in insurance revenues and net investment income and an increase in income tax            expense. These were partially offset by decreases in policyholder benefits, interest            credited to policyholder account balances, amortization of DAC and VOBA and operating            expenses. The improved results for the year ended 2006 compared to 2005 were largely            due to an increase in net investment income and decreases in policyholder benefits,            interest credited to policyholder account balances, and amortization of DAC and VOBA.            These favorable changes were partially offset by a decline in insurance revenues and            increased operating expenses.

 

***Sales***

The            Company measures sales in terms of new premiums and deposits. Premiums are included in            insurance revenues in the Consolidated Statements of Income, while deposits are shown            as a Financing Activity in the Consolidated Statements of Cash Flows. The first set of            tables below reconciles premiums included in insurance revenues and provides detail by            new and renewal business. New premiums are also detailed by product. The second set of            tables reconciles deposits with the Consolidated Statements of Cash Flows and provides            detail by new and renewal deposits. New deposits are also detailed by            product.

 

In            2007, the Company experienced a 1% increase in new individual life premiums, a 13%            increase in new immediate annuity sales and a 49% increase in new group life premiums.            The decline in 2006 largely resulted from 41% decline in new immediate annuity sales,            and a 23% decrease in new group life insurance premiums. Consolidated renewal premiums            declined 1% in 2007 compared to a 1% increase in 2006. The Company terminated a group            accident and health product line at year-end 2006, which impacts year-to-year            comparisons. The termination of this product line resulted in a $1.5 million reduction            in new premiums in 2007. Excluding the premiums for this product line from            both

 

**-20-** 

years,            a 1% increase in total premiums and a 6% increase in total new premiums would result.            Total premiums were flat in 2007, following a 2% decline in 2006.

 

 

|             |                                |               | 2007                     | %              |     | 2006    | %                        |          | 2005   |
|------------------|-------------------------------------|--------------------|--------------------------|----------------|----------|---------|--------------------------|---------------|--------|
| New premiums:    |                                |               |                     |           |     |    |                     |          |   |   |
|             | Individual life insurance           | $                  |   12,356            |    1 |     | $       |   12,242            |  (6)     |   | $ |   13,092 |
|             | Immediate annuities                 |               |     8,142 |  13       |     |    |     7,174 | (41)          |   |   |   12,159 |
|             | Group life insurance                |               |     1,516 |  49       |     |    |     1,020 | (23)          |   |   |     1,327 |
|             | Group accident and health insurance |               |     9,997 | (11)           |     |    |   11,267            |  17      |   |   |     9,612 |
|             |                                | Total new premiums |                     |   32,011  |   1 |    |                     |   31,703 | (12)   |   |   |   36,190 |
| Renewal premiums |                                | 143,449            | (1)                      |           |     | 144,223 |    1           |          |   | 143,376 |
| Total premiums   | $                                   | 175,460            | -                        |           | $        | 175,926 |  (2)                |          | $      | 179,566 |
|             |                                |               |                     |           |     |    |                     |          |   |   |   |   |

 

 

Total new deposits increased 8% in 2007 after declining 26% in 2006. The            improvement in 2007 was largely the result of a 37% increase in new variable annuity            deposits and a 7% increase in new universal life insurance deposits. The increase in            the sale of universal life products positively reflects the Company’s increased            emphasis on the sale of life insurance products. The increased sales of variable            annuity products continue to reflect customer interest in the equity markets.            Comparatively for 2006, new variable annuity deposits decreased 14% while new universal            life insurance deposits increased 1%.

 

New            variable universal life deposits increased 5% in 2007 and 7% in 2006. New fixed            deferred annuity deposits decreased 12% in 2007 and 40% in 2006. These declines can be            attributed to increased competition and the emergence of alternative            products.

 

Renewal deposits declined 2% in 2007 and 11% in 2006. The decline in            2007 primarily resulted from a $5.1 million or 25% decrease in fixed deferred annuities            that was partially offset by a $4.6 million or 44% increase in variable annuity            deposits. The decline in 2006 was primarily due to a $10.9 million or 35% decline in            fixed deferred annuity deposits and a $2.5 million or 19% decline in variable annuity            deposits.

 

|             |                              |               | 2007                     | %             |   | 2006    | %                        |          | 2005   |
|------------------|-----------------------------------|--------------------|--------------------------|---------------|--------|---------|--------------------------|---------------|--------|
| New deposits:    |                              |               |                     |          |   |    |                     |          |   |   |
|             | Universal life insurance          | $                  |   10,869            | 7             |   | $       |   10,117            | 1             |   | $ |  10,004 |
|             | Variable universal life insurance |               |     2,480 | 5             |   |    |     2,372 | 7             |   |   |    2,210 |
|             | Fixed deferred annuities          |               |   26,348            | (12)          |   |    |   29,815            | (40)          |   |   |   49,698 |
|             | Variable annuities                |               |   29,426            | 37            |   |    |   21,507            | (14)          |   |   |   24,894 |
|             |                              | Total new deposits |                     |   69,123 | 8      |    |                     |   63,811 | (26)   |   |   |   86,806 |
| Renewal deposits |                              | 136,644            | (2)                      |          |   | 139,139 | (11)                     |          |   | 155,807 |
| Total deposits   | $                                 | 205,767            | 1                        |          | $      | 202,950 | (16)                     |          | $      | 242,613 |
|             |                              |               |                     |          |   |    |                     |          |   |   |   |   |

 

 

 

 

**-21-** 

***Insurance Revenues***

 

Insurance revenues consist of premiums and contract charges, less            reinsurance ceded. Insurance revenues decreased $3.4 million or 1% to $231.9 million in            2007 compared to a similar decrease of $3.2 million or 1% in 2006. The decline in 2007            was primarily the result of a $3.1 million decrease in contract charges. A $1.0 million            increase in immediate annuity premiums was offset by a $0.9 million decrease in            individual life premiums and a $0.6 million decrease in accident and health premiums.            The decline in 2006 was largely the result of a $5.0 million decrease in immediate            annuity premiums and a $1.4 million decrease in individual life premiums. These changes            were partially offset by a $2.8 million increase in accident and health premiums, which            was largely the result of increased group dental sales.

 

Insurance revenues are affected by the level of new sales, the type of            products sold, and the persistency of policies, all of which may be influenced by            economic conditions, as well as competitive forces. Consumers continue to desire a            broad portfolio of products with safety and competitive return objectives, which the            Company strives to provide. The Company offers a broad range of products, including            variable insurance products, which allow policyholders to participate in both the            equity and fixed income markets. Interest sensitive and traditional insurance products            combine safety of principal with competitive interest returns.

 

Contract charges consist of cost of insurance, expense loads, the            amortization of unearned revenues and surrender charges. Certain contract charges for            universal life insurance are not recognized in income immediately but are deferred as            unearned revenues and are amortized into income in a manner similar to the amortization            of DAC. These contract charges, which are recorded as unearned revenues, are recognized            into income in proportion to the expected future gross profits of the business. In the            same manner as DAC, profit expectations are based upon assumptions of future interest            spreads, mortality margins, expense margins and policy and premium persistency            experience. At least annually, a review is performed of the assumptions related to            profit expectations. If it is determined the assumptions should be revised, the impact            is recorded as a change in the revenue reported in the current period as an unlocking            adjustment.

 

Contract charges declined 3% in 2007 and were flat in 2006. Contract            charges were reduced $1.7 million during the second quarter of 2007, resulting from a            correction of the unearned revenue portion of a universal life product. The amount of            the correction attributable to prior years was $1.1 million, including $0.9 million in            2006 and $0.2 million in 2005.

 

Reinsurance ceded declined $0.2 million to $55.0 million in 2007 from            $55.2 million in 2006. In 2005, reinsurance ceded was $55.8 million. The Company uses            reinsurance as a means to mitigate its risks and to reduce the earnings volatility from            claims.

 

***Investment Revenues***

Net            investment income decreased 3% in 2007 but increased 1% in 2006 from 2005. Net            investment income was $190.4 million in 2007, compared with $196.3 million in 2006 and            $194.6 million in 2005. The decrease in net investment income in 2007 resulted, in            part, from reduced investment assets. Total investments declined $128.0 million at            December 31, 2007 from the prior year. This included a decline of $50.6 million in 2007            due to the sale of Generations Bank. In addition, real estate assets declined $13.5            million during 2007, as the Company sold several real estate properties. Finally,            investments in mortgage loans decreased $21.9 million, as normal amortization and            prepayments in the portfolio outpaced new loan production. Investment expenses            increased $0.6 million in 2007, primarily resulting from reduced real estate accruals            in the prior year. The increase in net investment income in 2006 resulted from reduced            investment expenses, primarily due to lower real estate expenses. Negatively affecting            net investment income in 2006, total invested assets declined versus the prior year but            were offset by a slight increase in investment yields. In 2005, investment expenses            increased due to increased real estate expenses.

 

Net            investment income was largely composed of interest and dividends on fixed maturity            securities, equity securities and short-term investments. Net investment income also            includes income from mortgage loans, real estate and policy loans. Investment income is            stated net of investment expenses. Investment income on securities related activity            declined $2.6 million or 2% in 2007 compared with 2006. This same activity declined            less than $0.6 million or 1% in 2006 compared with 2005. Income from fixed maturity            securities decreased 3% in 2007 and 1% in 2006. Partially offsetting the decline in            investment income for fixed maturity securities, income from short-term investments            almost doubled during 2007 compared to a 21% increase in 2006. This was due to improved            short-term yields in both periods. In addition, there was increased purchase activity            in 2007.

 

Investments in mortgage loans decreased $21.9 million during 2007. The            sale of Generations Bank resulted in a decrease in mortgage loans of $18.3 million.            Consequently, investment income from mortgage loans decreased $0.5 million or 2% for            the year. Despite a $13.4 million increase in mortgage loan assets in 2006, mortgage            loan investment income declined $1.1 million or 3%. The reduced income in 2006            reflected a decline in available yields on new mortgages and the impact of the            prepayment of loans with rates higher than those of new loans.

 

**-22-** 

The            Company closely monitors its investments in securities classified as subprime.             Subprime securities include all bonds or portion of bonds where the underlying            collateral is made up of home equity loans or first mortgage loans to borrowers whose            credit scores at the time of origination were lower than the level recognized in the            market at prime. The Company’s classification of subprime does not include Alt-A            or jumbo loans, unless the collateral otherwise meets the preceding definition. At            December 31, 2007, the Company had investments with subprime residential mortgage            exposure of $39.1 million and a related $1.8 million unrealized loss.  This            exposure amounted to 1% of the Company’s invested assets and all such assets are            valued based on external pricing sources. Concerns arose during the second half of 2007            regarding subprime mortgage loan defaults.  Market dislocations have            exacerbated this issue as some sources of liquidity for mortgage lenders, such as            asset-backed commercial paper, have contracted dramatically.  Demand for            investments securitized by home loans has also fallen significantly, making it more            difficult for mortgage loan originators to sell their loans profitably.  Home            prices continue to fall, which hinders potential sales and loan refinancings            that might otherwise avert defaults.  These issues have largely been centered            around increasing delinquencies and default rates by subprime borrowers. Many investors            have shunned securities backed by home loans, regardless of the actual quality of the            underlying assets, sending market values for this entire class of securities            downward. 

 

Real            estate investments decreased $13.5 million in 2007 compared with 2006 due to property            sales during the year. Accordingly, investment income on real estate decreased 21% in            2007. Real estate investments increased $28.9 million in 2006 compared with 2005, but            many of these new investments were development properties where the income stream was            less than those of mature properties. As such, investment income from real estate            investments declined 5% in 2006 compared with 2005.

 

The            Company offers policy loans as a benefit to its policyholders, and loans are secured by            the cash value of the policy. Investment income from policy loans declined by $0.5            million in both 2007 and 2006. These declines were directly related to reduced balances            of loans outstanding.

 

The            Company recorded net realized investment gains of $5.4 million in 2007, $5.6 million in            2006 and $6.1 million in 2005. The realized investment gains were primarily the result            of the sale of real estate investment properties in all three years, including $7.1            million, $4.2 million and $6.8 million in 2007, 2006 and 2005, respectively. The            Company also recorded a $1.9 million gain from the sale of Generations Bank during            2007, which is included in other investment gains, below. The following table provides            detail concerning realized investment gains and losses over the three years ended            December 31.

 

| **Realized Investment Gains and Losses** | 2007                                 |                          | 2006                    |    | 2005               |
|------------------------------------------|--------------------------------------|-------------------------------|-------------------------|---------|--------------------|
| Gross gains resulting from:              |                                 |                          |                    |    |               |   |   |   |
|                                     | Sales of investment securities       | $                             |      964 |    | $                  |  3,550 |   | $ |   3,991 |
|                                     | Investment securities called         |                          |   1,090            |    |               |  1,142 |   |   |      989 |
|                                     | Sales of real estate                 |                          |   7,118            |    |               |  4,159 |   |   |   7,678 |
|                                     | Other investment gains               |                          |   1,905            |    |               |         1 |   |   |      905 |
|                                     |                                 | Total gross gains             |                    | 11,077  |               |   |  8,852 |   |   | 13,563 |
| Gross losses resulting from:             |                                 |                          |                    |    |               |   |   |   |
|                                     | Sales of investment securities       |                          | (1,240)                 |    |               | (1,151) |   |   | (6,009) |
|                                     | Write-downs of investment securities |                          | (4,036)                 |    |               | (1,060) |   |   | - |
|                                     | Investment securities called         |                          |    (332)      |    |               |    (593) |   |   |   (599) |
|                                     | Sales of real estate                 |                          | -                       |    |               | - |   |   |   (927) |
|                                     | Other investment losses              |                          | -                       |    |               |    (173) |   |   | - |
|                                     |                                 | Total gross losses            |                    | (5,608) |               |   | (2,977) |   |   | (7,535) |
| Amortization of DAC and VOBA             |                                 |      (43) |                    |    |    (254) |   |   |       85 |
| Realized investment gains                | $                                    |  5,426                   |                    | $       |  5,621        |   | $ |  6,113 |
|                                     |                                 |                          |                    |    |               |   |   |   |   |   |

 

 

**-23-** 

 

 

The            Company realized investment gains and losses from several other sources. Many            securities purchased by the Company contain call provisions, which allow the issuer to            redeem the securities at a particular price. Depending upon the terms of the call            provision and price at which the security was purchased, a gain or loss may be            realized. Sales and calls of investments in securities resulted in net realized gains            of $0.5 million in 2007 and $2.9 million in 2006 and a realized loss of $1.6 million in            2005. Other sources of realized investment gains and losses include write-downs of            investment securities, changes in the Company’s valuation reserve for potential            future losses in the commercial mortgage portfolio and other miscellaneous investment            gains and losses.

 

Real            estate investments were $96.0 million at December 31, 2007 and $109.5 million at            December 31, 2006. Real estate investments consist principally of office buildings and            industrial warehouses that are both in use and under development, and investments in            multi-family and single-family residential properties, including affordable housing.            The Company also invests in unimproved land for future development. Properties have            been acquired through individual purchases, build-to-suit and speculative development.            The Company generally maintains its ownership interest in these properties on a direct            and joint venture basis with the long-term intention of earning positive cash flow and            income by leasing the properties, along with the expectation of realizing capital            appreciation upon sale. The Company periodically sells certain real estate assets when            management believes that the market and timing are perceived to be            advantageous.

 

The            following table provides credit quality information on fixed maturity securities, as            determined by one of the nationally recognized ratings firms as of December 31,            2007.

 

|                   |                |      |                 |   |      |                 |   | % of   |
|------------------------|---------------------|-----------|----------------------|--------|-----------|----------------------|--------|--------|
| Investment             |                | Amortized |                 |   | Fair      |                 | Fair   |
| Quality                |                | Cost      |                 |   | Value     |                 | Value  |
|                   |                |      |                 |   |      |                 |   |   |
| Investment grade       | $                   | 2,449,197 |                 | $      | 2,462,193 |                 | 94     |
| Below investment grade |                |      |                 |   |      |                 |   |
|                   | (rated BB or lower) |      |    169,912 |   |      |    168,880 |   | 6      |
|                   |                | $         | 2,619,109            |   | $         | 2,631,073            |   |   |
|                   |                |      |                 |   |      |                 |   |   |

 

 

The            Company reviews and analyzes its securities on an ongoing basis to determine whether            impairments exist that are other-than-temporary. Based upon these analyses, specific            security values are written down to fair value through earnings as a realized            investment loss if the security's value is considered to be an other-than-temporary            impairment.

 

The            Company’s analysis of fixed maturity securities at year-end 2007 resulted in the            determination that two securities had other-than-temporary declines which were written            down by $4.0 million.  One of the two securities was below cost by 20% or more for            more than six consecutive months and was the subject of a recent leveraged buyout, that            was finalized during the fourth quarter 2007, which greatly increased the debt level of            the company.  The leveraged buyout plan is highly dependent upon the timely sale            of certain assets at what are perceived to be aggressive rates.  In addition, this            company is involved in several declining industries that are highly dependent on            general economic activity.  Accordingly, the Company wrote down this security $3.3            million at year-end 2007.  The second security filed for Chapter 11 protection and            indicated that it would not be able to fully meet all of its borrowings.  The            Company recognized an other-than-temporary impairment on this security at year-end 2006            of $1.1 million.  As a result of this new action, the Company recognized an            additional $0.7 million impairment in 2007.  At December 31, 2006, this            security

 

**-24-** 

 

 

was            below cost by 20% or more for more than twelve consecutive months.   It was            in a highly competitive and cyclical industry that was experiencing weakened demand and            overcapacity.  Capital expenditures for equipment upgrades were exceeding cash            generation.  In 2005, the Company had no securities that it identified as            other-than-temporarily impaired.  At year-end 2005, there were no investment            securities that were below cost by 20% or more for more than six consecutive            months

 

The            following table provides asset class detail of the investment portfolio. Fixed maturity            and equity securities represented 80% of the entire investment portfolio at December            31, 2007 and 2006.

 

 

| **Percent of Invested Assets** | 2007   |                            | 2006      |
|--------------------------------|--------|---------------------------------|-----------|
|                           |   | Amount                          |      | % |   | Amount |   | % |
| Fixed maturity securities      | $      | 2,631,073                       |      | 78 |   | $ | 2,719,439 |   | 78 |
| Equity securities              |   |      59,149 |      |   2 |   |   |      52,351 |   |   1 |
| Mortgage loans                 |   |    450,148            |      | 13 |   |   |    472,019 |   | 14 |
| Real estate                    |   |      96,049 |      |   3 |   |   |    109,525 |   |   3 |
| Policy loans                   |   |      92,803 |      |   3 |   |   |      96,218 |   |   3 |
| Short-term                     |   |      36,522 |      |   1 |   |   |      41,037 |   |   1 |
| Other                          |   | -                               |      | - |   |   |        3,182 |   | - |
|                           | Total  | $                               | 3,365,744 |   | 100 |   | $ | 3,493,771 |   | 100 |
|                           |   |                            |      |   |   |   |   |   |   |   |

 

 

The            securities portfolio had net unrealized gains before taxes of $13.2 million at year-end            2007 compared with $2.7 million at year-end 2006. The portfolio was broadly diversified            across sectors. A variety of measures have been employed to manage the            portfolio’s credit and interest rate risks, as discussed later in this document            in Item 7A – Quantitative and Qualitative Disclosures About Market            Risk.

 

Mortgage loans comprised 13% of the investment portfolio at December 31,            2007, down slightly from 14% of the investment portfolio at the end of 2006. The            majority of the mortgages were commercial loans on industrial warehouses and office            properties. None of the loans have been restructured nor have there been any loans in            foreclosure over the past three years. One mortgage loan was delinquent by less than            thirty days as of December 31, 2007. The portfolio’s fair value exceeded its            carrying value by $14.1 million at year-end 2007. Conversely, the portfolio’s            carrying value exceeded the fair value by $0.3 million as of year-end 2006. The Company            does not hold mortgage loans of any borrower that exceed 5% of stockholders’            equity.

 

Real            estate investments represented approximately 3% of the investment portfolio at year-end            2007, the same as year-end 2006. The real estate properties’ estimated fair value            is well above the carrying value.

 

***Policyholder Benefits***

Policyholder benefits consist of death benefits (mortality), annuity            benefits, accident and health benefits, surrenders and the associated increase or            decrease in reserves for future policy benefits. Policyholder benefits declined $1.4            million or 1% in 2007. This decrease was primarily due to declines in death benefits            and surrenders. These declines were partially offset by an increase in reserves            established for these benefits. The increase in immediate annuity premiums in 2007            contributed to the increase in reserves. Policyholder benefits declined $1.8 million or            1% in 2006 compared with 2005, as benefits paid were more than offset by the decrease            in the reserves established on these benefits. In addition, in 2006 a decrease in            immediate annuity premiums resulted in a decrease in reserves for future policy            benefits.

 

The            largest component of policyholder benefits was death benefits. Death benefits accounted            for 41% of policyholder benefits and interest credited to policyholder account balances            in both 2007 and 2006. Death benefits decreased 3% in 2007 versus a 2% increase in            2006. Mortality was within the range of anticipated mortality experience for both            years.

 

**-25-** 

Policyholder benefits for the group accident and health product line            increased $1.0 million or 4% in 2007 and $2.2 million or 11% in 2006, largely as the            result of an increase in group dental benefits paid.

 

***Interest Credited to Policyholder Account            Balances***

Interest credited to policyholder account balances declined $3.4 million            or 4% in 2007 and $4.0 million or 4% in 2006. Interest was credited to policyholder            account balances for universal life, fixed deferred annuities and other investment-type            products. Interest credited to policyholder account balances accounted for 35% of            policyholder benefits and interest credited to policyholder account balances in 2007,            down from 36% a year earlier. The amount of interest credited is a function of the            crediting rate and policyholder account balances. Policyholder account balances are            impacted by deposits, benefits, surrenders and contract charges. The decline in            interest credited for both 2007 and 2006 was due to a combination of reduced            policyholder account balances and lower crediting rates. Policyholder account balances            declined $103.1 million in 2007 and $87.3 million in 2006. The average interest rate            credited to policyholder account balances was 4.30% in 2007, 4.32% in 2006 and 4.37% in            2005.

 

***Amortization of Deferred Acquisition Costs (DAC) and Value of            Business Acquired (VOBA)***

The            amortization of DAC was $31.1 million in 2007 compared with $34.9 million in 2006 and            $35.6 million in 2005. The Company prospectively unlocked certain DAC assumptions,            which reduced amortization by $3.4 million in 2007, $0.7 million in 2006 and $2.2            million in 2005. DAC profit expectations are based upon assumptions of future interest            spreads, mortality margins, expense margins and policy and premium persistency            experience. At least annually, a review is performed of the assumptions related to            profit expectations. As warranted by a combination of historical results and expected            future trends, the Company may unlock these assumptions and, accordingly, increase or            decrease deferred acquisition costs.

 

During the fourth quarter of 2006, the Old American segment reduced its            amortization of DAC by $1.2 million. This adjustment, which was a correction of an            understatement of the capitalization of DAC in prior periods, was not material to 2006            or any prior period financial statements.

 

The            amortization of VOBA was $9.2 million in 2007, $7.4 million in 2006 and $7.5 million in            2005. The amortization of the value of business acquired (VOBA) also decreases in line            with the profit expectations on the acquired closed block of business. During 2007,            there was a $1.1 million unlocking adjustment that increased VOBA amortization and was            related to the assumptions for mortality margins. There were no VOBA unlocking            adjustments during 2006 or 2005.

 

***Reinsurance***

The            Company reinsures certain risks with unaffiliated insurance companies under traditional            indemnity reinsurance arrangements. These arrangements include yearly renewable term            agreements and coinsurance agreements. The Company enters into these agreements to            assist in diversifying risks and to limit the maximum loss from risks on certain            policies. The ceded reinsurance agreements do not relieve the Company of its            obligations to its policyholders. As such, the Company monitors the ongoing ability of            the reinsurers to perform under the terms of the reinsurance agreements.

 

Premiums are reported on a gross basis, with separate reporting for            premiums ceded under reinsurance agreements. Policyholder benefits and expenses are            reported net of reinsurance ceded, which included the following amounts.

 

|                               | 2007   |   | 2006   |   | 2005   |
|------------------------------------|--------|--------|--------|--------|--------|
| Policyholder benefits and expenses |   |   |   |   |   |   |   |   |
| ceded under reinsurance            | $      | 61,122 |   | $      | 57,248 |   | $ | 56,214 |

 

 

Future policy benefits and other related assets and liabilities are not            reduced for reinsurance in the balance sheet. A reinsurance receivable is established            for such balance sheet items. Reinsurance related to policy and claim reserves ceded of            $149.5 million and $142.2 million were included in the reinsurance receivables as of            December 31, 2007 and 2006, respectively. Ceded benefits recoverable from reinsurers            were $12.8 million and $16.0 million as of December 31, 2007 and 2006,            respectively.

 

The            Company’s overall reinsurance strategy has not changed during the periods            addressed in this report. However, the Company has implemented changes to its            reinsurance on certain new products by reducing the amount of coverage that is            reinsured. These changes have been made primarily due to the increased cost of            reinsurance currently available in the market.

 

**-26-** 

 

***Operating Expenses***

Operating expenses consist of commissions and production allowances, net            of the capitalization of commission and production allowances, and expenses from the            Company’s operations. In total, operating expenses decreased 5% in 2007 compared            to 2006 but increased 4% in 2006 over 2005. The decline in 2007 largely resulted from            reduced employee benefit accruals and legal costs. Operating expenses increased in 2006            over 2005, primarily due to an increase in salary expense and employee and agent            benefits.

 

***Income Taxes***

The            Company recorded income tax expense of $17.3 million or 33% of income before tax in            2007, compared to income tax expense of $13.7 million or 27% of income before tax in            2006. The increase in the tax expense in 2007 versus 2006 was due to higher income            before tax, a decrease in earned low income housing tax credits, and the provision            to tax return adjustments. In 2005, the Company recorded an income tax expense of $12.8            million or 26% of income before tax. The increase in the tax expense in 2006 versus            2005 was primarily the result of higher income before tax and the provision to tax            return adjustments, partially offset by a decrease in contingent tax liabilities.            Income taxes will fluctuate depending upon items such as net income, realized            investment gains and losses and affordable housing tax credits.

 

An            adjustment was reflected in the fourth quarter of 2007 that related to deferred tax            expense attributable to years 2004 and prior through 2006. The unrecorded deferred tax            expense (benefit) in 2004 and prior, 2005 and 2006 was $1.1 million, ($0.3) million and            ($0.3) million, respectively**.**

 

The            income tax rate in the three years was reduced by tax credits generated from the            Company’s investments in affordable housing. The effect of the affordable housing            credits on the effective tax rate was a tax benefit of $2.0 million or 4% in 2007, $2.9            million or 6% in 2006 and $3.0 million or 6% in 2005.

 

The            Company establishes contingent tax assets or liabilities, when appropriate, to provide            for potential challenges by taxing jurisdictions. In 2007, the Company’s income            tax expense was reduced $0.1 million, due to a net decrease in contingent tax            liabilities relating to the 2004 through 2006 tax years. In 2006, the Company’s            income tax expense was reduced $0.7 million or 1% of income before tax, due to a net            decrease in contingent tax liabilities. The Company reported no change in the tax            contingency balance in 2005.

 

**Operating Results by Segment**

 

The            Company has three reportable business segments, which are defined based on the nature            of the products and services offered: Individual Insurance, Group Insurance and Old            American. The Individual Insurance segment consists of individual insurance products            for both Kansas City Life and Sunset Life. The Individual Insurance segment is marketed            through a nationwide sales force of independent general agents and third-party            marketing arrangements. The Group Insurance segment consists of sales of group life,            group disability and dental products. This segment is marketed through a nationwide            sales force of independent general agents, group brokers and third-party marketing            arrangements. Old American consists of individual insurance products designed primarily            as final expense products. These products are marketed through a nationwide general            agency sales force with exclusive territories, using direct response marketing to            supply agents with leads.

 

**-27-** 

 

***Individual Insurance***

The            following table presents financial data of the Individual Insurance business segment            for the years ended December 31.

 

|                                                                          |                           |          |                        | 2007   |          | 2006                     |   | 2005                     |
|-------------------------------------------------------------------------------|--------------------------------|---------------|-----------------------------|--------|---------------|--------------------------|--------|--------------------------|
| Insurance revenues:                                                           |                           |          |                        |   |          |                     |   |                     |
|                                                                          | Premiums                       | $             |   55,412               |   | $             |   53,791            |   | $                        |   58,001 |
|                                                                          | Contract charges               |          | 111,422                     |   |          | 114,496                  |   |                     | 114,745 |
|                                                                          | Reinsurance ceded              |          | (42,644)                    |   |          | (41,069)                 |   |                     | (40,584) |
|                                                                          |                           |          | Total insurance revenues    |   | 124,190       |                     |   | 127,218                  |   |   | 132,162 |
| Investment revenues:                                                          |                           |          |                        |   |          |                     |   |                     |
|                                                                          | Net investment income          |          | 176,666                     |   |          | 182,766                  |   |                     | 181,311 |
|                                                                          | Realized investment gains      |          |     5,820    |   |          |     5,300 |   |                     |     6,488 |
| Other revenues                                                                |                           |   11,214 |                        |   |   10,717 |                     |   |     9,641 |
|                                                                          |                           |          | Total revenues              |   | 317,890       |                     |   | 326,001                  |   |   | 329,602 |
|                                                                          |                           |          |                        |   |          |                     |   |                     |   |   |   |
| Policyholder benefits                                                         |                           |   93,200 |                        |   |   95,603 |                     |   |   99,294            |
| Interest credited to policyholder account                            balances |                           |   91,215 |                        |   |   94,648 |                     |   |   98,637            |
| Amortization of deferred acquisition costs                                    |                           |          |                        |   |          |                     |   |                     |
|                                                                          | and value of business acquired |          |   27,568               |   |          |   30,581            |   |                     |   29,640 |
| Operating expenses                                                            |                           |   55,283 |                        |   |   59,952 |                     |   |   56,638            |
|                                                                          |                           |          | Total benefits and expenses |   | 267,266       |                     |   | 280,784                  |   |   | 284,209 |
|                                                                          |                           |          |                        |   |          |                     |   |                     |   |   |   |
| Income before income tax expense                                              |                           |   50,624 |                        |   |   45,217 |                     |   |   45,393            |
|                                                                          |                           |          |                        |   |          |                     |   |                     |   |   |   |
| Income tax expense                                                            |                           |   15,822 |                        |   |   12,049 |                     |   |   11,754            |
|                                                                          |                           |          |                        |   |          |                     |   |                     |   |   |   |
| Net income                                                                    | $                              |   34,802 |                        | $      |   33,168 |                     | $      |   33,639            |
|                                                                          |                           |          |                        |   |          |                     |   |                     |   |   |   |

 

 

This            segment’s direct insurance revenues (total insurance revenues excluding            reinsurance ceded) are primarily derived from premiums on traditional insurance            products and contract charges. Traditional insurance products principally include whole            life, term life and immediate annuities. Contract charges are collected from interest            sensitive insurance products, including universal life, fixed deferred annuities and            variable life and annuities. In 2007, this segment received 33% of its direct insurance            revenues from premiums on traditional products, compared to 32% in 2006 and 34% in            2005.

 

This            segment’s products are primarily marketed through a nationwide sales force of            independent general agents. The Individual Insurance segment is central to the            Company’s overall performance and generated 98% of consolidated net income in            2007. Customer revenues consist of insurance revenues and other revenues. This segment            produced 56% of consolidated customer revenues in 2007, the same as in 2006.

 

**-28-** 

Premium            information is provided in the table below. New premiums increased $0.8 million or 6%,            following a $5.0 million or 27% decrease in 2006. The increase in 2007 was due to a            $1.0 million or 13% increase in immediate annuities. Conversely, the decline in 2006            was due to a $5.0 million or 41% decline in sales of immediate annuities during the            year. New individual life insurance premiums declined 3% but were flat in 2006. Renewal            premiums increased $0.8 million or 2% in 2007, the same as in 2006.

 

|             |                      |               | 2007         | %         |     | 2006   | %              |   | 2005   |
|------------------|---------------------------|--------------------|--------------|-----------|----------|--------|----------------|--------|--------|
| New premiums:    |                      |               |         |      |     |   |           |   |   |   |
|             | Individual life insurance | $                  |   5,773 |  (3) |     | $      |   5,961   | -      |   | $ |   5,944 |
|             | Immediate annuities       |               |   8,142 | 13        |     |   |   7,174   | (41)   |   |   | 12,159 |
|             |                      | Total new premiums |         | 13,915    |   6 |   |           | 13,135 | (27)   |   |   | 18,103 |
| Renewal premiums |                      | 41,497             |   2     |      |     | 40,656 |    2 |   |   | 39,898 |
| Total premiums   | $                         | 55,412             |   3     |      | $        | 53,791 |   (7)     |   | $      | 58,001 |
|             |                      |               |         |      |     |   |           |   |   |   |   |   |

 

 

Deposit information is provided in the table below. New deposits            increased 8% in 2007 but decreased 26% in 2006. New fixed deferred annuity deposits            declined 12% and 40% in 2007 and 2006, respectively. The lower sales of fixed deferred            annuity deposits can be attributed to increased competition, changing consumer            preferences and the emergence of alternative products. New variable annuity deposits            increased 37% in 2007, improving from a decline of 14% in 2006. Increased sales of            variable annuity products reflect customer interest in the equity markets. New            universal life deposits increased 7% and new variable universal life deposits increased            5% in 2007 compared with 2006. These same deposits increased 1% and 7%, respectively,            in 2006 versus 2005. Universal life deposits have been a primary focus for sales and            marketing as part of the Company’s emphasis on sales of individual life            products.

 

|             |                              |               | 2007                     | %              |           | 2006    | %                        |           | 2005   |
|------------------|-----------------------------------|--------------------|--------------------------|----------------|----------------|---------|--------------------------|----------------|--------|
| New deposits:    |                              |               |                     |           |           |    |                     |           |   |   |
|             | Universal life insurance          | $                  |   10,869            |    7 |           | $       |   10,117            |    1 |   | $ |   10,004 |
|             | Variable universal life insurance |               |     2,480 |    5 |           |    |     2,372 |    7 |   |   |     2,210 |
|             | Fixed deferred annuities          |               |   26,348            | (12)           |           |    |   29,815            | (40)           |   |   |   49,698 |
|             | Variable annuities                |               |   29,426            |  37       |           |    |   21,507            | (14)           |   |   |   24,894 |
|             |                              | Total new deposits |                     |   69,123  |    8 |    |                     |   63,811  | (26)   |   |   |   86,806 |
| Renewal deposits |                              | 136,644            |  (2)                |           |           | 139,139 | (11)                     |           |   | 155,807 |
| Total deposits   | $                                 | 205,767            |    1           |           | $              | 202,950 | (16)                     |           | $      | 242,613 |
|             |                              |               |                     |           |           |    |                     |           |   |   |   |   |

 

 

Insurance revenues decreased 2% in 2007 and 4% in 2006. The decline in            2007 was primarily due to a reduction in contract charges, resulting from the unearned            revenue correction discussed below. A decline in immediate annuity sales, combined with            slightly lower contract charges accounted for the revenue decrease in 2006.

 

Contract charges consist of cost of insurance, expense loads, unearned            revenues and surrender charges. Certain contract charges for universal life insurance            are not recognized in income immediately but are deferred as unearned revenues and are            amortized into income in a manner similar to the amortization of DAC. These contract            charges, which are recorded as unearned revenues, are recognized into income in            proportion to the expected future gross profits of the business. In the same manner as            DAC, profit expectations are based upon assumptions of future interest spreads,            mortality margins, expense margins and policy and premium persistency experience. At            least annually, a review is performed of the

 

**-29-** 

assumptions related to profit expectations. If it is determined the            assumptions should be revised, the impact is recorded as a change in the revenue            reported in the current period as an unlocking adjustment.

 

Contract charges declined $3.1 million in 2007 and $0.2 million in 2006.            Contract charges were reduced by $1.7 million during the second quarter of 2007,            resulting from a correction of the unearned revenue portion of a universal life            product. The amount of the correction attributable to prior periods was $1.1 million,            including $0.2 million in 2005 and $0.9 million in 2006.

 

Net            investment income decreased 3% in 2007 and increased 1% in 2006. Investment income is            primarily driven by changes in interest rates, asset levels and investment expenses.            Investment yields increased in 2007 and 2006 from the prior years. However, the asset            level declined in both 2007 and 2006. In addition, investment expenses declined in            2006, reflecting reduced real estate expenses and a decline in interest expense from            reduced notes payable.

 

Policyholder benefits consist of death benefits (mortality), annuity            benefits, individual accident and health benefits, surrenders and the associated            increase or decrease in reserves for future policy benefits. Policyholder benefits            decreased $2.4 million or 3% in 2007 versus 2006 and $3.7 million or 4% in 2006            compared with 2005. The decline in 2007 was largely due to a decrease in both death            benefits and surrenders of individual life insurance. Immediate annuity premium            receipts declined in 2006, which contributed to the decline in policyholder benefits            because of the resulting decrease in reserves for future policy benefits.

 

Death benefits decreased 5% in 2007 but increased 5% in 2006. Death            benefits will fluctuate from period-to-period. While mortality results were different            for 2007 and 2006, both years were within the range of anticipated            mortality.

 

Interest was credited to policyholder account balances for universal            life, fixed deferred annuities and other investment-type products. The amount of            interest credited is a function of the crediting rate and account balances. Account            balances are impacted by deposits, benefits, surrenders and contract charges. Interest            credited to policyholder account balances decreased $3.4 million in 2007 versus 2006            and $4.0 million in 2006 compared with 2005. The declines in both years were primarily            due to a combination of lower policyholder account balances and lower crediting            rates.

 

The            amortization of DAC has fluctuated over the past three years due to prospective            unlocking adjustments for changes in assumptions for future years. The impact of these            unlocking adjustments was to reduce the amortization of DAC as follows: $3.4 million in            2007, $0.7 million in 2006 and $2.2 million in 2005. The amortization of the VOBA also            decreases in line with the profit expectations on the acquired block of business.            During 2007, there was a $1.1 million unlocking adjustment, which increased VOBA            amortization and was related to the assumptions for mortality margins. There were no            VOBA unlocking adjustments during 2006 or 2005.

 

Operating expenses include commissions, net of the capitalization of            certain commissions, expenses on operations and other expenses. In 2007, commissions            decreased while capitalization of commissions increased. In 2006, both commissions and            capitalization of commissions decreased. Operating expenses decreased $4.7 million in            2007 compared to a $3.3 million increase in 2006. The decrease in 2007 was largely due            to reductions in employee benefits, legal fees and guaranty assessments. Expenses            increased in 2006, primarily due to an increase in salary expense and employee and            agent benefits.

 

Net            income for this segment increased 5% in 2007 over 2006, but decreased 1% in 2006            compared with 2005. The improved results for 2007 were due to decreases in policyholder            benefits, interest credited to policyholder account balances, amortization of DAC and            VOBA and operating expenses. Partially offsetting these improvements were decreases in            contract charges and net investment income and an increase in income tax expense. The            increase in tax expense was due in part to a reduction in affordable housing tax            credits. The decrease in 2006 reflected reduced revenues that were partially offset by            reduced benefits and expenses, along with increased income taxes. Income excluding            realized investment gains, net of tax, increased 4% in 2007 compared with 2006 and 1%            in 2006 versus 2005. These increases primarily reflect reduced policyholder benefits            and interest credited to policyholder account balances. Non-insurance subsidiaries are            included in this segment, but they are not material to results of the            segment.

 

**-30-** 

***Group Insurance***

The            following table presents financial data of the Group Insurance business segment for the            years ended December 31.

 

|                           |                  |                         |                         | 2007   |                         | 2006                         |   | 2005                         |
|--------------------------------|-----------------------|------------------------------|------------------------------|--------|------------------------------|------------------------------|--------|------------------------------|
| Insurance revenues:            |                  |                         |                         |   |                         |                         |   |                         |
|                           | Premiums              | $                            | 54,062                       |   | $                            | 54,065                       |   | $                            | 50,783 |
|                           | Reinsurance ceded     |                         | (8,286)                      |   |                         | (9,488)                      |   |                         | (9,913) |
|                           |                  |                         | Total insurance revenues     |   | 45,776                       |                         |   | 44,577                       |   |   | 40,870 |
| Investment revenues:           |                  |                         |                         |   |                         |                         |   |                         |
|                           | Net investment income |                         |      426 |   |                         |      272 |   |                         |      233 |
| Other revenues                 |                  |      278 |                         |   |      608 |                         |   |      661 |
|                           |                  |                         | Total revenues               |   | 46,480                       |                         |   | 45,457                       |   |   | 41,764 |
|                           |                  |                         |                         |   |                         |                         |   |                         |   |   |   |
| Policyholder benefits          |                  | 30,061                       |                         |   | 28,596                       |                         |   | 25,950                       |
| Operating expenses             |                  | 19,309                       |                         |   | 19,114                       |                         |   | 19,220                       |
|                           |                  |                         | Total benefits and expenses  |   | 49,370                       |                         |   | 47,710                       |   |   | 45,170 |
|                           |                  |                         |                         |   |                         |                         |   |                         |   |   |   |
| Loss before income tax benefit |                  | (2,890)                      |                         |   | (2,253)                      |                         |   | (3,406)                      |
|                           |                  |                         |                         |   |                         |                         |   |                         |   |   |   |
| Income tax benefit             |                  |    (867)           |                         |   |   (676)                 |                         |   | (1,022)                      |
|                           |                  |                         |                         |   |                         |                         |   |                         |   |   |   |
| Net loss                       | $                     | (2,023)                      |                         | $      | (1,577)                      |                         | $      | (2,384)                      |
|                           |                  |                         |                         |   |                         |                         |   |                         |   |   |   |

 

 

The            Company offers several insurance products in the Group Insurance segment: dental, group            life, short and long-term disability, and vision. The Group Insurance segment markets            its group products primarily to small and mid-size organizations. Products are sold            through group representatives targeting a nationwide network of independent general            agents and group brokers, along with the Company’s career general agents. This            sales network is this segment’s core distribution system. Additionally, the            Company enters into selective third-party marketing arrangements to market group            products. This segment generated 19% of the Company’s customer revenues in 2007,            an increase from 18% in 2006.

 

The            group market is highly competitive and group policies are periodically reviewed to            ensure they conform to target claims, expenses and profit objectives. Renewal terms            that meet target pricing objectives are communicated to the group policyholder who may            then decide to seek alternative bids from competing carriers.

 

At            year-end 2006, the Group segment exited the stop loss market. The stop loss product            line was being offered through an independent managing general underwriter, which also            provided third-party administration. During the fourth quarter of 2006, the independent            managing general underwriter was acquired by another organization, which then            terminated the agreement. The Company will continue to focus on its core products and            services, but may re-enter the stop loss market at a later date.

 

The            Group Insurance segment has experienced net losses in each of the three years            presented. Improvement efforts continue to be focused in three primary areas. First,            emphasis is being placed on the growth of the in-force business to achieve better            expense ratios from fixed costs and overhead. This sales growth will be achieved            through increased individual productivity of the existing group representatives and            through a continued expansion of the group distribution

 

**-31-** 

system.            The second area of focus for improvement is to increase the use of technology to            achieve improved administrative efficiency, which will ultimately reduce expenses. The            third area of focus is to add new products to the portfolio, particularly voluntary            products which tend to be more profitable and will increasingly becoming a larger share            of the group marketplace.

 

Premium information is provided in the table below. New premiums            decreased 6% in 2007 over 2006, following a 12% increase in 2006. New group life            premiums increased 49% in 2007, following a 23% decrease in 2006. New group accident            and health premiums declined 11% in 2007. However, excluding the terminated stop loss            block, new group accident and health premiums increased 3% compared with a year ago.            The growth in new premiums in 2006 was largely the result of a $2.4 million or 59%            increase in dental premiums compared with 2005. This growth resulted from the focus of            improved production through group sales representatives, one of the primary areas of            targeted improvement.

 

Renewal premiums increased $0.8 million or 2% in 2007. Excluding the            adjustment for unrecorded premiums discussed below, renewal premiums increased $1.4            million or 3%. Renewal premiums increased $1.9 million or 5% in 2006, reflecting            improved persistency and the recognition of previously unrecorded premiums from earlier            periods of $0.6 million. An adjustment was reflected in the second quarter of 2006 that            related to renewal premiums attributable to years 2003 through 2006. The unrecorded            premiums in 2003, 2004 and 2005 were $0.1 million, $0.2 million and $0.3 million,            respectively. Total group premiums were flat in 2007 compared with an increase of $3.3            million or 6% in 2006. Excluding the terminated stop loss product line, total group            premiums increased 3% in 2007 compared with 2006.

 

|             |                       |               | 2007                         | %              |      | 2006   | %                            |     | 2005     |
|------------------|----------------------------|--------------------|------------------------------|----------------|-----------|--------|------------------------------|----------|----------|
| New premiums:    |                       |               |                         |           |      |   |                         |     |     |   |
|             | Group life insurance       | $                  |   1,517                 |  49       |      | $      |   1,020                 | (23)     |     | $ |   1,327 |
|             | Group dental insurance     |               |   6,785                 |    4 |      |   |   6,524                 |  59 |     |   |   4,112 |
|             | Group disability insurance |               |   1,530                 |    5 |      |   |   1,454                 | (26)     |     |   |   1,971 |
|             | Group stop loss insurance  |               |   1,423            | (52)           |      |   |   2,971                 | (10)     |     |   |   3,283 |
|             | Other group insurance      |               |      258 | (19)           |      |   |      318 |  29 |     |   |      246 |
|             |                       | Total new premiums |                         | 11,513         |  (6) |   |                         | 12,287   |  12 |   |   | 10,939 |
| Renewal premiums |                       | 42,549             |   2                     |           |      | 41,778 |    5               |     |     | 39,844 |
| Total premiums   | $                          | 54,062             | -                            |           | $         | 54,065 |    6               |     | $        | 50,783 |
|             |                       |               |                         |           |      |   |                         |     |     |   |   |   |

 

 

The            Company has used reinsurance in several of its group product lines to help mitigate            risk. Reinsurance on premiums declined $1.2 million or 13% in 2007 and $0.4 million or            4% in 2006. The decrease in 2007 was largely due to the termination of the stop loss            business and a change in reinsurance structure on accidental death and dismemberment            reinsurance. A major portion of the stop loss premiums was reinsured in order to manage            the potential risks associated with this product line. Reinsurance ceded on stop loss            premiums were $0.9 million in 2007, $2.0 million in 2006 and $2.3 million in            2005.

 

Policyholder benefits consist of death benefits (mortality), accident            and health benefits and the associated increase or decrease in reserves for future            policy benefits. Policyholder benefits increased $1.5 million or 5% in 2007, reflecting            increased stop loss and dental benefits. Policyholder benefits increased $2.6 million            or 10% in 2006, reflecting an increase in dental benefits and death            benefits.

 

Operating expenses in this segment include commissions, expenses            associated with operations, insurance related taxes and other expenses. Expenses            associated with operations in this segment are specifically and directly identified,            but also include allocated expenses. Operating expenses in this segment increased 1% in            2007, following a 1% decline in 2006. The increase in 2007 largely resulted from two            items. First, operating expenses increased, reflecting charges incurred for            enhancements made to operating systems and software. These enhancements will improve            efficiencies and provide opportunities to reduce expenses in the future. This was            partially offset by a reduction in legal fees as 2006 legal expense included the            contingency reserve expense. The decrease in 2006 was due to reduced salary costs, as a            result of a

 

**-32-** 

reduction in third-party arrangements and improvements in processing and            technology. The reduction in operating expenses was achieved in spite of a $0.7 million            increase in a legal expense contingency reserve and a $0.3 million increase in            commissions over 2005.

 

The            net loss in the Group Insurance segment increased $0.5 million or 28% in 2007. This            increase was largely due to increased policyholder benefits and increased operating            expenses that were partially offset by an increase in insurance revenues. The net loss            in this segment decreased $0.8 million or 34% in 2006, primarily resulting from            improvement in insurance revenues. The Company continues to pursue opportunities for            revenue growth through improved productivity of group representatives and selective            third-party marketing arrangements.

 

**-33-** 

***Old American***

The            following table presents financial data of the Old American business segmentfor the            years ended December 31.

 

|                                       |                               |                                         |                        | 2007   |                                    | 2006                         |   | 2005                                    |
|--------------------------------------------|------------------------------------|----------------------------------------------|-----------------------------|--------|-----------------------------------------|------------------------------|--------|-----------------------------------------|
| Insurance revenues:                        |                               |                                         |                        |   |                                    |                         |   |                                    |
|                                       | Premiums                           | $                                            | 66,537                      |   | $                                       | 68,644                       |   | $                                       | 71,326 |
|                                       | Reinsurance ceded                  |                                         | (4,058)                     |   |                                    | (4,601)                      |   |                                    | (5,311) |
|                                       |                               |                                         | Total insurance revenues    |   | 62,479                                  |                         |   | 64,043                                  |   |   | 66,015 |
| Investment revenues:                       |                               |                                         |                        |   |                                    |                         |   |                                    |
|                                       | Net investment income              |                                         | 13,313                      |   |                                    | 13,242                       |   |                                    | 13,064 |
|                                       | Realized investment gains (losses) |                                         |    (394)          |   |                                    |      321 |   |                                    |     (375) |
| Other revenues                             |                               |         7 |                        |   |        24 |                         |   |        10 |
|                                       |                               |                                         | Total revenues              |   | 75,405                                  |                         |   | 77,630                                  |   |   | 78,714 |
|                                       |                               |                                         |                        |   |                                    |                         |   |                                    |   |   |   |
| Policyholder benefits                      |                               | 43,197                                       |                        |   | 43,706                                  |                         |   | 44,457                                  |
| Amortization of deferred acquisition costs |                               |                                         |                        |   |                                    |                         |   |                                    |
|                                       | and value of business acquired     |                                         | 12,765                      |   |                                    | 11,730                       |   |                                    | 13,418 |
| Operating expenses                         |                               | 14,266                                       |                        |   | 14,588                                  |                         |   | 13,830                                  |
|                                       |                               |                                         | Total benefits and expenses |   | 70,228                                  |                         |   | 70,024                                  |   |   | 71,705 |
|                                       |                               |                                         |                        |   |                                    |                         |   |                                    |   |   |   |
| Income before income tax expense           |                               |   5,177                                 |                        |   |   7,606                            |                         |   |   7,009                            |
|                                       |                               |                                         |                        |   |                                    |                         |   |                                    |   |   |   |
| Income tax expense                         |                               |   2,295                                 |                        |   |   2,279                            |                         |   |   2,080                            |
|                                       |                               |                                         |                        |   |                                    |                         |   |                                    |   |   |   |
| Net income                                 | $                                  |   2,882                                 |                        | $      |   5,327                            |                         | $      |   4,929                            |
|                                       |                               |                                         |                        |   |                                    |                         |   |                                    |   |   |   |

 

 

The            Old American segment sells final expense insurance products nationwide through its            general agency system with exclusive territories. This segment provides agents with            sales leads using direct response marketing. This segment produced 26% of consolidated            customer revenues, the same as in 2006. Net income for this segment decreased 46% to            $2.9 million in 2007. Net income for 2006 increased 8% to $5.3 million. The 2007            decline largely resulted from a decrease in insurance revenues and increases in            realized investment losses and amortization of DAC. Also in 2007, this segment recorded            a $0.7 million increase in income tax expense, reflecting corrections in estimates from            tax years prior to 2005. The increase in net income for 2006 reflected reduced            policyholder benefits from improved mortality and a reduction in the amortization of            DAC. During 2006, this segment introduced several product enhancements that have            resulted in a more competitive position with regard to selected products. In 2007, this            segment provided 8% of consolidated net income, compared to 14% in 2006.

 

Premium information is provided in the table below. New premiums            increased 5% in 2007, compared to a 12% decrease in 2006. The increase in 2007 reflects            a combination of product, compensation and distribution changes, which have improved            the Company’s competitive position. Renewal premiums decreased 4% in 2007 and 3%            in 2006. Old American continues to focus on the recruitment and development of new            agencies and agents, along with improved production from existing agencies and            agents.

 

 

**-34-** 

 

|             | 2007   | %                 |   | 2006   | %      |         | 2005   |
|------------------|--------|-------------------|--------|--------|--------|--------------|--------|
|             |   |              |   |   |   |         |   |   |   |   |
| New premiums     | $      |   6,583 | 5      |   | $      |   6,281 | (12)   |   | $ |   7,148 |
| Renewal premiums |   | 59,954            | (4)    |   |   | 62,363       | (3)    |   |   | 64,178 |
| Total premiums   | $      | 66,537            | (3)    |   | $      | 68,644       | (4)    |   | $ | 71,326 |
|             |   |              |   |   |   |         |   |   |   |   |

 

 

Net            investment income increased 1% in 2007 as investment yields increased in 2007 over            2006. However, the asset level declined slightly during the year. Net investment income            increased 1% in 2006, reflecting increased investment yields and reduced investment            expenses. These improvements were offset by reduced investment assets in 2006. Reduced            investment expenses largely resulted from reduced interest expense on notes payable.            Old American had realized investment losses in 2007 of $0.4 million but had realized            investment gains of $0.3 million in 2006.

 

Policyholder benefits consist of death benefits (mortality), accident            and health benefits, surrenders, and the associated increase or decrease in reserves            for future policy benefits. Policyholder benefits decreased 1% in 2007 and 2% in 2006,            reflecting reduced mortality. A decrease in death benefits was partially offset by an            increase in reserves in both years.

 

The            policyholder benefit ratio (policyholder benefits divided by total revenues, excluding            realized investment gains and losses) remained consistent in 2007 compared with 2006            but was higher than 2005. Lower revenues, primarily from reduced renewal premiums, more            than offset the decreased policyholder benefits. These results are largely reflective            of the combined effect of a decline in premiums and improved mortality over this            timeframe.

 

|                       |           | 2007   |               | 2006   |   | 2005                         |
|----------------------------|----------------|--------|--------------------|--------|--------|------------------------------|
|                       |           |   |               |   |   |                         |   |   |   |
| Total revenue              | $              | 75,405 |               | $      | 77,630 |                         | $ | 78,714 |
| Less: Realized investment  |           |   |               |   |   |                         |   |   |
|                       | gains (losses) |   |    (394) |   |   |      321 |   |   |     (375) |
| Revenue excluding realized |           |   |               |   |   |                         |   |   |
| investment gains (losses)  |           | 75,799 |               |   | 77,309 |                         |   | 79,089 |
|                       |           |   |               |   |   |                         |   |   |   |
| Policyholder benefits      | $              | 43,197 |               | $      | 43,706 |                         | $ | 44,457 |
|                       |           |   |               |   |   |                         |   |   |   |
| Policyholder benefit ratio |           | 57%    |               |   | 57%    |                         |   | 56% |

 

 

During the fourth quarter of 2006, the Old American segment reduced its            amortization of DAC by $1.2 million. This adjustment, which was a correction of an            understatement of the capitalization of DAC in prior periods, was not material to 2006            or any prior period financial statements.

 

Operating expenses include commissions and production allowances, net of            the capitalization of certain commission and production allowances, and expenses from            operations. Operating expenses decreased 2% in 2007 largely due to reduced salaries and            benefits and a reduction in agent costs. Operating expenses increased 5% in 2006,            primarily reflecting increased agent costs from increased lead generation.

 

An            adjustment was reflected in the fourth quarter of 2007 that related to deferred tax            expense attributable to years 2003 and prior through 2006. The unrecorded deferred tax            expense in 2003 and prior, 2004, 2005 and 2006 was $0.3 million, $0.4 million, and $0.1            million and none, respectively.

 

**-35-** 

**Liquidity and Capital Resources**

 

***Liquidity***

The            Company meets liquidity requirements primarily through positive cash flows from            operations. The Company has sufficient sources of liquidity to satisfy operational            requirements. Primary sources of cash flow are premiums, other insurance considerations            and deposits, receipts for policyholder accounts, investment sales and maturities,            investment income and access to credit from other financial institutions. The principal            uses of cash are for the insurance operations, including the purchase of investments,            payments of insurance benefits, operating expenses, dividends, income taxes,            withdrawals from policyholder accounts and costs related to acquiring new            business.

 

Cash            provided from operations in each of the three years ended 2007, 2006 and 2005 was $32.9            million, $23.9 million, and $44.3 million, respectively. Cash provided from operating            activities increased $9.0 million in 2007 compared with a decline of $20.4 million in            2006. The increase in 2007 compared with 2006 was largely the result of a $7.2 million            reduction in claims paid to policyholders. Partially offsetting this, premium receipts            decreased $1.6 million and commissions paid to agents from premium and deposit activity            increased $1.4 million. Cash is also affected by changes in receivables and payables.            At year-end 2007 compared with 2006, receivables increased $5.8 million while payables            and suspense items from ongoing operations increased $2.1 million. In 2006 compared            with 2005, cash provided from operations declined as premium receipts declined $3.8            million and claims paid to policyholders increased $10.7 million, offset by lower            commissions paid to agents from premium and deposit activity of $2.4 million. At            year-end 2006 compared with 2005, receivables increased $4.6 million while payables            from claims declined $5.9 million, and payables and suspense items on ongoing            operations decreased $6.1 million. Other liabilities increased $6.7 million in 2006,            following a $7.3 million decrease in 2005.

 

Net            cash provided by investing activities was $84.1 million in 2007, $68.1 million in 2006            and $54.3 million in 2005. The Company’s new investments in fixed maturity and            equity securities were $328.3 million in 2007, up from $285.4 million during 2006, but            down from $547.0 million during 2005. New investments in mortgage loans were $54.8            million in 2007, $72.6 million in 2006, and $109.6 million in 2005. During 2007, the            Company decreased its purchases of real estate investments to $4.5 million, down from            $45.0 million in 2006 and $17.8 million in 2005. Approximately 13% of the securities            portfolio was sold, called or matured in both 2007 and 2006. The Company had $58.4            million in mortgage loan maturities and principal paydowns in 2007, compared with $59.1            million in 2006 and $82.4 million in 2005. During 2007, the Company had sales of real            estate investments of $22.5 million, compared with $18.8 million in 2006 and $33.3            million in 2005. During these three years, the Company sold several real estate            properties which resulted in realized gains.

 

Net            cash used in financing activities was $108.8 million in 2007, $100.2 million in 2006            and $91.8 million in 2005. The net repayments of short-term notes payable were $4.3            million in 2007, $12.6 million in 2006 and $64.9 million in 2005. Deposits on            policyholder account balances equaled $205.8 million in 2007, $203.0 million in 2006            and $242.6 million in 2006. Withdrawals on policyholder account balances were $294.8            million in 2007, $273.8 million in 2006 and $245.9 million in 2005. The increase in            withdrawals over the three years was consistent with rising interest rates, changing            consumer preferences, increased competition and the emergence of alternative products.            Finally, the Company’s stockholder dividends were $36.5 million in 2007, $12.8            million in 2006 and $12.9 million in 2005. During 2007, the Company paid a special,            one-time dividend of $2.00 per share in addition to its quarterly dividends.

 

The            above information excludes net proceeds from variable insurance products. These            proceeds are segregated into separate accounts and are not held in the Company’s            general investments because the policyholders, rather than the Company, assume the            underlying investment risks.

 

***Separate Accounts***

At            December 31, 2007, the Company had $420.4 million in separate account assets. This was            an increase of $19.6 million from $400.7 million at December 31, 2006. Positive            investment performance increased separate accounts by $33.8 million in 2007 and $52.0            million in 2006. Deposits in separate accounts increased in 2007 to $57.8 million            versus $46.8 million in 2006. Partially offsetting these increases, policyholder            withdrawals on these products were $57.1 million in 2007 and $51.8 million in 2006. In            addition, contract charges were $14.8 million and $14.1 million in 2007 and 2006,            respectively.

 

***Debt and Short-Term Borrowing***

The            Company and certain subsidiaries have access to borrowing capacity through their            membership affiliation with the Federal Home Loan Bank of Des Moines (FHLB). At            December 31, 2007, outstanding balances in notes payable to the FHLB were $10.4            million. All outstanding balances have maturities of less than one year. The primary            purpose for

 

**-36-** 

these            borrowings is to ensure access to liquidity. This is accomplished through the purchase            of highly liquid marketable securities from the proceeds of these            borrowings.

 

Borrowings were $10.4 million at year-end 2007, down from $14.7 million            at year-end 2006. The decrease in borrowings was due to reductions in borrowing from            FHLB, which declined $4.3 million during 2007. The Company has access to unsecured            revolving lines of credit of $60.0 million with two major commercial banks with no            balances outstanding. Both lines of credit will expire during 2008, and it is expected            that the Company will renew these facilities.

 

***Capital Resources***

The            Company considers existing capital resources to be more than adequate to support the            current level of business activities.

 

The            following table shows the capital adequacy of the Company for the past two            years.

 

|                                | 2007   |                 | 2006   |
|-------------------------------------|--------|----------------------|--------|
| Total assets less separate accounts | $      | 3,931,715            |   | $ | 4,057,046 |
| Total stockholders' equity          |   |    684,401 |   |   |    684,304 |
| Ratio of stockholders' equity       |   |                 |   |   |   |
| to assets less separate accounts    |   | 17%                  |   |   | 17% |

 

The            ratio of equity to assets less separate accounts has remained relatively constant. Net            unrealized gains on available for sale securities, which are included as a component of            stockholders’ equity, increased $6.4 million at December 31, 2007 following a            $16.2 million decrease at December 31, 2006.

 

The            Company’s statutory equity exceeds the minimum capital deemed necessary to            support its insurance business, as determined by the risk based capital calculations            and guidelines established by the National Association of Insurance Commissioners. The            maximum stockholder dividends that can be paid out of stockholders’ equity in            2008 without prior approval of the Missouri Director of Insurance are $59.6 million -            the statutory gain from operations at year-end 2007.

 

Stockholders’ equity per share, or book value, equaled $58.17 for            year-end 2007, a 1% increase for the year. The Company has defined contribution plans            for employees and agents whereby they may purchase shares of Company stock. Also, the            Company makes contributions to these plans through the purchase of Company stock. The            purchases and sales of Company stock for these purposes are handled as purchases and            sales of treasury stock. Accordingly, in 2007, the benefit plans purchased 140,240            treasury stock shares for $6.7 million (2006 – 82,191 shares for $4.2 million)            and sold 140,121 treasury stock shares for $6.3 million (2006 – 24,030 for $1.1            million).

 

The            stock repurchase program was extended by the Board of Directors through January 2009 to            permit the purchase of up to one million of the Company’s shares on the open            market, which would represent approximately 8% of the shares currently outstanding.            During 2007, the Company repurchased 90,341 shares of its common stock at a total cost            of $4.1 million. The Company purchased 4,976 shares for $0.2 million in 2006. No shares            were purchased under this program in 2005.

 

On            January 28, 2008, the Board of Directors declared a quarterly dividend of $0.27 per            share that was paid February 12, 2008 to stockholders of record as of February 7, 2008.            On January 29, 2007, the Board of Directors declared two dividends, including a            quarterly dividend of $0.27 per share and a special, one-time dividend of $2.00 per            share. Both dividends, totaling $26.9 million, were paid on February 13, 2007 to            shareholders of record as of February 8, 2007.

 

Current            legislative activities are not expected to have a significant impact on the ongoing            operations of the Company

 

***Contractual Obligations***

The            following table summarizes (in millions) the Company’s information about            contractual obligations by due date and expiration date as of December 31, 2007.            Contractual obligations of the Company are those obligations fixed by agreement as to            dollar amount and date of payment.

 

 

**-37-** 

 

|                            |                      |   |                          |                     |   | Less than              |              |   |                               |   |    |                                     |   | After  |
|---------------------------------|---------------------------|--------|-------------------------------|--------------------------|--------|------------------------|-------------------|--------|------------------------------------|--------|---------|------------------------------------------|--------|--------|
|                            |                      |   | Total                         |                     | 1 year |                   | 1-3 years         |   | 4-5 years                          |   | 5 years |
| Borrowings (1)                  |                      | $      |     10.4            |                     | $      |   10.4            |              | $      | -                                  |   | $       | -                                        |   | $      | - |
| Operating lease obligations (2) |                      |   |       3.5 |                     |   |     1.8 |              |   |       1.6 |   |    |        0.1 |   |   | - |
| Purchase obligations (3)        |                      |   |       0.9 |                     |   |     0.9 |              |   | -                                  |   |    | -                                        |   |   | - |
| Mortgage loan commitments       |                      |   | -                             |                     |   |                   |              |   |                               |   |    |                                     |   |   |   |
|                            | and other investments (4) |   |                          |      10.5 |   |                   |    10.5 |   |                               | -      |    |                                     | -      |   |   | - |
| Annuity certain contracts (5)   |                      |   |      66.7 |                     |   |    14.1      |              |   | 22.4                               |   |    | 15.9                                     |   |   | 14.3 |
| Insurance liabilities (6)       |                      |   | 2,939.2                       |                     |   |  327.2            |              |   |     631.4           |   |    |     589.2                 |   |   |   1,391.4 |
|                            |                      |   |                          |                     |   |                   |              |   |                               |   |    |                                     |   |   |   |   |
| Total contractual obligations   |                      | $      | 3,031.2                       |                     | $      |  364.9            |              | $      |     655.4           |   | $       |     605.2                 |   | $      |   1,405.7 |
|                            |                      |   |                          |                     |   |                   |              |   |                               |   |    |                                     |   |   |   |

             

| (1) | Borrowings include short-term debt as described in the                            previous section – Debt and short-term borrowing. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------|

 

| (2) | As a lessee, the Company leases its mainframe computer                            and certain related support equipment. The Company is also a lessee of                            an office building with a 20-year lease that began in 1989 with two                            five-year renewal options. In 1998, the Company assigned the interest                            in the lease to a third-party for the remainder of the lease                            period. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| (3) | Purchase obligations include contracts where the Company                            has a non-cancelable commitment to purchase goods and                            services. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| (4) | Mortgage loan commitments to provide funding to                            originate commercial mortgage loans. Mortgage loan commitments                            generally do not extend beyond 90 days. Other investments are primarily                            commitments for real estate investments. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| (5) | Annuity certain contracts are those insurance                            liabilities (included in future policyholder benefits and policyholder                            contract balances), which do not have life contingencies and have                            scheduled payments. Annuity certain contracts without life                            contingencies consist of single premium immediate annuities,                            supplementary contracts and structured settlements. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| (6) | Insurance liabilities consist primarily of future                            policyholder benefits and policyholder contract balances for which the                            timing of cash flows is uncertain and which have life contingencies.                            The schedule of payments for these liabilities can vary significantly                            because of the uncertainty of the timing of cash flows, which depend                            upon insurable events or policyholder surrenders. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

             

             

             

             

             

             

**-38-** 

 

**Item 7A****:****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET            RISK**

 

The            Company holds a diversified portfolio of investments that includes cash, bonds,            preferred stocks, mortgage-backed securities, commercial mortgages and real estate.            Each of these investments is subject, in varying degree, to market risks that can            affect their return and their fair value. A majority of these assets are debt            instruments of corporations or U.S. Government Sponsored Enterprises (GSE) and are            considered fixed income investments. Thus, the primary market risks affecting the            Company’s portfolio are interest rate risk, credit risk and liquidity            risk.

 

Interest rate risk arises from the price sensitivity of investments to            changes in interest rates. Coupon and dividend income represent the greatest portion of            an investment’s total return for most fixed income instruments in stable interest            rate environments. The changes in the fair market price of such investments are            inversely related to changes in market interest rates. As interest rates fall, the            coupon and dividend streams of existing fixed rate investments become more valuable and            market values rise. As interest rates rise, the opposite effect occurs.

 

The            net unrealized gain on the Company’s investment portfolio increased in 2007,            primarily due to decreasing interest rates. At year-end, the fair value of the            securities exceeded its book value by $13.2 million.

 

Due            to the complex nature of interest rate movements and their uneven effects on the value            of fixed income investments, the Company uses sophisticated computer programs to help            consider potential changes in the value of the portfolio. Assuming that changes occur            equally over the entire term structure of interest rates or yield curve, it is            estimated that a 100 basis point increase in rates would translate to a $138.4 million            loss of fair value for the $2.7 billion securities portfolio. Conversely, a 100 basis            point rate decrease would translate to a $134.1 million increase in fair            value.

 

**-39-** 

Market            changes rarely follow a linear pattern in one direction for any length of time. Within            any diversified portfolio, an investor will likely find embedded options, both puts and            calls, that change the structure of the cash flow stream. Mortgage-backed securities            are particularly sensitive to interest rate changes. As long-term interest rates fall,            homeowners become more likely to refinance their mortgage or move up to a larger home,            causing a prepayment of the outstanding mortgage principal, which must then be            reinvested at a lower rate. Should interest rates rise suddenly, prepayments expected            by investors may decrease, extending the duration of a mortgage pool. This represents a            further interest rate risk to investors.

 

As            interest rates rise, policyholders may become more likely to surrender policies or to            borrow against cash values, often to meet sudden needs in an inflationary environment            or to invest in higher yielding opportunities elsewhere. This risk of disintermediation            may force the Company to liquidate parts of its portfolio at a time when the fair value            of fixed income investments is falling. If interest rates fall, the Company may also be            forced to invest new cash receipts at levels below the minimum guaranteed rates payable            to policyholders, eroding profit margins. The Company can usually adapt to small sudden            changes in interest rates or even large changes that occur over longer periods of time.            However, cash flow may increase or decrease over the course of the business cycle.            Therefore, the Company takes steps to ensure that adequate liquidity is available to            meet obligations in a timely manner. To this end, the Company utilizes an            asset/liability management program, and the Company maintains lines of credit with            commercial banks and other short-term borrowing arrangements with financial            institutions.

 

The            majority of the Company’s investments are exposed to varying degrees of credit            risk. Credit risk is the risk that the value of the investment may decline due to            deterioration in the financial strength of the issuer and that the timely or ultimate            payment of principal or interest might not occur. A default by an issuer usually            involves some loss of principal to the investor. Losses can be mitigated by timely            sales of affected securities or by active involvement in a restructuring process.            However, there can be no assurance that the efforts of an investor will lead to            favorable outcomes in a bankruptcy or restructuring. Information about the write-down            of investment securities is provided in the table of Realized Investment Gains and            Losses, under the section Consolidated Results of Operations in Item 7 -            Management’s Discussion and Analysis of Financial Condition and Results of            Operations.

 

The            Company mitigates credit risk by diversifying the investment portfolio across a broad            range of issuers, investment sectors and security types, and by limiting the amount            invested in any particular entity. With the exception of certain GSE’s, there is            no exposure to any single corporate issuer greater than one percent of assets on a book            value basis. The Company also invests in securities collateralized by physical assets.            These securities can improve the likelihood of payment according to contractual terms            and increase recovery amounts in the case of bankruptcy or restructuring.

 

The            Company currently holds $157.6 million of foreign bonds. The foreign securities do not            expose the Company directly to foreign currency risk, as the securities are denominated            in U.S. dollars. As a result, the foreign currency risk lies with the issuer of the            securities and may expose the issuer to fluctuations in the foreign currency            market.

 

As            market interest rates fluctuate, so will the value of the Company's investment            portfolio and its stockholders' equity. At December 31, 2007, the Company had an            unrealized investment gain of $7.6 million (net of related taxes, and amounts allocable            to policyholder account balances and deferred acquisition costs), compared to $1.2            million at year-end 2006. This increase was primarily the result of lower interest            rates.

 

***Asset/Liability Management***

Kansas City Life’s asset/liability management programs and            procedures involve the monitoring of asset and liability durations for various product            lines, cash flow testing under various interest rate scenarios to evaluate the            potential sensitivity of assets and liabilities to interest rate movements, and the            continuous rebalancing of assets and liabilities with respect to yield, risk, and cash            flow characteristics.

 

Kansas City Life believes its asset/liability management programs and            procedures, along with certain product features, provide protection for the Company            against the effects of changes in interest rates under various scenarios.

 

Cash            flows and effective durations of the asset and liability portfolios are measured at            points in time and are affected by changes in the level and term structure of interest            rates, as well as changes in policyholder behavior. Further, durations are managed on            an individual product level, and an aggregate portfolio basis. As a result, differences            typically exist between the duration, cash flows and yields of assets versus            liabilities on an individual portfolio and aggregate basis. The Company’s            asset/liability management programs and procedures enable management to monitor the            changes, which

 

**-40-** 

have            both positive and negative correlations among certain portfolios, and to make            adjustments to asset mix, liability crediting rates and product terms so as to manage            risk and profitability over time.

 

The            Company performs cash flow scenario testing through models of its in-force business.            These models reflect specific product characteristics and include assumptions based on            current and anticipated experience regarding the relationships between short-term and            long-term interest rates (i.e., the slope of the yield curve), credit spreads, market            liquidity and other factors, including policyholder behavior in certain market            conditions. In addition, these models include asset cash flow projections, reflecting            interest payments, sinking fund payments, principal payments, bond calls and mortgage            prepayments.

 

The            Company has a risk that the asset or liability portfolio performance may differ from            forecasted results as a result of unforeseen economic circumstances, estimates or            assumptions that prove incorrect, unanticipated policyholder behavior or other factors.            The result of such deviation of actual versus expected performance could include excess            or insufficient liquidity in future periods. Excess liquidity, in turn, could result in            reduced profitability on one or more product lines. Insufficient liquidity could result            in the need to generate liquidity through borrowing, asset sales or other means. The            Company believes that adherence to its asset/liability management programs will provide            sufficient liquidity to enable it to fulfill its obligation to pay benefits under its            various insurance and deposit contracts. On a historical basis, the Company has not            needed to liquidate assets to ensure sufficient cash flows. The Company maintains            borrowing lines on a secured and unsecured basis to provide additional liquidity, if            needed.

 

The            Company markets certain variable products. The policyholder assumes essentially all the            investment earnings risk for the portion of the account balance invested in the            separate accounts. However, the Company assesses certain charges based on the policy            account values and changes to the account values can affect the Company's earnings. The            portion of the policyholder's account balance invested in the fixed general account, if            any, is affected by many factors, including the absolute level of interest rates,            relative performance of the fixed income and equity markets, spreads between interest            yields on investments and rates credited to the policyholder's accounts, and changes in            consumer preferences.

 

***Expected Cash Flows***

The            table below details the nature of expected cash flows from the securities portfolio,            including the cash flows from mortgage-backed securities pools, corporate bonds and            commercial mortgages. Calls and prepayments represent the principal amount expected to            return to the Company. Total principal equals invested cash scheduled to return in each            year, including maturities, calls, sinking funds and prepayments.

 

 

**-41-** 

 

**Expected Cash Flows**

(amounts in millions)

 

|                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | There- |   |   | Total     |   | Fair                               |
|--------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-----------|--------|------------------------------------|
|                                 |   | 2008   |   |   | 2009   |   |   | 2010   |   |   | 2011   |   |   | 2012   |   |   | after  |   |   | Principal |   | Value                              |
| Corporate bonds currently callable   | $      | 5      |   | $      | -      |   | $      | -      |   | $      | 3      |   | $      | 3      |   | $      | 16     |   | $      | 27        |   | $    27                  |
| Average interest rate                |   | 7.57   | %      |   | -      | %      |   | -      | %      |   | 4.91   | %      |   | 4.68   | %      |   | 7.63   | %      |   | 6.99      | %      |                               |
| Mortgage-backed securities and CMO's |   | 75     |   |   | 78     |   |   | 51     |   |   | 46     |   |   | 50     |   |   | 302    |   |   | 602       |   |       603      |
| Average interest rate                |   | 4.83   | %      |   | 5.14   | %      |   | 5.42   | %      |   | 5.60   | %      |   | 5.56   | %      |   | 5.75   | %      |   | 5.50      | %      |                               |
| All other securities                 |   | 161    |   |   | 168    |   |   | 180    |   |   | 160    |   |   | 175    |   |   | 1,135  |   |   | 1,979     |   |    2,060                 |
| Average interest rate                |   | 5.28   | %      |   | 5.60   | %      |   | 5.56   | %      |   | 6.00   | %      |   | 5.72   | %      |   | 6.26   | %      |   | 6.00      | %      |                               |
| Investment securities                |   | 241    |   |   | 246    |   |   | 231    |   |   | 209    |   |   | 228    |   |   | 1,453  |   |   | 2,608     |   |    2,690                 |
| Average interest rate                |   | 5.19   | %      |   | 5.45   | %      |   | 5.53   | %      |   | 5.90   | %      |   | 5.67   | %      |   | 6.18   | %      |   | 5.90      | %      |                               |
| Mortgages                            |   | 31     |   |   | 50     |   |   | 41     |   |   | 58     |   |   | 35     |   |   | 235    |   |   | 450       |   |       464 |
| Average interest rate                |   | 6.82   | %      |   | 6.81   | %      |   | 7.18   | %      |   | 6.95   | %      |   | 6.74   | %      |   | 6.30   | %      |   | 6.59      | %      |                               |
| Total                                | $      | 272    |   | $      | 296    |   | $      | 272    |   | $      | 267    |   | $      | 263    |   | $      | 1,688  |   | $      | 3,058     |   | $ 3,154                            |
| Average interest rate                |   | 5.38   | %      |   | 5.68   | %      |   | 5.78   | %      |   | 6.13   | %      |   | 5.81   | %      |   | 6.20   | %      |   | 6.00      | %      |                               |

 

 

 

 

 

**-42-** 

**Item 8****.****FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

| **KANSAS CITY LIFE INSURANCE COMPANY**                                                |
|---------------------------------------------------------------------------------------|
| **CONSOLIDATED BALANCE SHEETS**                                                       |
| (amounts in thousands, except share data)                                             |
|                                                                                  |   |   |   |   |   |   |   |   |   |
|                                                                                  |   |   |   |   | December 31 |
|                                                                                  |   |   |   |   | 2007 |   | 2006 |
| **ASSETS**                                                                            |   |   |   |   |   |   |   |
| Investments:                                                                          |   |   |   |   |   |   |
|                                                                                  | Fixed maturity securities available for sale, at fair                        value |   |   |   |   |   |
|                                                                                  |   |   | (amortized cost: 2007 - $2,619,109; 2006 -                        $2,718,960) | $ | 2,631,073 |   | $ | 2,719,439 |
|                                                                                  | Equity securities available for sale, at fair                        value |   |   |   |   |   |
|                                                                                  |   |   | (cost: 2007 - $57,906; 2006 - $50,180) |   | 59,149 |   |   | 52,351 |
|                                                                                  | Mortgage loans |   |   | 450,148 |   |   | 472,019 |
|                                                                                  | Real estate |   |   | 96,049 |   |   | 109,525 |
|                                                                                  | Policy loans |   |   | 92,803 |   |   | 96,218 |
|                                                                                  | Short-term investments |   | 36,522 |   |   | 41,037 |
|                                                                                  | Other investments |   | - |   |   | 3,182 |
|                                                                                  |   |   | Total investments |   | 3,365,744 |   |   |  3,493,771 |
|                                                                                  |   |   |   |   |   |   |   |   |   |
| Cash                                                                                  |   |   |   |   | 12,158 |   |   | 3,908 |
| Accrued investment income                                                             |   | 36,499 |   |   | 38,661 |
| Deferred acquisition costs                                                            |   | 217,512 |   |   | 220,595 |
| Value of business acquired                                                            |   | 73,517 |   |   | 82,769 |
| Reinsurance receivables                                                               |   | 162,340 |   |   | 158,231 |
| Property and equipment                                                                |   | 27,781 |   |   | 29,364 |
| Other assets                                                                          |   |   | 36,164 |   |   | 29,747 |
| Separate account assets                                                               |   | 420,393 |   |   | 400,749 |
|                                                                                  |   |   | Total assets | $ |  4,352,108 |   | $ |  4,457,795 |
|                                                                                  |   |   |   |   |   |   |   |   |   |
| **LIABILITIES**                                                                       |   |   |   |   |   |   |
| Future policy benefits                                                                | $ | 851,277 |   | $ | 853,102 |
| Policyholder account balances                                                         |   | 2,087,965 |   |   | 2,191,105 |
| Policy and contract claims                                                            |   | 31,742 |   |   | 32,188 |
| Other policyholder funds                                                              |   | 107,109 |   |   | 87,094 |
| Notes payable                                                                         |   |   | 10,400 |   |   | 14,700 |
| Income taxes                                                                          |   |   | 40,300 |   |   | 35,319 |
| Other liabilities                                                                     |   |   | 118,521 |   |   | 159,234 |
| Separate account liabilities                                                          |   | 420,393 |   |   | 400,749 |
|                                                                                  |   |   | Total liabilities |   | 3,667,707 |   |   | 3,773,491 |
|                                                                                  |   |   |   |   |   |   |   |   |   |
| **STOCKHOLDERS' EQUITY**                                                              |   |   |   |   |   |
| Common stock, par value $1.25 per share                                               |   |   |   |   |   |
|                                                                                  | Authorized 36,000,000 shares, |   |   |   |   |   |
|                                                                                  |   |   | issued 18,496,680 shares |   | 23,121 |   |   | 23,121 |
| Additional paid in capital                                                            |   | 30,244 |   |   | 25,852 |
| Retained earnings                                                                     |   |   | 780,133 |   |   | 780,892 |
| Accumulated other comprehensive loss                                                  |   | (19,811) |   |   | (25,118) |
| Treasury stock, at cost (2007 - 6,731,643 shares;                                     |   |   |   |   |   |
|                                                                                  | 2006 - 6,641,183 shares) |   | (129,286) |   |   | (120,443) |
|                                                                                  |   |   | Total stockholders' equity |   | 684,401 |   |   | 684,304 |
|                                                                                  |   |   |   |   |   |   |   |   |   |
|                                                                                  |   |   | Total liabilities and stockholders' equity | $ | 4,352,108 |   | $ | 4,457,795 |
|                                                                                  |   |   |   |   |   |   |   |   |   |
| *See accompanying Notes to Consolidated Financial                        Statements.* |

 

 

 

**-43-** 

 

| **KANSAS CITY LIFE INSURANCE COMPANY**                                                    |
|-------------------------------------------------------------------------------------------|
| **CONSOLIDATED STATEMENTS OF INCOME**                                                     |
| (amounts in thousands, except share data)                                                 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                      |   |   |   | Year Ended December 31 |
|                                                                                      |   |   |   | 2007 |   | 2006 |   | 2005 |
| **REVENUES**                                                                              |   |   |   |   |   |   |   |   |
| Insurance revenues:                                                                       |   |   |   |   |   |   |   |   |
|                                                                                      | Premiums | $ | 175,460 |   | $ | 175,926 |   | $ | 179,566 |
|                                                                                      | Contract charges |   | 111,422 |   |   | 114,496 |   |   | 114,745 |
|                                                                                      | Reinsurance ceded |   | (54,988) |   |   | (55,158) |   |   | (55,808) |
|                                                                                      |   |   | Total insurance revenues |   | 231,894 |   |   | 235,264 |   |   | 238,503 |
| Investment revenues:                                                                      |   |   |   |   |   |   |   |   |
|                                                                                      | Net investment income |   | 190,405 |   |   | 196,280 |   |   | 194,608 |
|                                                                                      | Realized investment gains |   | 5,426 |   |   | 5,621 |   |   | 6,113 |
| Other revenues                                                                            |   | 11,499 |   |   | 11,349 |   |   | 10,312 |
|                                                                                      |   |   | Total revenues |   | 439,224 |   |   | 448,514 |   |   | 449,536 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| **BENEFITS AND EXPENSES**                                                                 |   |   |   |   |   |   |   |   |
| Policyholder benefits                                                                     |   | 166,458 |   |   | 167,905 |   |   | 169,701 |
| Interest credited to policyholder account                            balances             |   | 91,215 |   |   | 94,648 |   |   | 98,637 |
| Amortization of deferred acquisition costs                                                |   |   |   |   |   |   |   |   |
|                                                                                      | and value of business acquired |   | 40,333 |   |   | 42,311 |   |   | 43,058 |
| Operating expenses                                                                        |   | 88,307 |   |   | 93,080 |   |   | 89,144 |
|                                                                                      |   |   | Total benefits and expenses |   | 386,313 |   |   | 397,944 |   |   | 400,540 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| Income before income tax expense                                                          |   | 52,911 |   |   | 50,570 |   |   | 48,996 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| Income tax expense                                                                        |   | 17,250 |   |   | 13,652 |   |   | 12,812 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| **NET INCOME**                                                                            | $ | 35,661 |   | $ | 36,918 |   | $ | 36,184 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| Basic and diluted earnings per share:                                                     |   |   |   |   |   |   |   |   |
|                                                                                      | Net income | $ | 3.01 |   | $ | 3.11 |   | $ | 3.03 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| *See accompanying Notes to Consolidated Financial                            Statements.* |

 

 

 

 

**-44-** 

 

| **KANSAS CITY LIFE INSURANCE COMPANY**                                                |
|---------------------------------------------------------------------------------------|
| **CONSOLIDATED STATEMENTS OF STOCKHOLDERS'                        EQUITY**            |
| (amounts in thousands, except share data)                                             |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
|                                                                                  |   |   | Year Ended December 31 |
|                                                                                  |   |   | 2007 |   | 2006 |   | 2005 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **COMMON STOCK,**beginning and end                        of year                     | $ | 23,121 |   | $ | 23,121 |   | $ | 23,121 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **ADDITIONAL PAID IN CAPITAL**                                                        |   |   |   |   |   |   |   |   |
| Beginning of year                                                                     |   | 25,852 |   |   | 25,063 |   |   | 24,279 |
| Excess of proceeds over cost of treasury stock                        sold            |   | 4,392 |   |   | 789 |   |   | 784 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
|                                                                                  | End of year |   | 30,244 |   |   | 25,852 |   |   | 25,063 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **RETAINED EARNINGS**                                                                 |   |   |   |   |   |   |   |   |
| Beginning of year                                                                     |   | 780,892 |   |   | 756,807 |   |   | 733,499 |
| Net income                                                                            |   | 35,661 |   |   | 36,918 |   |   | 36,184 |
| Stockholder dividends of $3.08 per share                                              |   |   |   |   |   |   |   |   |
|                                                                                  | (2006 - $1.08; 2005 - $1.08) |   | (36,420) |   |   | (12,833) |   |   | (12,876) |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
|                                                                                  | End of year |   | 780,133 |   |   | 780,892 |   |   | 756,807 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **ACCUMULATED OTHER COMPREHENSIVE**                                                   |   |   |   |   |   |   |   |   |
|                                                                                  | **LOSS** |   |   |   |   |   |   |   |   |
| Beginning of year                                                                     |   | (25,118) |   |   | (8,406) |   |   | 26,231 |
| Other comprehensive income (loss)                                                     |   | 5,307 |   |   | (12,588) |   |   | (34,637) |
| Adjustment to adopt SFAS 158                                                          |   | - |   |   | (4,124) |   |   | - |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
|                                                                                  | End of year |   | (19,811) |   |   | (25,118) |   |   | (8,406) |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **TREASURY STOCK**, at                        cost                                    |   |   |   |   |   |   |   |   |
| Beginning of year                                                                     |   | (120,443) |   |   | (116,366) |   |   | (114,234) |
| Cost of 230,581 shares acquired                                                       |   |   |   |   |   |   |   |   |
|                                                                                  | (2006 - 87,167 shares; 2005 - 50,689 shares) |   | (10,799) |   |   | (4,418) |   |   | (2,458) |
| Cost of 140,121 shares sold                                                           |   |   |   |   |   |   |   |   |
|                                                                                  | (2006 - 24,030 shares; 2005 - 22,930 shares) |   | 1,956 |   |   | 341 |   |   | 326 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
|                                                                                  | End of year |   | (129,286) |   |   | (120,443) |   |   | (116,366) |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| **TOTAL STOCKHOLDERS' EQUITY**                                                        | $ | 684,401 |   | $ | 684,304 |   | $ | 680,219 |
|                                                                                  |   |   |   |   |   |   |   |   |   |   |
| *See accompanying Notes to Consolidated Financial                        Statements.* |

 

 

 

             

             

             

**-45-** 

| **KANSAS CITY LIFE INSURANCE COMPANY**                                                    |
|-------------------------------------------------------------------------------------------|
| **CONSOLIDATED STATEMENTS OF CASH FLOWS**                                                 |
| (amounts in thousands)                                                                    |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                      |   |   |   |   | Year Ended December 31 |
|                                                                                      |   |   |   | 2007 |   | 2006 |   | 2005 |
| **OPERATING ACTIVITIES**                                                                  |   |   |   |   |   |   |   |   |
| Net income                                                                                | $ | 35,661 |   | $ | 36,918 |   | $ | 36,184 |
| Adjustments to reconcile net income to                                                    |   |   |   |   |   |   |   |   |
|                                                                                      | net cash provided by operating activities: |   |   |   |   |   |   |   |   |
|                                                                                      |   | Amortization of investment premium (discount) |   | 6,279 |   |   | 7,908 |   |   | 10,493 |
|                                                                                      |   | Depreciation |   | 3,323 |   |   | 4,223 |   |   | 4,247 |
|                                                                                      |   | Acquisition costs capitalized |   | (28,642) |   |   | (26,554) |   |   | (28,092) |
|                                                                                      |   | Amortization of deferred acquisition costs |   | 31,073 |   |   | 34,919 |   |   | 35,608 |
|                                                                                      |   | Amortization of value of business acquired |   | 9,260 |   |   | 7,392 |   |   | 6,821 |
|                                                                                      |   | Realized investment gains |   | (4,060) |   |   | (5,621) |   |   | (6,113) |
|                                                                                      |   | Changes in assets and liabilities: |   |   |   |   |   |   |   |   |
|                                                                                      |   |   | Future policy benefits |   | (1,825) |   |   | (5,650) |   |   | (3,252) |
|                                                                                      |   |   | Policyholder account balances |   | (21,356) |   |   | (28,061) |   |   | (17,275) |
|                                                                                      |   |   | Income taxes payable and deferred |   | 1,577 |   |   | 3,946 |   |   | 5,064 |
|                                                                                      |   | Other, net |   | 1,607 |   |   | (5,484) |   |   | 637 |
|                                                                                      |   | Net cash provided |   | 32,897 |   |   | 23,936 |   |   | 44,322 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| **INVESTING ACTIVITIES**                                                                  |   |   |   |   |   |   |   |   |
| Purchases of investments:                                                                 |   |   |   |   |   |   |   |   |
|                                                                                      | Fixed maturity securities |   | (313,080) |   |   | (274,662) |   |   | (541,305) |
|                                                                                      | Equity securities |   | (15,249) |   |   | (10,761) |   |   | (5,690) |
|                                                                                      | Mortgage loans |   | (54,816) |   |   | (72,569) |   |   | (109,561) |
|                                                                                      | Real estate |   | (4,507) |   |   | (45,006) |   |   | (17,804) |
|                                                                                      | Other investment assets |   | - |   |   | - |   |   | (98) |
| Sales of investments:                                                                     |   |   |   |   |   |   |   |   |
|                                                                                      | Fixed maturity securities |   | 168,259 |   |   | 94,717 |   |   | 175,317 |
|                                                                                      | Equity securities |   | 4,583 |   |   | 5,078 |   |   | 6,296 |
|                                                                                      | Real estate |   | 22,457 |   |   | 18,778 |   |   | 33,267 |
|                                                                                      | Other investment assets |   | 7,930 |   |   | 9,213 |   |   | 29,055 |
| Maturities and principal paydowns of                            investments:              |   |   |   |   |   |   |   |   |
|                                                                                      | Fixed maturity securities |   | 198,224 |   |   | 279,010 |   |   | 394,366 |
|                                                                                      | Equity securities |   | 2,806 |   |   | 7,175 |   |   | 9,026 |
|                                                                                      | Mortgage loans |   | 58,405 |   |   | 59,120 |   |   | 82,414 |
| Net additions to property and equipment                                                   |   | (969) |   |   | (2,028) |   |   | (1,019) |
| Proceeds from sale of non insurance affiliate                                             |   | 10,104 |   |   | - |   |   | - |
|                                                                                      |   | Net cash provided |   | 84,147 |   |   | 68,065 |   |   | 54,264 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| **FINANCING ACTIVITIES**                                                                  |   |   |   |   |   |   |   |   |
| Proceeds from borrowings                                                                  |   | 359,680 |   |   | 67,001 |   |   | 45,315 |
| Repayment of borrowings                                                                   |   | (363,980) |   |   | (79,583) |   |   | (110,252) |
| Deposits on policyholder account balances                                                 |   | 205,767 |   |   | 202,950 |   |   | 242,613 |
| Withdrawals from policyholder account                            balances                 |   | (294,799) |   |   | (273,816) |   |   | (245,927) |
| Net transfers from separate accounts                                                      |   | 11,706 |   |   | 16,451 |   |   | 5,213 |
| Change in other deposits                                                                  |   | 13,703 |   |   | (17,074) |   |   | (14,565) |
| Cash dividends to stockholders                                                            |   | (36,420) |   |   | (12,833) |   |   | (12,876) |
| Net acquisition of treasury stock                                                         |   | (4,451) |   |   | (3,288) |   |   | (1,348) |
|                                                                                      |   | Net cash used |   |  (108,794) |   |   |  (100,192) |   |   | (91,827) |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| Increase (decrease) in cash                                                               |   | 8,250 |   |   | (8,191) |   |   | 6,759 |
| Cash at beginning of year                                                                 |   | 3,908 |   |   | 12,099 |   |   | 5,340 |
|                                                                                      |   |   |   |   |   |   |   |   |   |
|                                                                                      |   | Cash at end of year | $ | 12,158 |   | $ | 3,908 |   | $ | 12,099 |
|                                                                                      |   |   |   |   |   |   |   |   |   |   |   |
| *See accompanying Notes to Consolidated Financial                            Statements.* |

 

**-46-** 

 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

(amounts in thousands, except share data)

 

***1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING            POLICIES***

             

**Business**

Kansas City Life Insurance Company (the Company) is a Missouri domiciled            stock life insurance company which, with its subsidiaries, is licensed to sell            insurance products in 49 states and the District of Columbia. The Company offers a            diversified portfolio of individual insurance, annuity and group products through three            life insurance companies: Kansas City Life Insurance Company (Kansas City Life) the            parent company, and wholly owned subsidiaries Sunset Life Insurance Company of America            (Sunset Life) and Old American Insurance Company (Old American).

 

**Basis of Presentation**

The            accompanying consolidated financial statements have been prepared on the basis of            accounting principles generally accepted in the United States of America (GAAP) and            include the accounts of Kansas City Life and its subsidiaries, principally Sunset Life            and Old American. All material intercompany accounts and transactions have been            eliminated in consolidation.

 

Certain amounts in prior years have been reclassified to conform with            the current year presentation. Upon the adoption of SFAS 158, the Company recorded the            related $4.1 million (net of tax) adjustment as a component of other            comprehensive loss for the year ended December 31, 2006. The Company has since            determined that this adjustment should have been presented as an adjustment of the            ending balance of accumulated other comprehensive loss. The accompanying Consolidated            Statements of Stockholders’ Equity for the year ended December 31, 2006 and Note            12 – Comprehensive Income have been modified to reflect this            presentation.

 

**Use of Estimates**

The            preparation of the consolidated financial statements requires management of the Company            to make estimates and assumptions relating to the reported amounts of assets and            liabilities and the disclosure of contingent assets and liabilities at the date of the            consolidated financial statements, and the reported amounts of revenue and expenses            during the period. These estimates are inherently subject to change and actual results            could differ from these estimates. Included among the material (or potentially            material) reported amounts and disclosures that require extensive use of estimates are            the fair value of certain invested assets, deferred acquisition costs, value of            business acquired, future policy benefits, policy and contract claim liabilities and            the valuation allowance on deferred income tax assets.

 

**Business Changes**

On            January 23, 2006 the Company entered into a definitive agreement to sell its bank            subsidiary, Generations Bank, for $10.1 million in cash to Brooke Corporation. On            January 8, 2007, the Company completed the sale of Generations Bank after receiving            regulatory approval from the Office of Thrift Supervision. The gain on the sale was            $1.9 million and is included in realized investment gains. The bank subsidiary and the            results of operations were not material to the financial statements of the Company and            are not disclosed separately.

 

In            2006, the Company entered into a Master General Agent and Marketing Agreement with            American Republic Insurance Company (American Republic) under which American Republic            agents market Kansas City Life’s insurance products. Sales under this agreement            are reflected in the Individual Insurance segment.

 

**Investments**

Investment income is recognized when earned. Realized gains and losses            on the sale of investments are determined on the basis of specific security            identification recorded on the trade date. Securities available for sale are stated at            fair value. Unrealized gains and losses, net of adjustments to deferred acquisition            costs (DAC), value of business acquired (VOBA), policyholder account balances and            deferred income taxes, are reported as a separate component of accumulated other            comprehensive loss in stockholders' equity. The adjustments to DAC and VOBA represent            changes in the amortization of DAC and VOBA that would have been required as a charge            or credit to income had such unrealized amounts been realized. The adjustment to            policyholder account balances represents the increase from using a discount rate that            would have been required if such unrealized gains had been realized and the proceeds            reinvested at current market interest rates, which were lower than the then current            effective portfolio rate.

 

 

**-47-** 

**                                                                   KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

The            Company’s fair value of fixed maturity and equity securities are derived from            external pricing sources, brokers, and internal matrices. Approximately 94% of these            investments are from external pricing services while 6% are derived from brokers and            internal matrices. The Company reviews and analyzes its securities on an ongoing basis            to determine whether impairments exist that are other-than-temporary. Based upon these            analyses, specific security values are written down to fair value through earnings as a            realized investment loss if the security's value is considered to be an            other-than-temporary impairment. Premiums and discounts on fixed maturity securities            are amortized over the life of the related security as an adjustment to yield using the            effective interest method. See Note 2 – Investments for further            details.

 

Investment income on mortgage-backed securities is initially based upon            yield, cash flow, and prepayment assumptions at the date of purchase. Subsequent            revisions in those assumptions are recorded using the retrospective method, except for            ARMs (adjustable rate mortgage-backed securities) where the prospective method is used.            Under the retrospective method the amortized cost of the security is adjusted to the            amount that would have existed had the revised assumptions been in place at the time of            purchase. Under the prospective method, future cash flows are estimated and interest            income is recognized going forward using the new internal rate of return. The            adjustments to amortized cost under both methods are recorded as a charge or credit to            net investment income.

 

Mortgage loans are stated at cost, adjusted for amortization of premium            and accrual of discount, less a valuation reserve for probable losses. A loan is            considered impaired if it is probable that contractual amounts due will not be            collected. The valuation reserve is based upon historical impairment experience,            including an estimate of probable impairment of any delinquent or defaulted loans. Such            estimates are based upon the value of the expected cash flows and the underlying            collateral on a net realizable basis. Loans in foreclosure and loans considered to be            impaired are placed on a non-accrual status.

 

Real            estate consists of directly owned investments and real estate joint ventures. Real            estate that is directly owned is carried at depreciated cost. Real estate joint            ventures consist primarily of office buildings, unimproved land for future development            and low income housing tax credit (“LIHTC”) investments. Real estate joint            ventures are consolidated where required or are valued at cost, adjusted for the            Company’s equity in earnings.

 

Policy loans are carried at cost, less principal payments received.            Short-term investments are stated at cost, adjusted for amortization of premium and            accrual of discount.

 

**Deferred Acquisition Costs**

Deferred acquisition costs (DAC), principally agent commissions and            other selling, selection and issue costs, which vary with and are directly related to            the production of new business, are capitalized as incurred. These deferred costs are            then amortized in proportion to future premium revenues or the expected future profits            of the business, depending upon the type of product. Profit expectations are based upon            assumptions of future interest spreads, mortality margins, expense margins and policy            and premium persistency experience. These assumptions involve judgment and are compared            to actual experience on an ongoing basis. If it is determined that the assumptions            related to the profit expectations for interest sensitive and variable insurance            products should be revised, the impact of the change is reported in the current            period’s income as an unlocking adjustment. The DAC unlocking adjustment was $3.4            million for the year ended 2007 (2006 – $0.7 million; 2005 – $2.2 million)            which reduced the amortization of DAC. During the fourth quarter of 2006, the Old            American segment reduced its amortization of DAC by $1.2 million. This adjustment,            which is a correction of an understatement of the capitalization of DAC in prior            periods, was not material to 2006 or any prior period financial statements.

 

DAC            is reviewed on an ongoing basis to determine that the unamortized portion does not            exceed the expected recoverable amounts. If it is determined from emerging experience            that the premium margins or gross profits are insufficient to amortize deferred            acquisition costs, then the asset will be adjusted downward with the adjustment            recorded as an expense in the current period. No impairment adjustments have been            recorded in the years presented. The DAC asset is adjusted to reflect the impact of            unrealized gains and losses on fixed maturity securities available for sale, as            described in the Investments section of Note 1*.*

 

 

 

 

**-48-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

| The following table provides information about DAC at                            December 31. |
|-----------------------------------------------------------------------------------------------|

        

|                                                                                 |   | 2007                           |                                                                           | 2006   |                     | 2005                                      |
|--------------------------------------------------------------------------------------|--------|--------------------------------|--------------------------------------------------------------------------------|--------|--------------------------|-------------------------------------------|
|                                                                                 |   |                           |                                                                           |   |                     |                                      |   |   |   |
| Balance at beginning of year                                                         |   | $                              | 220,595                                                                        |   | $                        | 226,963                                   |   | $ | 229,712 |
| Capitalization of commissions, sales and issue                            expenses   |   |                           |   28,643                                                                  |   |                     |   26,554                             |   |   |   28,092 |
| Gross amortization                                                                   |   |                           | (43,341)                                                                       |   |                     |  (47,378)                            |   |   | (48,699) |
| Accrual of interest                                                                  |   |                           |   12,268                                                                  |   |                     |   12,459                        |   |   |   13,091 |
| Amortization due to realized investment (gains)                            losses    |   |                           |                                     33 |   |                     |        (58) |   |   |                                     78 |
| Change in DAC due to unrealized investment (gains)                            losses |   |      (686) |                                                                           |   |     2,055 |                                      |   |     4,689 |
|                                                                                 |   |                           |                                                                           |   |                     |                                      |   |   |   |
| Balance at end of year                                                               |   | $                              | 217,512                                                                        |   | $                        | 220,595                                   |   | $ | 226,963 |
|                                                                                 |   |                           |                                                                           |   |                     |                                      |   |   |   |

 

 

**Value of Business Acquired**

When            a new block of business is acquired, a portion of the purchase price is allocated to a            separately identifiable intangible asset, called the value of business acquired (VOBA).            VOBA is established as the actuarially determined present value of future gross profits            of the business acquired and is amortized in proportion to future premium revenues or            the expected future profits, depending on the type of business acquired. Amortization            of VOBA occurs with interest over the anticipated lives of the underlying business to            which it relates, initially 15 to 30 years. Similar to DAC, the assumptions regarding            future experience can affect the carrying value of VOBA, including interest spreads,            mortality, expense margins and policy and premium persistency experience. Significant            changes in these assumptions can impact the carrying balance of VOBA and produce            changes that are reflected in the current period’s income as an unlocking            adjustment. A VOBA unlocking adjustment was made in the second quarter of 2007 which            increased the amortization of VOBA in the amount of $1.1 million for mortality margins.            There were no unlocking adjustments in 2006 and 2005.

 

VOBA            is reviewed on an ongoing basis to determine that the unamortized portion does not            exceed the expected recoverable amounts. If it is determined from emerging experience            that the premium margins or gross profits are insufficient to support the value of            VOBA, then the asset will be adjusted downward with the adjustment recorded as an            expense in the current period. No impairment adjustments have been recorded in the            years presented. The VOBA asset is adjusted to reflect the impact of unrealized gains            and losses on fixed maturity securities available for sale, as described in the            Investments section of Note 1*.*

 

The            following table provides information about VOBA at December 31.

 

|                                                                          |   | 2007   |                                    | 2006   |   | 2005                               |
|-------------------------------------------------------------------------------|--------|--------|-----------------------------------------|--------|--------|------------------------------------|
|                                                                          |   |   |                                    |   |   |                               |   |   |   |
| Balance at beginning of year                                                  |   | $      |   82,769                           |   | $      |   89,505                      |   | $ |  96,853 |
| Gross amortization                                                            |   |   | (14,545)                                |   |   | (13,868)                           |   |   | (13,996) |
| Accrual of interest                                                           |   |   |     5,285                |   |   |    6,476                 |   |   |    6,546 |
| Amortization due to realized investment (gains)                        losses |   |   |       (76)     |   |   |      (195)     |   |   |                                  7 |
| Change in VOBA due to unrealized investment                        losses     |   |   |        84 |   |   |       851 |   |   |         95 |
|                                                                          |   |   |                                    |   |   |                               |   |   |   |
| Balance at end of year                                                        |   | $      | 73,517                                  |   | $      |  82,769                       |   | $ |  89,505 |
|                                                                          |   |   |                                    |   |   |                               |   |   |   |

 

 

 

**-49-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

The            accrual of interest for Old American VOBA was calculated at a 13.0% interest rate for            the life block and a 7.0% rate for the accident and health block. In 2007, interest            accrued on the GuideOne acquisition VOBA at the rates of 4.58% on the interest            sensitive life block, 4.05% on the deferred annuity block and 5.25% on the traditional            life block. The VOBA on a separate acquired block of business used a 7.0% interest rate            on the traditional life portion and a 5.4% interest rate on the interest sensitive            portion. The interest rates used in the calculation of VOBA are based on rates            appropriate at the time of acquisition. The expected amortization of VOBA each year            over the next five years, 2008 through 2012, is $7,279, $7,156, $6,899, $6,352, and            $4,284, respectively.

 

**Separate Accounts**

Separate account assets and liabilities arise from the sale of variable            life insurance and annuity products. The separate account represents funds segregated            for the benefit of certain policyholders who bear the investment risk. The assets are            legally segregated and are not subject to claims which may arise from any other            business of the Company. The separateaccount assets and            liabilities, which are equal, are recorded at fair value. Policyholder account deposits            and withdrawals, investment income and realized investment gains and losses are            excluded from the amounts reported in the Consolidated Statements of Income. Revenues            to the Company from separate accounts consist principally of contract charges, which            include maintenance charges, administrative fees and mortality and risk            charges.

 

The            following table provides a reconciliation of activity within separate account            liabilities at December 31.

 

|                                        | 2007   |                 | 2006   |   | 2005                 |
|---------------------------------------------|--------|----------------------|--------|--------|----------------------|
|                                        |   |                 |   |   |                 |   |   |   |
| Balance at beginning of year                | $      | 400,749              |   | $      | 367,860              |   | $ | 353,983 |
|                                        |   |                 |   |   |                 |   |   |   |
| Deposits on variable policyholder contracts |   |   57,767        |   |   |   46,771        |   |   |   49,360 |
| Transfers to general account                |   |    (2,476) |   |   |    (2,686) |   |   |    (6,040) |
| Investment performance                      |   |   33,826        |   |   |   52,026        |   |   |   25,131 |
| Policyholder benefits                       |   | ( 54,663)            |   |   |  (49,135)       |   |   |  (40,890) |
| Contract charges                            |   |  (14,810)       |   |   |  (14,087)       |   |   |  (13,684) |
|                                        |   |                 |   |   |                 |   |   |   |
| Balance at end of year                      | $      | 420,393              |   | $      | 400,749              |   | $ | 367,860 |
|                                        |   |                 |   |   |                 |   |   |   |

             

 

The            total separate account assets were $420.4 million as of December 31, 2007. Variable            life and variable annuity assets comprised 30% and 70% of this amount, respectively.            Two guarantees are offered under variable life and variable annuity contracts: a            guaranteed minimum death benefit rider is available on certain variable universal life            contracts, and guaranteed minimum death benefits are provided on variable annuities.            The guaranteed minimum death benefit rider for variable universal life contracts            guarantees the death benefit for specified periods of time, regardless of investment            performance, provided cumulative premium requirements are met. Kansas City Life            introduced a Guaranteed Minimum Withdrawal Benefit (GMWB) rider in 2007 that can be            added to new or existing variable annuity contracts. The rider provides a minimum            guarantee that the owner can make annual withdrawals equal to 5% of the initial annuity            deposit for twenty years, or for life if withdrawals were started at age 65 or later,            regardless of market returns.  The value of variable annuity            separate accounts with the GMWB rider was $9.6 million at the end of 2007. The            liabilities associated with these guarantees are not material.

 

**-50-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

As            of December 31, 2007, separate account balances for variable annuity contracts were            $295.2 million. The total reserve held for variable annuity guaranteed minimum death            benefits was $0.1 million. Additional information related to the guaranteed minimum            death benefits and related separate account balances and net amount at risk (the amount            by which the guaranteed minimum death benefit exceeds the account balance) as of            December 31, 2007 is provided below:

 

| Type of Guarantee                                                                     | Separate                                                                   |    | Net                    |
|---------------------------------------------------------------------------------------|----------------------------------------------------------------------------|---------|------------------------|
| *(amounts in millions)*                                                               | Account                                                                    |    | Amount                 |
|                                                                                  |                                                                       | Balance |                   | at Risk |
|                                                                                  |                                                                       |    |                   |   |   |   |
| Return of net deposits                                                                | $                                                                          | 267.4   |                   | $ | 2.5 |
| Return of the greater of the highest                            anniverary            |                                                                       |    |                   |   |   |
|                                                                                  | contract value or net deposits                                             |    |   12.1            |   |   | 0.2 |
| Return of the greater of every fifth year                            highest          |                                                                       |    |                   |   |   |
|                                                                                  | anniversary contract value or net deposits                                 |    |     8.3 |   |   | 0.1 |
| Return of the greater of net deposits accumulated                            annually |                                                                       |    |                   |   |   |
|                                                                                  | at 5% or the highest anniversary contract                            value |    |     7.4 |   |   | 0.1 |
| Total                                                                                 | $                                                                          | 295.2   |                   | $ | 2.9 |
|                                                                                  |                                                                       |    |                   |   |   |   |

 

 

**Recognition of Revenues**

Premiums for traditional life insurance products are reported as revenue            when due. Premiums on accident and health, disability and dental insurance are reported            as earned ratably over the contract period in proportion to the amount of insurance            protection provided. A reserve is provided for the portion of premiums written which            relate to unexpired terms of coverage.

 

Deposits related to universal life, fixed deferred annuity contracts and            investment-type products are credited to policyholder account balances. Revenues from            such contracts consist of amounts assessed against policyholder account balances for            mortality, policy administration and surrender charges, and are recognized in the            period in which the services are provided.

 

**Future Policy Benefits**

Liabilities for future policy benefits of traditional life insurance            have been computed by a net level premium method based upon estimates at the time of            issue for investment yields, mortality and withdrawals. These estimates include            provisions for experience less favorable than actually expected. Mortality assumptions            are based on Company experience expressed as a percentage of standard mortality tables.            The 2001 VBT and the 1975-1980 Select and Ultimate Basic Table serve as the basis for            mortality assumptions.

 

Liabilities for future policy benefits of immediate annuities and            supplementary contracts with life contingencies are also computed by a net level            premium method, based upon estimates at the time of issue for investment yields and            mortality.

 

Liabilities for future policy benefits of accident and health insurance            represent estimates of payments to be made on reported insurance claims, as well as            claims incurred but not yet reported. These liabilities are estimated using actuarial            analyses and case basis evaluations that are based upon past claims experience, claim            trends and industry experience.

 

 

 

 

**-51-** 

 

**KANSAS CITY LIFE INSURANCE            COMPANY**

**                                             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)**

 

The following table provides detail about future policy            benefits at December 31.

 

|   |                          |                    |                         | 2007   |    | 2006          |
|--------|-------------------------------|-------------------------|------------------------------|--------|---------|---------------|
|   |                          |                    |                         |   |    |          |   |   |
|   | Life insurance                | $                       | 623,079                      |   | $       | 625,359       |
|   | Immediate annuities and       |                    |                         |   |    |          |
|   |                          | supplementary contracts |                         |   |    |          |   |
|   |                          |                    | with life contingencies      |   | 186,268 |          |   | 186,782 |
|   |                          |                    | Total                        |   | 809,347 |          |   | 812,141 |
|   |                          |                    |                         |   |    |          |   |   |
|   | Accident and health insurance |                    |  41,930                 |   |    |   40,961 |
|   |                          |                    |                         |   |    |          |   |   |
|   |                          |                    | Total future policy benefits | $      | 851,277 |          | $ | 853,102 |
|   |                          |                    |                         |   |    |          |   |   |

**Policyholder Account Balances**

Liabilities for universal life and fixed deferred annuity products are            included in policyholder account balances, without reduction for potential surrender            charges and deferred front-end contract charges. Front-end contract charges are            amortized over the term of the policies. Policyholder benefits incurred in excess of            related policyholder account balances are charged to policyholder benefits expense.            Interest on policyholder account balances is credited as earned.

 

Crediting rates for universal life insurance and fixed deferred annuity            products ranged from 3.00% to 5.50% (2006 – 3.00% to 5.75%; 2005 – 3.00% to            5.75%).

 

The            following table provides detail about policyholder account balances at December            31.

 

|   |                     |                          | 2007                            |      | 2006   |
|--------|--------------------------|-------------------------------|---------------------------------|-----------|--------|
|   |                     |                          |                            |      |   |   |   |
|   | Universal life insurance | $                             | 1,033,693                       |      | $      | 1,054,911 |
|   | Fixed deferred annuities |                          |    987,014            |      |   | 1,068,286 |
|   | Other                    |                          |      67,258 |      |   |      67,908 |
|   |                     |                          |                            |      |   |   |   |
|   |                     | Policyholder account balances | $                               | 2,087,965 |   | $ | 2,191,105 |
|   |                     |                          |                            |      |   |   |   |

 

**Income Taxes**

Deferred income taxes are recorded on the differences between the tax            bases of assets and liabilities and the amounts at which they are reported in the            consolidated financial statements. Recorded amounts are adjusted to reflect changes in            income tax rates and other tax law provisions as they become enacted. The Company and            its subsidiaries file a consolidated federal income tax return that includes both life            insurance companies and non-life insurance companies.

 

Deferred income tax assets are subject to ongoing evaluation of whether            such assets will be realized. The ultimate realization of deferred income tax assets            depends on generating future taxable income during the periods in which temporary            differences become deductible. If future taxable income is not expected, a valuation            allowance against deferred income tax assets may be required.

 

**-52-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

**Participating Policies**

The            Company has some insurance contracts where the policyholder is entitled to share in the            entity’s earnings through dividends that reflect the difference between the            premium charged and the actual experience. Participating business at year-end 2007            approximated 5% of statutory premiums and 6% of the life insurance in force. The amount            of dividends to be paid is determined annually by the Board of Directors. Provision has            been made in the liability for future policy benefits to allocate amounts to            participating policyholders on the basis of dividend scales contemplated at the time            the policies were issued. Additional provisions have been made for policyholder            dividends in excess of the original scale, which have been declared by the Board of            Directors.

 

**Reinsurance**

In            the normal course of business, the Company cedes risks to other insurers, primarily to            protect the Company against adverse fluctuations in mortality experience. Reinsurance            is effected on individual risks and through various quota share arrangements. Business            is reinsured primarily through yearly renewable term and coinsurance agreements. Under            yearly renewable term insurance, the Company pays annual premiums and the reinsurer            reimburses claims paid related to this coverage. Under coinsurance, the reinsurer            receives a proportionate share of the premiums less applicable commissions and is            liable for a corresponding share of policy benefits. The Company remains contingently            liable if the reinsurer should be unable to meet obligations assumed under the            reinsurance contract. The Company also assumes risks ceded by other            companies.

 

Reinsurance receivables include amounts related to paid benefits and            estimated amounts related to unpaid policy and contract claims, future policy benefits            and policyholder account balances. The cost of reinsurance is accounted for over the            terms of the underlying reinsured policies using assumptions consistent with those used            to account for the policies.

 

**Income Per Share**

Due            to the Company's capital structure and the absence of other potentially dilutive            securities, there is no difference between basic and diluted earnings per common share            for any of the years or periods reported. The weighted average number of shares            outstanding during the year was 11,836,213 shares (2006 – 11,883,830 shares; 2005            – 11,923,831 shares). The number of shares outstanding at year-end was 11,765,037            (2006 – 11,855,497).

 

**Comprehensive Income**

Comprehensive income is comprised of net income and other comprehensive            income (loss). Other comprehensive income (loss) includes the unrealized investment            gains or losses on securities available for sale (net of reclassification adjustments            for realized investment gains or losses) net of adjustments to DAC, VOBA and            policyholder account balances. In addition, other comprehensive income (loss) includes            the change in the additional minimum pension liability, and the adjustment to adopt            SFAS 158 – described below under New Accounting Pronouncements. The adjustment to            adopt SFAS 158 consisted of pension and postretirement net losses and prior service            costs. Other comprehensive income (loss) also includes deferred income taxes on these            items.

 

**New            Accounting Pronouncements**

In            December 2004, the Financial Accounting Standards Board (FASB) issued Statement of            Financial Accounting Standards No. 123 (revised 2004) "Share-Based Payment"            (“SFAS 123R”). This statement requires recognition in the financial            statements of the fair-value-based measurement method of stock-based compensation            issued to employees. SFAS 123R became effective January 1, 2006. Historically the            Company had expensed all stock-based compensation using a fair-value-based measurement            method. The Company adopted this standard on January 1, 2006 with no material impact to            the consolidated financial statements. See Note 8 – Share-Based Payment in the            Notes to Consolidated Financial Statements.

 

In            May 2005, the FASB issued Statement of Financial Accounting Standards No. 154            “Accounting Changes and Error Corrections” (“SFAS 154”). The            Statement replaces APB Opinion No. 20 and SFAS 3. SFAS 154 requires retrospective            application to prior periods’ financial statements of changes in accounting            principle. However, if it is impracticable to determine the effects of such changes,            then other rules apply. SFAS 154 became effective January 1, 2006. The Company adopted            this standard on January 1, 2006. SFAS 154 had no immediate impact on the            Company’sconsolidated financial statements, though it will            impact the presentation of future voluntary accounting changes, should such changes            occur.

 

In            September 2005, the Accounting Standards Executive Committee of the American Institute            of Certified Public Accountants (AcSEC) issued Statement of Position 05-1 (SOP            05-1),*“Accounting by Insurance Enterprises            for*

 

**-53-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

*Deferred Acquisition Costs in Connection with Modifications or            Exchanges of Insurance Contracts”.*SOP 05-1 provides            guidance on accounting by insurance enterprises for deferred acquisition costs on            internal replacements of insurance contracts other than those specifically described in            Statement of Financial Accounting Standards (SFAS) No. 97,*“Accounting and Reporting by Insurance Enterprises for Certain            Long-Duration Contracts and for Realized Gains and Losses from the Sale of            Investments”.*SOP 05-1 defines an internal replacement            as a modification in product benefits, features, rights, or coverages that occurs by            exchange of a contract for a new contract, or by amendment, endorsement, or rider to a            contract, or by the election of a feature or coverage within a contract. SOP 05-1            became effective for internal replacements occurring in fiscal years beginning after            December 31, 2006. Retrospective application of SOP 05-1 to previously issued            consolidated financial statements is not permitted. The Company adopted SOP 05-1 on            January 1, 2007 with no material impact to the consolidated financial            statements.

 

In            June 2006, the FASB issued Interpretation 48 “Accounting for Uncertainty in            Income Taxes” (FIN 48). FIN 48 applies to all uncertain tax positions accounted            for under SFAS 109 “Accounting for Income Taxes”. FIN 48 addresses whether            tax positions taken or to be taken on tax returns should be reflected in the financial            statements before they are resolved with the appropriate taxing authority. Previous            statements provided no specific guidance related to such positions. FIN 48 was adopted            on January 1, 2007, with no material impact to the consolidated financial            statements.

 

In            August 2006, the Securities and Exchange Commission (SEC) adopted SEC Release No.            33-8732A, “Executive Compensation and Related Person Disclosure” which            amends the disclosure requirements for executive and director compensation, related            person transactions, director independence and other corporate governance matters and            security ownership of officers and directors. The release expands the currently            required tabular disclosures and adds a narrative Compensation Discussion &            Analysis (CD&A) which must describe the Company’s compensation policies and            decisions. The amendments in the release apply to disclosures included in proxy and            information statements, periodic and current reports, as well as other filings under            the Securities Exchange Act of 1934 and to registration statements under the Exchange            Act and the Securities Act of 1933. For financial statement purposes, this release is            effective for years ending on or after December 15, 2006. The Company has adopted this            release and includes the required disclosures in the appropriate filings.

 

In            September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for            Defined Benefit Pension and Other Postretirement Plans” (SFAS 158). SFAS 158            requires calendar year-end companies with publicly traded equity securities that            sponsor postretirement benefit plans to fully recognize, as an asset or liability, the            funded status of the benefit plans as of December 31, 2006. The funded status is to be            measured as the difference between the fair value of the plan assets and the projected            benefit obligation at year-end. The Company adopted this statement as of December 31,            2006. See Note 7 – Pensions and Other Postretirement Benefits in the Notes to            Consolidated Financial Statements.

 

In            September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”            (SFAS 157). SFAS 157 provides a single definition of fair value, together with a            framework for measuring it, and requires additional disclosure about the use of fair            value to measure assets and liabilities. SFAS 157 also emphasizes that fair value is a            market-based measurement, not an entity-specific measurement, and established a fair            value hierarchy with the highest priority being the quoted price in active markets.            This statement became effective for years beginning after November 15, 2007. The            Company adopted SFAS 157 on January 1, 2008 with no material impact to the consolidated            financial statements.

 

In            February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial            Assets and Financial Liabilities – including an amendment of SFAS No. 115.”            SFAS 159 permits an entity to measure certain financial assets and liabilities at fair            value. Under SFAS 159, entities that elect the fair value option will report unrealized            gains and losses in earnings at each subsequent reporting date. The fair value option            may be elected on an instrument-by-instrument basis, with a few exceptions, as long as            it is applied to the instrument in its entirety. Once adopted, the fair value option            election is irrevocable, unless a new election date occurs. This statement became            effective for years beginning after November 15, 2007. The Company adopted SFAS 159 on            January 1, 2008 with no material impact to the consolidated financial            statements.

 

All            other Standards and Interpretations of those Standards issued during 2007 did not            relate to accounting policies and procedures pertinent to the Company at this            time.

 

 

 

**-54-** 

***2. INVESTMENTS***

 

**Investment Revenues**

The            following tables provide investment revenues by major category for the years ended            December 31. Realized gains and losses on the sale of investments are determined on the            basis of specific security identification.

 

|                                    |                      |     | 2007                                     |    | 2006     |                               | 2005        |
|-----------------------------------------|---------------------------|----------|------------------------------------------|---------|----------|------------------------------------|-------------|
| **Net investment income:**              |                      |     |                                     |    |     |                               |        |   |
|                                    | Fixed maturity securities | $        | 149,951                                  |    | $        | 153,885                            |        | $ | 155,726 |
|                                    | Equity securities         |     |     4,159                 |    |     |     4,644           |        |   |     3,699 |
|                                    | Mortgage loans            |     |   31,292                            |    |     |   31,774                      |        |   |   32,923 |
|                                    | Real estate               |     |     5,909                 |    |     |     7,494           |        |   |     7,900 |
|                                    | Policy loans              |     |     6,230                 |    |     |     6,713           |        |   |     7,174 |
|                                    | Short-term                |     |     3,716                 |    |     |     1,863           |        |   |     1,544 |
|                                    | Other                     |     |        775 |    |     |       980 |        |   |        667 |
|                                    |                      |     |                                     | 202,032 |     |                               | 207,353     |   |   | 209,633 |
| Less investment expenses                |                      | (11,627) |                                     |    | (11,073) |                               |        | (15,025) |
|                                    |                      |     |                                     |    |     |                               |        |   |   |   |
|                                    |                      |     | $                                        | 190,405 |     | $                                  | 196,280     |   | $ | 194,608 |
|                                    |                      |     |                                     |    |     |                               |        |   |   |   |
| **Realized investment gains (losses):** |                      |     |                                     |    |     |
|                                    | Fixed maturity securities | $        | (3,295)                                  |    | $        | 2,280                              |        | $ | (1,576) |
|                                    | Equity securities         |     |   1,645                             |    |     |  (464)                        |        |   |      (37) |
|                                    | Mortgage loans            |     | -                                        |    |     |  (100)                        |        |   |      890 |
|                                    | Real estate               |     |   7,118                             |    |     | 4,159                              |        |   |   6,751 |
|                                    | Other                     |     |       (42)      |    |     |   (254)                       |        |   |        85 |
|                                    |                      |     |                                     |    |     |                               |        |   |   |   |
|                                    |                      |     | $                                        | 5,426   |     | $                                  |  5,621 |   | $ |  6,113 |
|                                    |                      |     |                                     |    |     |                               |        |   |   |   |

 

 

**-55-** 

 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

**Unrealized Gains and Losses**

The            following table provides unrealized gains (losses) on the Company’s investments            in securities, at December 31.

 

|                    |                   |                          |                      | 2007               |         | 2006         |         | 2005                                    |
|-------------------------|------------------------|-------------------------------|---------------------------|--------------------|--------------|--------------|--------------|-----------------------------------------|
| **Available for sale:** |                   |                          |                      |               |         |         |         |                                    |
|                    | End of year            | $                             | 13,208                    |               | $            | 2,650        |         | $                                       | 35,182 |
|                    | Amounts allocable to:  |                          |                      |               |         |         |         |                                    |   |
|                    |                   | DAC and VOBA                  |                      |    (898) |         |         |   (296) |                                    |   | (3,203) |
|                    |                   | Policyholder account balances |                      |    (548) |         |         |   (433) |                                    |   | (5,036) |
|                    | Deferred income taxes  |                          | (4,117)                   |               |         |   (672) |         |                                    | (9,454) |
|                    |                   |                          |                      |               |         |         |         |                                    |   |   |   |
|                    |                   |                          |                      | $                  |  7,645  |         | $            |  1,249                             |   | $ | 17,489 |
|                    |                   |                          |                      |               |         |         |         |                                    |   |   |   |
|                    | Increase (decrease) in |                          |                      |               |         |         |         |                                    |   |
|                    |                   | net unrealized gains          |                      |               |         |         |         |                                    |   |   |
|                    |                   | during the year:              |                      |               |         |         |         |                                    |   |   |
|                    |                   |                          | Fixed maturity securities | $                  | 6,958        |         | $            | (17,008)                                |   | $ | (34,280) |
|                    |                   |                          | Equity securities         |               |   (562) |         |         |       768 |   |   |      (353) |
|                    |                   |                          |                      |               |         |         |         |                                    |   |   |   |
|                    |                   |                          |                      | $                  | 6,396        |         | $            | (16,240)                                |   | $ | (34,633) |
|                    |                   |                          |                      |               |         |         |         |                                    |   |   |   |

 

**Analysis of Unrealized Losses on Securities**

The            Company has a policy and process in place to identify securities that could potentially            have an impairment that is other-than-temporary. This process involves monitoring            market events that could impact issuers’ credit ratings, business climate,            management changes, litigation and government actions, and other similar factors. This            process also involves monitoring late payments, downgrades by rating agencies, key            financial ratios, financial statements, revenue forecasts and cash flow projections as            indicators of credit issues.

 

At            the end of each quarter, all securities are reviewed to determine whether impairments            should be recorded. This quarterly process includes an assessment of the credit quality            of each investment in the entire securities portfolio. Additional reporting and review            procedures are conducted for those securities where fair value is less than 90% of            amortized cost. Further, detailed analysis is performed for each issue or issues having            experienced a formal restructuring or where the security has experienced material            deterioration in fair value.

 

The            Company considers relevant facts and circumstances in evaluating whether the impairment            of a security is other-than-temporary. Relevant facts and circumstances considered            include (1) the current fair value of the security as compared to cost, (2) the length            of time the fair value has been below cost, (3) the financial position of the issuer,            including the current and future impact of any specific events, and (4) the            Company’s ability and intent to hold the security to maturity or until it            recovers in value. To the extent the Company determines that a security is deemed to be            other than temporarily impaired, the difference between amortized cost and fair value            would be charged to income as a realized investment loss, resulting in a permanent            reduction to the cost basis of the underlying investment.

 

There are a number of significant risks and uncertainties inherent in            the process of monitoring impairments and determining if an impairment is            other-than-temporary. These risks and uncertainties include (1) the risk that the            Company’s assessment of an issuer’s ability to meet all of its contractual            obligations will change based on changes in the

 

**-56-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

credit characteristics of that issuer, (2) the risk that the economic            outlook will be worse than expected or have more of an impact on the issuer than            anticipated, (3) the risk that fraudulent information could be provided to the            Company’s investment professionals who determine the fair value estimates, and            (4) the risk that new information obtained by the Company or changes in other facts and            circumstances lead the Company to change its intent to hold the security to maturity or            until it recovers in value. Any of these situations could result in a charge to income            in a future period.

 

The            Company’s analysis of fixed maturity securities at year-end 2007 resulted in the            determination that two securities had other-than-temporary declines which were written            down by $4.0 million.  One of the two securities was below cost by 20% or more for            more than six consecutive months and was the subject of a recent leveraged buyout, that            was finalized during the fourth quearter of 2007, which greatlyincreased the debt level of the company.  The leveraged buyout plan            is highly dependent upon the timely sale of certain assets at what are perceived to be            aggressive rates.  In addition, this company is involved in several declining            industries that are highly dependent on general economic activity.  Accordingly,            the Company wrote down this security $3.3 million at year-end 2007.  The second            security filed for Chapter 11 protection and indicated that it would not be able to            fully meet all of its borrowings.  The Company recognized an other-than-temporary            impairment on this security at year-end 2006 of $1.1 million.  As a result of this            new action, the Company recognized an additional $0.7 million impairment in 2007.             At December 31, 2006, this security was below cost by 20% or more for more than twelve            consecutive months.   It was in a highly competitive and cyclical industry            that was experiencing weakened demand and overcapacity.  Capital expenditures for            equipment upgrades were exceeding cash generation.  In 2005, the Company had no            securities that it identified as other-than-temporarily impaired.  At year-end            2005, there were no investment securities that were below cost by 20% or more for more            than six consecutive months

 

The            following table provides information regarding unrealized losses on investments            available for sale, as of December 31, 2007.

 

|                        |                         |                           | Investments with unrealized losses |
|-----------------------------|------------------------------|--------------------------------|------------------------------------|
|                        |                         |                           |                               | Less than 12 months |   |   | 12 months or longer |   |   | Total |   |
|                        |                         |                           |                               | Fair |   |   | Unrealized |   |   | Fair |   |   | Unrealized |   |   | Fair |   |   | Unrealized |   |
| Bonds:                      |                         | Value                          |                               |   | Losses |   |   | Value |   |   | Losses |   |   | Value |   |   | Losses |   |
|                        | U.S. Treasury securities and |                           |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | obligations of U.S. Government | $                                  |      100 |   | $ | - |   | $ |   19,487 |   | $ | 409 |   | $ |     19,587 |   | $ | 409 |   |
|                        | Federal agencies1            |                           | -                                  |   |   | - |   |   |   12,190 |   |   | 113 |   |   |     12,190 |   |   | 113 |   |
|                        | Federal agency issued        |                           |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | mortgage-backed securities1    |                               |   12,404 |   |   | 125 |   |   | 154,035 |   |   | 2,852 |   |   |   166,439 |   |   | 2,977 |   |
|                        | Corporate obligations        |                           | 255,243                            |   |   | 7,712 |   |   | 461,961 |   |   | 22,688 |   |   |   717,204 |   |   | 30,400 |   |
|                        | Corporate private-labeled    |                           |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | mortgage-backed securities     |                               |   96,276 |   |   | 1,715 |   |   | 101,526 |   |   | 3,195 |   |   |   197,802 |   |   | 4,910 |   |
|                        | Other                        |                           |   60,656                      |   |   | 4,228 |   |   |   84,804 |   |   | 2,008 |   |   |   145,460 |   |   | 6,236 |   |
| Redeemable preferred stocks |                         |     4,927       |                               |   | 124 |   |   | - |   |   | - |   |   |       4,927 |   |   | 124 |   |
| Fixed maturity securities   |                         | 429,606                        |                               |   | 13,904 |   |   | 834,003 |   |   | 31,265 |   |   | 1,263,609 |   |   | 45,169 |   |
| Equity securities           |                         |     4,576       |                               |   | 688 |   |   |     5,800 |   |   | 1,157 |   |   |      10,376 |   |   | 1,845 |   |
|                        |                         | Total                          | $                                  | 434,182 |   | $ | 14,592 |   | $ | 839,803 |   | $ | 32,422 |   | $ | 1,273,985 |   | $ | 47,014 |   |
|                        |                         |                           |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

 

**-57-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

The            following table provides information regarding unrealized losses on investments            available for sale, as of December 31, 2006.

 

|                        |                         |                                     | Investments with unrealized losses |
|-----------------------------|------------------------------|------------------------------------------|------------------------------------|
|                        |                         |                                     |                               | Less than 12 months |   |   | 12 months or longer |   |   | Total |   |
|                        |                         |                                     |                               | Fair |   |   | Unrealized |   |   | Fair |   |   | Unrealized |   |   | Fair |   |   | Unrealized |   |
| Bonds:                      |                         | Value                                    |                               |   | Losses |   |   | Value |   |   | Losses |   |   | Value |   |   | Losses |   |
|                        | U.S. Treasury securities and |                                     |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | obligations of U.S. Government           | $                                  |   12,636 |   | $ | 41 |   | $ |      32,340 |   | $ | 873 |   | $ |      44,976 |   | $ | 914 |   |
|                        | Federal agencies1            |                                     |     9,970                |   |   | 61 |   |   |      98,677 |   |   | 1,844 |   |   |    108,647 |   |   | 1,905 |   |
|                        | Federal agency issued        |                                     |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | mortgage-backed securities1              |                               |   25,326 |   |   | 92 |   |   |    216,083 |   |   | 5,514 |   |   |    241,409 |   |   | 5,606 |   |
|                        | Corporate obligations        |                                     | 209,000                            |   |   | 3,015 |   |   |    686,507 |   |   | 29,602 |   |   |    895,507 |   |   | 32,617 |   |
|                        | Corporate private-labeled    |                                     |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |                         | mortgage-backed securities               |                               |   61,511 |   |   | 1,148 |   |   |      97,879 |   |   | 2,315 |   |   |    159,390 |   |   | 3,463 |   |
|                        | Other                        |                                     |   32,225                      |   |   | 289 |   |   |    111,701 |   |   | 2,577 |   |   |    143,926 |   |   | 2,866 |   |
| Redeemable preferred stocks |                         |        520 |                               |   | 10 |   |   | - |   |   | - |   |   |                                      520 |   |   | 10 |   |
| Fixed maturity securities   |                         | 351,188                                  |                               |   | 4,656 |   |   | 1,243,187 |   |   | 42,725 |   |   | 1,594,375 |   |   | 47,381 |   |
| Equity securities           |                         |     4,636                 |                               |   | 3 |   |   |        9,141 |   |   | 634 |   |   |       13,777 |   |   | 637 |   |
|                        |                         | Total                                    | $                                  | 355,824 |   | $ | 4,659 |   | $ | 1,252,328 |   | $ | 43,359 |   | $ | 1,608,152 |   | $ | 48,018 |   |
|                        |                         |                                     |                               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

_________

1 Federal agency securities are not backed by the full faith            and credit of the U.S. Government.

 

Securities with unrealized losses for less than twelve consecutive            months included 132 issues with a carrying value of $434,182 and unrealized losses of            $14,592. Of this portfolio, 93.5% were investment grade (rated AAA through BBB-) at            December 31, 2007, with associated unrealized losses of $12,134. The unrealized losses            on these securities were primarily due to changes in market interest rates and credit            spreads since the securities were acquired.

 

Securities with unrealized losses for twelve consecutive months or            longer included 326 issues with a carrying value of $839,803 and unrealized losses of            $32,422. Of this portfolio, 94.5% were investment grade at December 31, 2007, with            associated unrealized losses of $26,669. The unrealized losses on these securities were            primarily due to changes in market interest rates and credit spreads since the            securities were acquired.

 

Fixed maturities with a fair value to amortized cost ratio less than 80%            for six consecutive months or longer are considered potentially distressed securities            and are subject to rigorous ongoing review. As of December 31, 2007, there were six            issues with a fair value to amortized cost ratio of less than 80% for less than six            months. These securities had a carrying value of $13,935 and unrealized losses of            $5,350. Additionally, the Company has a perpetual preferred security in this category            with a carrying value of $764 and unrealized loss of $270. Based on the Company’s            ability and intent to hold the investments for a reasonable period of time sufficient            for recovery of fair value, the Company does not consider these investments to be            other-than-temporarily impaired at December 31, 2007.

 

The            table below summarizes the fixed maturity securities with unrealized losses as of            December 31, 2007.

 

| Fair Value to  |   |      |                            |   |   |                            |   |   |              |   |   |
|----------------|--------|-----------|---------------------------------|--------|--------|---------------------------------|--------|--------|-------------------|--------|--------|
| Amortized Cost |   | Amortized |                            | Fair   |   | Unrealized                      |   |   |
| Ratio          |   | Cost      |                            | Value  |   | Losses                          |   | %      |
| 90%-99%        |   | $         | 1,221,745                       |   | $      | 1,191,230                       |   | $      | 30,515            |   | 67%    |
| 80%-89%        |   |      |      67,748 |   |   |      58,444 |   |   |   9,304 |   | 21%    |
| Below 80%      |   |      |      19,285 |   |   |      13,935 |   |   |   5,350      |   | 12%    |
| Total          |   | $         | 1,308,778                       |   | $      | 1,263,609                       |   | $      | 45,169            |   | 100%   |
|           |   |      |                            |   |   |                            |   |   |              |   |   |

 

 

**-58-** 

**                                                                   KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

**Summary of Cost and Fair Value Information for            Securities**

The            following table provides amortized cost and fair value securities at December 31,            2007.

 

|                        |                                                                                     |                                       |                            |      |         | Gross                        |   |                         |                         |
|-----------------------------|------------------------------------------------------------------------------------------|--------------------------------------------|---------------------------------|-----------|--------------|------------------------------|--------|------------------------------|------------------------------|
|                        |                                                                                     |                                       |                            | Amortized |         | Unrealized                   |   |                         | Fair                         |
|                        |                                                                                     |                                       |                            | Cost      |         |                         | Gains  |                         |                         | Losses |   |   | Value |
| Bonds:                      |                                                                                     |                                       |                            |      |         |                         |   |                         |                         |   |   |
|                        | U.S. Treasury securities & obligations of U.S.                            Government | $                                          |      71,211 |      | $            |   1,638                 |   | $                            |      409 |   | $ |     72,440 |
|                        | Federal agencies1                                                                        |                                       |    103,057       |      |         |   2,527                 |   |                         |      113 |   |   |    105,471 |
|                        | Federal agency issued mortgage-backed securities1                                        |                                       |    230,771            |      |         |   1,047                 |   |                         |   2,977            |   |   |    228,841 |
|                        | Corporate obligations                                                                    |                                       | 1,771,376                       |      |         | 50,170                       |   |                         | 30,400                       |   |   | 1,791,146 |
|                        | Corporate private-labeled mortgage-backed                            securities          |                                       |    250,525            |      |         |      590 |   |                         |   4,910            |   |   |    246,205 |
|                        | Other                                                                                    |                                       |    187,118            |      |         |   1,161                 |   |                         |   6,236                 |   |   |    182,043 |
| Redeemable preferred stocks |                                                                                     |        5,051 |                            |      | -            |                         |   |      124 |                         |   |        4,927 |
| Fixed maturity securities   |                                                                                     | 2,619,109                                  |                            |      | 57,133       |                         |   | 45,169                       |                         |   | 2,631,073 |
| Equity securities           |                                                                                     |      57,906            |                            |      |   3,088 |                         |   |   1,845                 |                         |   |      59,149 |
|                        |                                                                                     | Total                                      | $                               | 2,677,015 |         | $                            | 60,221 |                         | $                            | 47,014 |   | $ | 2,690,222 |
|                        |                                                                                     |                                       |                            |      |         |                         |   |                         |                         |   |   |   |   |

 

 

The            following table provides amortized cost and fair value of securities at December 31,            2006.

 

|                        |                                                                                 |                            |                            |      |                         | Gross                        |   |                                    |                         |
|-----------------------------|--------------------------------------------------------------------------------------|---------------------------------|---------------------------------|-----------|------------------------------|------------------------------|--------|-----------------------------------------|------------------------------|
|                        |                                                                                 |                            |                            | Amortized |                         | Unrealized                   |   |                                    | Fair                         |
|                        |                                                                                 |                            |                            | Cost      |                         |                         | Gains  |                                    |                         | Losses |   |   | Value |
| Bonds:                      |                                                                                 |                            |                            |      |                         |                         |   |                                    |                         |   |   |
|                        | U.S. Treasury securities & obligations of U.S.                        Government | $                               |      82,957 |      | $                            |   1,025                 |   | $                                       |      914 |   | $ |     83,068 |
|                        | Federal agencies1                                                                    |                            |    154,062            |      |                         |      425 |   |                                    |   1,905                 |   |   |    152,582 |
|                        | Federal agency issued mortgage-backed securities1                                    |                            |    278,919            |      |                         |      696 |   |                                    |   5,606                 |   |   |    274,009 |
|                        | Corporate obligations                                                                |                            | 1,784,393                       |      |                         | 43,974                       |   |                                    | 32,617                       |   |   | 1,795,750 |
|                        | Corporate private-labeled mortgage-backed                        securities          |                            |    211,909            |      |                         |      533 |   |                                    |   3,463                 |   |   |    208,979 |
|                        | Other                                                                                |                            |    196,222            |      |                         |      788      |   |                                    |   2,866                 |   |   |    194,144 |
| Redeemable preferred stocks |                                                                                 |      10,498 |                            |      |      419 |                         |   |        10 |                         |   |      10,907 |
| Fixed maturity securities   |                                                                                 | 2,718,960                       |                            |      | 47,860                       |                         |   | 47,381                                  |                         |   | 2,719,439 |
| Equity securities           |                                                                                 |      50,180 |                            |      |   2,808                 |                         |   |      637            |                         |   |      52,351 |
|                             | $                                                                                    |   2,769,140           |                                 | $         |   50,668                |                              | $      |    48,018                     |                              | $ |   2,771,790 |

 

The            Company held non-income producing securities with a carrying value of $483 at December            31, 2007 (2006 - 0).

 

_________

1 Federal agency securities are not backed by the full faith            and credit of the U.S. Government.

 

**-59-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

The            table below provides sales of investment securities available for sale, excluding            maturities and calls, for the year ended December 31. Realized gains and losses on the            sale of investments are determined on the basis of specific security            identification.

 

|                  | 2007   |                               | 2006   |   | 2005        |
|-----------------------|--------|------------------------------------|--------|--------|-------------|
|                  |   |                               |   |   |        |   |   |   |
| Proceeds              | $      | 209,605                            |   | $      | 99,795      |   | $ | 181,613 |
| Gross realized gains  |   |       964 |   |   |  3,550 |   |   |     3,991 |
| Gross realized losses |   |    1,240                 |   |   |  1,151 |   |   |     6,009 |

 

 

The            Company did not hold securities of any corporation and its affiliates that exceeded 10%            of stockholders' equity.

 

No            derivative financial instruments were or are currently employed.

 

The            Company is exposed to risk that issuers of securities owned by the Company will default            or that interest rates or credit spreads will change and cause a decrease in the value            of its investments. With mortgage-backed securities, the Company is also exposed to            prepayment and extension risks. As interest rates change, the rate at which these            securities pay down principal may change. These risks are mitigated by investing in            high-grade securities and managing the maturities and cash flows of investments and            liabilities.

 

Subprime securities include all bonds or portion of bonds where the            underlying collateral is made up of home equity loans or first mortgage loans to            borrowers whose credit scores at the time of origination were lower than the level            recognized in the market at prime. The Company’s classification of subprime does            not include Alt-A or jumbo loans, unless the collateral otherwise meets the preceding            definition. At December 31, 2007, the Company had investments with subprime residential            mortgage exposure of $39.1 million and a related $1.8 million unrealized loss.             This exposure amounted to 1% of the Company’s invested assets.

 

**Contractual Maturities**

The            following table provides the distribution of maturities for fixed maturity investment            securities available for sale as of December 31, 2007. Expected maturities may differ            from these contractual maturities since borrowers may have the right to call or prepay            obligations.

 

|                                   |   | Amortized                  |   |   | Fair                            |
|----------------------------------------|--------|----------------------------|--------|--------|---------------------------------|
|                                   |   | Cost                       |   |   | Value                           |
|                                   |   |                       |   |   |                            |
| Due in one year or less                | $      |      93,590 |   | $      |      93,948 |
| Due after one year through five years  |   |    582,316       |   |   |    583,958            |
| Due after five years through ten years |   |    742,514       |   |   |    745,325            |
| Due after ten years                    |   |    648,826       |   |   |    661,880            |
| Mortgage-backed securities             |   |    551,863       |   |   |    545,962            |
|                                   |   |                       |   |   |                            |
|                                   | $      | 2,619,109                  |   | $      | 2,631,073                       |
|                                   |   |                       |   |   |                            |

 

 

 

 

**-60-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

**Mortgage Loans**

Most            of the Company’s mortgage loans are secured by commercial real estate and are            carried net of a valuation reserve of $3,410 (2006 – $3,600). The valuation            reserve for mortgage loans is maintained at a level believed adequate by management to            absorb estimated credit losses. Management’s periodic evaluation and assessment            of the adequacy of the valuation reserve is based on known and inherent risks in the            portfolio, historical and industry data, current economic conditions and other relevant            factors. No mortgage loans were foreclosed upon and transferred to real estate            investments during the past two years. Also, there was one delinquent mortgage loan at            December 31, 2007 (2006 – none). The Company does not hold mortgage loans of any            borrower that exceeds 5% of stockholders’ equity.

 

The            following table provides geographic and property type diversification of the mortgage            portfolio at December 31.

 

|                   |               | 2007   |                     | 2006   |
|------------------------|--------------------|--------|--------------------------|--------|
|                   |               |   | Carrying                 |   |   | Fair |   |   | Carrying |   |   | Fair |
|                   |               |   | Amount                   |   |   | Value |   |   | Amount |   |   | Value |
| **Geographic region:** |               |   |                     |   |   |   |   |   |   |   |   |
|                   | East north central | $      |    18,913      |   | $ |   19,612 |   | $ |   22,962 |   | $ |   23,344 |
|                   | Mountain           |   |    60,497      |   |   |   62,336 |   |   |   68,203 |   |   |   68,041 |
|                   | Pacific            |   |  118,377            |   |   | 121,656 |   |   | 132,265 |   |   | 132,252 |
|                   | West south central |   |    97,355      |   |   | 100,617 |   |   |   95,641 |   |   |   96,211 |
|                   | West north central |   |  106,183            |   |   | 109,421 |   |   | 112,827 |   |   | 111,486 |
|                   | Other              |   |    52,233      |   |   |   53,979 |   |   |   43,721 |   |   |   43,946 |
|                   | Valuation reserve  |   |    (3,410)     |   |   |    (3,410) |   |   |   (3,600) |   |   |   (3,600) |
|                   |               | $      | 450,148                  |   | $ | 464,211 |   | $ | 472,019 |   | $ | 471,680 |
| **Property type:**     |               |   |                     |   |   |   |   |   |   |   |   |
|                   | Industrial         | $      | 265,981                  |   | $ | 274,062 |   | $ | 264,662 |   | $ | 265,522 |
|                   | Retail             |   | -                        |   |   | - |   |   |        211 |   |   |        211 |
|                   | Office             |   | 184,753                  |   |   | 190,687 |   |   | 191,030 |   |   | 189,827 |
|                   | Other              |   |     2,824 |   |   |     2,872 |   |   |   19,716 |   |   |   19,720 |
|                   | Valuation reserve  |   |    (3,410)     |   |   |    (3,410) |   |   |   (3,600) |   |   |   (3,600) |
|                   |               | $      | 450,148                  |   | $ | 464,211 |   | $ | 472,019 |   | $ | 471,680 |
|                   |               |   |                     |   |   |   |   |   |   |   |   |   |

 

The            Company had commitments to originate mortgage loans of $1.7 million at December 31,            2007. These commitments expire in 2008.

 

 

 

**-61-** 

****KANSAS CITY LIFE INSURANCE            COMPANY****

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

**Real            Estate**

The table below provides information concerning the Company's real            estate investments as of December 31.

 

|      |                          |                        | 2007     |          | 2006          |
|-----------|-------------------------------|-----------------------------|----------|---------------|---------------|
| Land      | $                             |   16,232               |     | $             |   16,469 |
| Buildings |                          |   39,645               |     |          |   53,637 |
|      | Less accumulated depreciation |                        | (22,626) |          |          | (24,105) |
|      |                          | Real estate, commercial     |     |   33,251 |          |   |   46,001 |
|      |                          | Real estate, joint ventures |     |   62,798 |          |   |   63,524 |
|      |                          |                        | $        |   96,049 |          | $ | 109,525 |
|      |                          |                        |     |          |          |   |   |

 

 

Investment real estate, other than foreclosed properties, is depreciated            on a straight-line basis over periods ranging from 10 to 60 years.

 

The            Company had non-income producing real estate of $13,095, consisting of properties under            development at December 31, 2007 (2006 – $17,386).

 

The            Company had commitments to purchase real estate investments of $6.3 million at December            31, 2007. These commitments expire in 2008.

 

***3. UNPAID ACCIDENT and HEALTH CLAIMS LIABILITY***

 

The            liability for unpaid accident and health claims is included with "Policy and contract            claims" on the Consolidated Balance Sheets. Claim adjustment expenditures are expensed            as incurred and were not material in any year presented. Activity in the liability            follows.

 

|                               |              | 2007         |                         | 2006   |         | 2005                         |
|------------------------------------|-------------------|--------------|------------------------------|--------|--------------|------------------------------|
| Gross liability at                 |              |         |                         |   |         |                         |   |   |
|                               | beginning of year | $            |   7,391                 |   | $            |  6,986                  |   | $ |   8,605 |
| Less reinsurance recoverable       |              | (3,829)      |                         |   | (3,999)      |                         |   | (4,207) |
| Net liability at beginning of year |              |   3,562 |                         |   |  2,987  |                         |   |   4,398 |
|                               |              |         |                         |   |         |                         |   |   |   |
| Incurred benefits related to:      |              |         |                         |   |         |                         |   |   |
|                               | Current year      |         | 23,852                       |   |         | 22,174                       |   |   | 20,287 |
|                               | Prior years 1     |         |      180 |   |         |      766 |   |   |    (319) |
|                               |              |         |                         |   |         |                         |   |   |   |
| Total incurred benefits            |              | 24,032       |                         |   | 22,940       |                         |   | 19,968 |
|                               |              |         |                         |   |         |                         |   |   |   |
| Paid benefits related to:          |              |         |                         |   |         |                         |   |   |
|                               | Current year      |         | 20,824                       |   |         | 18,939                       |   |   | 17,767 |
|                               | Prior years       |         |   3,507                 |   |         |   3,426                 |   |   |   3,612 |
|                               |              |         |                         |   |         |                         |   |   |   |
| Total paid benefits                |              | 24,331       |                         |   | 22,365       |                         |   | 21,379 |
|                               |              |         |                         |   |         |                         |   |   |   |
| Net liability at end of year       |              |   3,263 |                         |   |   3,562 |                         |   |   2,987 |
| Plus reinsurance recoverable       |              |   3,826 |                         |   |   3,829 |                         |   |   3,999 |
|                               |              |         |                         |   |         |                         |   |   |   |
| Gross liability at end of year     | $                 |   7,089 |                         | $      |   7,391 |                         | $ |   6,986 |
|                               |              |         |                         |   |         |                         |   |   |   |

 

_________

1 The incurred benefits related to prior years’ unpaid            accident and health claims reflect the (favorable) unfavorable development of these            liabilities.

 

 

 

 

 

**-62-** 

**                                                                   KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***4. NOTES PAYABLE***

 

The            following table provides information for Notes Payable as of December 31.

 

|                                                                                       |                                                                                     | 2007   |   | 2006   |
|--------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------|--------|--------|--------|
| Federal Home Loan Bank (FHLB) loans with various                            maturities and |                                                                                     |   |   |   |   |
|                                                                                       | a weighted average interest rate, currently 4.87%,                            secured by |   |   |   |   |   |
|                                                                                       | mortgage-backed securities totaling $135,355.                                            | $      | 10,400 |   | $ | 14,700 |
|                                                                                       |                                                                                     |   |   |   |   |   |
|                                                                                       |                                                                                     | $      | 10,400 |   | $ | 14,700 |
|                                                                                       |                                                                                     |   |   |   |   |   |

 

 

As a            member of the FHLB with a capital investment of $9.2 million, the Company has the            ability to borrow on a collateralized basis from the FHLB. The Company earned a 3.33%            average rate on the capital investment in the FHLB for 2007.

 

The            Company has unsecured revolving lines of credit of $60.0 million with two major            commercial banks with no balances outstanding, and which are at variable interest rates            - currently at 3.76%. Both lines of credit will expire during 2008, and it is expected            that the Company will renew these facilities at then-current market            conditions.

 

All            borrowings are used to enhance liquidity and investment strategies. Interest paid on            all borrowings equaled $1,618 (2006 – $1,016; 2005 – $2,129). The interest            expense on all borrowings totaled $1,628 (2006 – $942; 2005 –            $1,978).

 

Maturities on notes payable are $10.4 million, due in 2008.

 

**-63-** 

 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***5. STATUTORY INFORMATION and STOCKHOLDER DIVIDENDS            RESTRICTION***

 

The            table below provides the Company's net gain from operations, net income, unassigned            surplus (retained earnings) and capital and surplus (stockholders' equity), on the            statutory basis used to report to regulatory authorities for the years ended December            31.

|                               |   | 2007          |   | 2006   |          | 2005   |
|------------------------------------|--------|---------------|--------|--------|---------------|--------|
|                               |   |          |   |   |          |   |   |   |   |
| Net gain from operations           | $      |   59,601 |   | $      |   46,801 |   | $ |   49,500 |
|                               |   |          |   |   |          |   |   |   |   |
| Net income                         |   |   57,178 |   |   |   49,353 |   |   |   48,668 |
|                               |   |          |   |   |          |   |   |   |   |
| Unassigned surplus at December 31  |   | 442,674       |   |   | 443,236       |   |   | 408,144 |
|                               |   |          |   |   |          |   |   |   |   |
| Capital and surplus at December 31 |   | 366,754       |   |   | 371,766       |   |   | 339,961 |

 

 

Stockholder dividends may not exceed statutory unassigned surplus.            Additionally, under Missouri law, the Company must have the prior approval of the            Missouri Director of Insurance in order to pay dividends in any consecutive            twelve-month period exceeding the greater of statutory net gain from operations for the            preceding year or 10% of statutory stockholders' equity at the end of the preceding            year. The maximum stockholder dividends payable in 2008 without prior approval is $59.6            million, the statutory net gain from operations in 2007. The Company believes these            statutory limitations impose no practical restrictions on its dividend payment            plans.

 

The            Company is required to deposit a defined amount of assets with state regulatory            authorities. Such assets had an aggregate carrying value of $13,000 at December 31,            2007 (2006 – $12,000; 2005 – $12,000).

 

| ***6. INCOME TAXES*** |
|-----------------------|

 

The            following tables provide information about income taxes and a reconciliation of the            federal income tax rate to the Company’s effective income tax rate for the years            ended December 31.

 

|                                  |   |    | 2007   |   | 2006        |   | 2005   |         |
|---------------------------------------|--------|---------|--------|--------|-------------|--------|--------|--------------|
|                                  |   |    |   |   |        |   |   |         |   |   |   |
| Current income tax expense            | $      | 20,649  |   | $      |  8,842 |   | $      |   6,353 |   |
| Deferred income tax expense (benefit) |   | (3,399) |   |   |  4,810 |   |   |   6,459 |   |
|                                  |   |    |   |   |        |   |   |         |   |   |   |
| Total income tax expense              | $      | 17,250  |   | $      | 13,652      |   | $      | 12,812       |   |
|                                  |   |    |   |   |        |   |   |         |   |   |   |
|                                  |   |    |   |   |        |   |   |         |   |   |   |
|                                  | 2007   |    | 2006   |   | 2005        |   |
|                                  |   |    |   |   |        |   |   |         |   |   |   |
| Federal income tax rate               |   | 35      | %      |   | 35          | %      |   | 35           | % |
| Tax credits                           |   | (4)     |   |   | (6)         |   |   | (6)          |   |
| Other permanent differences           |   | 2       |   |   | (2)         |   |   | (3)          |   |
|                                  |   |    |   |   |        |   |   |         |   |   |   |
| Effective income tax rate             |   | 33      | %      |   | 27          | %      |   | 26           | % |
|                                  |   |    |   |   |        |   |   |         |   |   |

 

 

**-64-** 

**                                                                    KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

Presented below are tax effects of temporary differences that result in            significant deferred tax assets and liabilities at December 31.

 

|                              |                                   |                            | 2007         |   | 2006          |
|-----------------------------------|----------------------------------------|---------------------------------|--------------|--------|---------------|
| Deferred tax assets:              |                                   |                            |         |   |          |
|                              | Future policy benefits                 | $                               | 44,255       |   | $             |   45,169 |
|                              | Employee retirement benefits           |                            | 17,067       |   |          |   19,934 |
|                              | Tax carryovers                         |                            | -            |   |          |     3,323 |
|                              | Other                                  |                            | -            |   |          |     1,213 |
| Gross and net deferred tax assets |                                   | 61,322                          |         |   |   69,639 |
|                              |                                   |                            |         |   |          |   |   |
| Deferred tax liabilities:         |                                   |                            |         |   |          |
|                              | Basis differences between tax and      |                            |         |   |          |   |
|                              |                                   | GAAP accounting for investments |         | 11,314 |          |   |    9,152 |
|                              | Unrealized investment gains            |                            |   4,083 |   |          |      776 |
|                              | Capitalization of deferred acquisition |                            |         |   |          |   |
|                              |                                   | costs, net of amortization      |         | 39,825 |          |   |   44,362 |
|                              | Value of business acquired             |                            | 25,731       |   |          |   28,969 |
|                              | Property and equipment, net            |                            |   8,018 |   |          |    8,380 |
|                              | Other                                  |                            |   5,837 |   |          |   11,949 |
| Gross deferred tax liabilities    |                                   | 94,808                          |         |   | 103,588       |
|                              | Net deferred tax liability             |                            | 33,486       |   |          |   33,949 |
|                              | Current tax liability                  |                            |   6,814 |   |          |     1,370 |
|                              |                                   | Income taxes payable            | $            | 40,300 |          | $ |   35,319 |
|                              |                                   |                            |         |   |          |   |   |

 

 

A            valuation allowance must be established for any portion of the deferred tax asset which            is believed not to be realizable. Based predominately upon review of our anticipated            future earnings and reversal of future taxable differences, in management's opinion, it            is more likely than not that the Company will realize the benefit of its deferred tax            asset.

 

Federal            income taxes paid this year were $14,572 (2006 – $8,121; 2005 –            $6,054).

 

The            Company and/or one of its subsidiaries files income tax returns in the U.S. federal            jurisdiction, and various state jurisdictions. In general, the Company is no longer            subject to U.S. federal, state or local income tax examinations by tax authorities for            years before 2004. The Company is not currently under examination by the Internal            Revenue Service.

 

The            Company adopted the provisions of FASB Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*,            on January 1, 2007. The Company did not change the liability for unrecognized tax            benefits as of January 1, 2007 as a

 

**-65-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

result of implementing Interpretation 48. A reconciliation of the            beginning and ending amount of unrecognized tax benefits is as follows:

 

        

| Balance at January 1, 2007                                                              |   |       |   | $                 | 5,261  |
|-----------------------------------------------------------------------------------------|--------|------------|--------|-------------------|--------|
|                                                                                    |   |       |   |              |   |   |   |
| Additions based on tax positions related to the current                            year |   |   112 |
| Additions for tax positions of prior years                                              |   |       |   |   170        |
| Reductions for tax positions of prior years                                             |   |       |   |    (24) |
| Reductions for statute of limitations lapse                                             |   |       |   |    (87) |
|                                                                                    |   |       |   |              |   |   |   |
| Balance at December 31, 2007                                                            |   |       |   | $                 | 5,432  |
|                                                                                    |   |       |   |              |   |   |   |

 

 

The            total amount of unrecognized tax benefits, if recognized, that would impact the            effective tax rate was $0.8 million as of December 31, 2007.

 

The            Company recognizes interest and penalties accrued related to unrecognized tax benefits            in income tax expense. During the years ended December 31, 2007, 2006, and 2005, the            Company recognized expense of approximately $0.3 million, ($0.6) million, and $0.6            million in interest and penalties, respectively. The Company had approximately $0.8            million and $0.5 million for the payment of interest and penalties accrued at            December 31, 2007 and 2006, respectively.

 

An            adjustment was reflected in the fourth quarter of 2007 that related to deferred tax            expense attributable to years 2004 and prior through 2006. The unrecorded deferred tax            expense (benefit) in 2004 and prior, 2005 and 2006 was $1.1 million, ($0.3) million and            ($0.3) million, respectively**.**

 

The            income tax expense is recorded in various places in the Company's financial statements,            as detailed below, for the years ended December 31.

 

|                               |                             |                         |              | 2007         |                     | 2006         |    | 2005              |
|------------------------------------|----------------------------------|------------------------------|-------------------|--------------|--------------------------|--------------|---------|-------------------|
|                               |                             |                         |              |         |                     |         |    |              |   |   |   |
| Income tax expense                 | $                                | 17,250                       |              | $            | 13,652                   |         | $       |   12,812     |
| Stockholders' equity:              |                             |                         |              |         |                     |         |    |              |
|                               | Related to:                      |                         |              |         |                     |         |    |              |   |
|                               |                             | Unrealized gains, net        |              |   3,444 |                     |         | (8,782) |              |   | (18,612) |
|                               |                             | Change in minimum            |              |         |                     |         |    |              |   |   |
|                               |                             |                         | pension liability |         |     (587) |         |    |   1,968 |   |   |         (2) |
|                               |                             | Adjustment to adopt SFAS 158 |              | -            |                     |         | (2,221) |              |   | - |
| Total income tax expense (benefit) |                             |                         |              |         |                     |         |    |              |
|                               | included in financial statements | $                            | 20,107            |         | $                        |   4,617 |    | $                 | (5,802) |
|                               |                             |                         |              |         |                     |         |    |              |   |   |

 

 

**-66-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***7. PENSIONS and OTHER POSTRETIREMENT BENEFITS***

 

The            Company has pension and other postretirement benefit plans covering substantially all            its employees for which the measurement date is December 31.

 

The            Kansas City Life Pension Plan was amended and restated effective January 1, 1998 as the            Kansas City Life Cash Balance Pension Plan. Plan benefits are based on a cash balance            account consisting of credits to the account based upon an employee’s years of            service, compensation and interest credits on account balances calculated using the            greater of the average 30-year Treasury bond rate for November of each year or 5.5%.            The benefits expected to be paid in each year from 2008 through 2012 are $8,700,            $11,200, $9,100, $11,700, and $12,300, respectively. The aggregate benefits expected to            be paid in the five years from 2013 through 2017 are $62,300. The expected benefits to            be paid are based on the same assumptions used to measure the Company’s benefit            obligation at December 31, 2007 and include estimated future employee service. The 2008            contribution for the plan cannot be reasonably estimated at this time. The asset            allocation of the fair value of pension plan assets at December 31 was:

 

|              |   | Plan Assets |   | Target |
|-------------------|--------|-------------|--------|--------|
|              |   | 2007        |   | 2006   |   | Allocation |
|              |   |        |   |   |   |   |   |   |
| Debt securities   |   | 30%         |   | 31%    |   | 26% | - | 32% |
| Equity securities |   | 68%         |   | 69%    |   | 56% | - | 76% |
| Cash equivalents  |   | 2%          |   | 0%     |   | 0% | - | 2% |

 

 

This            allocation of plan assets is within the targeted mix by asset class. The strategic goal            is to achieve an optimal rate of return at an acceptable level of investment risk in            order to provide for the payment of benefits. The Plan does not expect to return any            plan assets to the Company during 2008.

 

The            current assumption for the expected long-term rate of return on plan assets is 8.0%.            This assumption is determined by analyzing: 1) historical average returns, 2)            historical data on the volatility of returns, 3) current yields available in the            marketplace, 4) actual returns on plan assets, and 5) current and anticipated future            allocation among asset classes. Theasset classes used for this            analysis are large cap equities, investment grade corporate bonds and cash. The overall            rate is derived as a weighted average of the estimated long-term returns on the asset            classes represented in the investment portfolio of the plan.

 

The            assumed discount rate used to determine the benefit obligation for pension benefits is            5.50% and 5.75% for other postretirement benefits. The discount rates were determined            by reference to the AA finance corporate bond index yield curve on December 31, 2007,            as published by Bloomberg L.P. Specifically, the yield curve was converted to spot            rates to determine the rates on zero coupon securities of the same quality at various            maturities. By discounting benefit cash flows at these rates, a notional amount equal            to the market value of a cash flow defeasing a portfolio of AA finance corporate bonds            was determined. The discount rate for benefits was calculated as a single rate giving            the same discounted value as the notional amount.

 

The            postretirement medical plans for the employees, full-time agents, and their dependents            are contributory with contributions adjusted annually. The benefits expected to be paid            in each year from 2008 through 2012 are $990, $1,050, $1,120, $1,190, and $1,200,            respectively. The aggregate benefits expected to be paid in the five years from 2013            through 2017 are $7,120. The expected benefits to be paid are based on the same            assumptions used to measure the Company’s benefit obligation at December 31,            2007. The 2008 contribution for the plan is estimated to be $990. The Company pays            these medical costs as they become due and the plan incorporates cost-sharing            features.

 

The            postretirement life insurance plan is non-contributory with level annual payments over            the participants' expected service periods. The plan covers only those employees with            at least one year of service as of December 31, 1997. The benefits in this plan are            frozen using the employees' years of service and compensation as of December 31,            1997.

 

**-67-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

Non-contributory defined contribution retirement plans for general            agents and eligible sales agents provide supplemental payments based upon earned agency            first year individual life and annuity commissions. Contributions to these plans were            $78 (2006 - $98; 2005 - $106). Non-contributory deferred compensation plans for            eligible agents based upon earned first year commissions are also offered.            Contributions to these plans were $400 (2006 – $300; 2005 –            $503).

 

Savings plans for eligible employees and agents match employee and agent            contributions up to 6% of salary and 2.5% of agents’ prior year paid commissions,            respectively. Contributions to the plan were $1,167 (2006 – $1,683; 2005 –            $1,468). The Company may contribute an additional profit sharing amount up to 4% of            salary for eligible employees, depending upon corporate profits. The Company made no            profit sharing contribution in 2007 or in the prior two years.

 

A            non-contributory trusteed employee stock ownership plan covers substantially all            salaried employees. No contributions have been made to this plan since 1992.

 

In            2005, the Company amended the Kansas City Life Insurance Company Employee Benefits Plan            and the Kansas City Life Insurance Company Agent and General Agent Health and Dental            Plan (“the Plans”), to eliminate prescription drug coverage as of January            1, 2006. Since prescription drug coverage to retirees became available under the Act,            participants of the Plans are able to obtain coverage under the Medicare Prescription            Drug Plan. At the same time, the Company has elected to reduce required retiree premium            payments to the Plans.

 

A            re-measurement of the APBO was calculated for the amendment to the Plans and the            reduced retiree premium payments. The change in the APBO resulted in a decrease of $0.9            million in the net periodic postretirement benefit cost for the year ended December 31,            2005.

 

In            September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for            Defined Benefit Pension and Other Postretirement Plans” SFAS 158. SFAS 158            requires calendar year-end companies with publicly traded equity securities that            sponsor postretirement benefit plans to fully recognize, as an asset or liability, the            overfunded or underfunded status of the benefit plans as of December 31, 2006. The            funded status is to be measured as the difference between the fair value of the            plan’s assets and its benefit obligation. The Company adopted SFAS 158 as of            December 31, 2006.

 

**-68-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

|                                                                      |                                         | Pension Benefits                       |    | Other Benefits |
|---------------------------------------------------------------------------|----------------------------------------------|----------------------------------------|---------|----------------|
|                                                                      |                                         | 2007                                   |    | 2006           |   | 2007 |   | 2006 |
|                                                                      |                                         |                                   |    |           |   |   |   |   |   |   |   |   |
| Change in projected benefit obligation:                                   |                                         |                                   |    |           |   |   |   |   |   |   |   |
| Benefit obligation at beginning of year                                   | $                                            | 140,052                                |    | $              | 136,513 |   | $ | 24,475 |   | $ | 25,056 |
| Service cost                                                              |                                         | 2,310                                  |    |           | 2,257 |   |   |      789 |   |   |      815 |
| Interest cost                                                             |                                         | 7,448                                  |    |           | 7,430 |   |   |    1,423 |   |   |   1,308 |
| Actuarial (gain) loss                                                     |                                         | 679                                    |    |           | 2,815 |   |   |    1,999 |   |   | (1,644) |
| Benefits paid                                                             |                                         |       (8,114) |    |           |       (8,963) |   |   |     (962) |   |   | (1,060) |
|                                                                      | Benefit obligation at end of year            | $                                      | 142,375 |           | $ | 140,052 |   | $ | 27,724 |   | $ | 24,475 |
|                                                                      |                                         |                                   |    |           |   |   |   |   |   |   |   |   |
| Change in plan assets:                                                    |                                         |                                   |    |           |   |   |   |   |   |   |   |
| Fair value of plan assets at beginning of                            year | $                                            | 120,426                                |    | $              | 109,170 |   | $ |      964 |   | $ |      984 |
| Return on plan assets                                                     |                                         | 9,007                                  |    |           | 14,139 |   |   |        50 |   |   |        50 |
| Company contributions                                                     |                                         | 6,076                                  |    |           | 6,080 |   |   | - |   |   | - |
| Benefits paid                                                             |                                         |       (8,114) |    |           |       (8,963) |   |   |      (93) |   |   |      (70) |
|                                                                      | Fair value of plan assets at end of year     | $                                      | 127,395 |           | $ | 120,426 |   | $ |      921 |   | $ |      964 |
|                                                                      |                                         |                                   |    |           |   |   |   |   |   |   |   |   |
| Funded status at end of year                                              | $                                            |     (14,980)            |    | $              |     (19,626) |   | $ | (26,803) |   | $ | (23,511) |
|                                                                      |                                         |                                   |    |           |   |   |   |   |   |   |   |   |
| Amounts recognized in accumulated other                                   |                                         |                                   |    |           |   |   |   |   |   |   |   |
|                                                                      | comprehensive income:                        |                                   |    |           |   |   |   |   |   |   |   |   |
| Net loss                                                                  | $                                            | 41,350                                 |    | $              | 42,526 |   | $ | 6,059 |   | $ | 4,232 |
| Prior service cost                                                        |                                         | (1,969)                                |    |           | (2,616) |   |   | (3,200) |   |   | (3,578) |
|                                                                      | Total accumulated other comprehensive income | $                                      | 39,381  |           | $ | 39,910 |   | $ | 2,859 |   | $ | 654 |
|                                                                      |                                         |                                   |    |           |   |   |   |   |   |   |   |   |

 

 

| Other changes in plan assets and benefit                            obligations |                                     |                                                                      | Pension |                     |   | Other          |
|---------------------------------------------------------------------------------|------------------------------------------|---------------------------------------------------------------------------|---------|--------------------------|--------|----------------|
|                                                                            | recognized in other comprehensive income |                                                                      |    | 2007                     |   | 2006           |   |   | 2007 |   | 2006 |
|                                                                            |                                     | Unrecognized actuarial loss                                               |    |                     | $      |  1,128    |   | n/a |   | $ | 2,002 |   | n/a |
|                                                                            |                                     | Amortization of net gain                                                  |    |                     |   |   (2,303) |   | n/a |   |   |  (176) |   | n/a |
|                                                                            |                                     | Amortization of prior service cost                                        |    |                     |   | 647            |   | n/a |   |   |    378 |   | n/a |
|                                                                            |                                     | Total recognized in other comprehensive                            income | $       |     (528) |   | n/a            |   | $ | 2,204 |   | n/a |
|                                                                            |                                     |                                                                      |    |                     |   |           |   |   |   |   |   |   |   |   |   |
|                                                                                 |                                          |                                                                           |         |                          |        |                |  |  |  |  |  |  |  |  |  |

 

**-69-** 

**                                                                    KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

|                               |                              | Pension Benefits |   | Other Benefits |    |
|------------------------------------|-----------------------------------|------------------|--------|----------------|---------|
|                               |                              | 2007             |   | 2006           |    | 2007 |   | 2006 |   |
| Plans with underfunded accumulated |                              |             |   |           |    |   |   |   |   |   |   |   |
|                               | benefit obligation:               |             |   |           |    |   |   |   |   |   |   |   |   |
| Projected benefit obligation       | $                                 | 142,375          |   | $              | 140,052 |   |   | n/a |   |   | n/a |   |
| Accumulated benefit obligation     |                              | 136,445          |   |           | 134,361 |   |   | n/a |   |   | n/a |   |
| Fair value of plan assets          |                              | 127,395          |   |           | 120,426 |   |   | n/a |   |   | n/a |   |
|                               |                              |             |   |           |    |   |   |   |   |   |   |   |   |
| Weighted average assumptions used  |                              |             |   |           |    |   |   |   |   |   |   |   |
|                               | to determine benefit obligations  |             |   |           |    |   |   |   |   |   |   |   |   |
|                               | at December 31:                   |             |   |           |    |   |   |   |   |   |   |   |   |
| Discount rate                      |                              | 5.50             | %      | 5.50           | %       | 5.75 | % | 5.75 | % |
| Expected return on plan assets     |                              | 8.00             |   |           | 8.00    |   |   | 5.50 |   |   | 5.50 |   |
| Rate of compensation increase      |                              | 3.75             |   |           | 3.75    |   |   | - |   |   | - |   |
|                               |                              |             |   |           |    |   |   |   |   |   |   |   |   |
| Weighted average assumptions used  |                              |             |   |           |    |   |   |   |   |   |   |   |
|                               | to determine net periodic benefit |             |   |           |    |   |   |   |   |   |   |   |   |
|                               | cost for years ended December 31: |             |   |           |    |   |   |   |   |   |   |   |   |
| Discount rate                      |                              | 5.50             | %      | 5.50           | %       | 5.75 | % | 5.75 | % |
| Expected return on plan assets     |                              | 8.00             |   |           | 8.00    |   |   | 5.50 |   |   | 5.50 |   |
| Rate of compensation increase      |                              | 3.75             |   |           | 3.75    |   |   | - |   |   | - |   |

 

 

The            assumed growth rate of health care costs has a significant effect on the benefit            amounts reported, as the table below demonstrates.

|                                 | One Percentage Point      |
|--------------------------------------|---------------------------|
|                                 | Change in the Growth Rate |
|                                 | Increase                  |   | Decrease |
|                                 |                      |   |   |   |   |
| Service and interest cost components | $                         | 433 |   | $ | (363) |
| Postretirement benefit obligation    |                      | 4,741 |   |   | (3,933) |

 

 

For            measurement purposes a 11.5% annual increase in the per capita cost of covered health            care benefits was assumed to decrease gradually to 6% in 2018 and            thereafter.

 

|                                              |                                  | Pension Benefits                           |                                       | Other Benefits |
|---------------------------------------------------|---------------------------------------|--------------------------------------------|--------------------------------------------|----------------|
|                                              |                                  | 2007                                       |                                       | 2006           |   | 2005 |   | 2007 |   | 2006 |   | 2005 |
| The following table provides the                  |                                  |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                              | components of net periodic benefit    |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                              | cost for the years ended December 31: |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service cost                                      | $                                     | 2,310                                      |                                       | $              |  2,257 |   | $ |  2,246 |   | $ | 789 |   | $ | 815 |   | $ | 598 |
| Interest cost                                     |                                  | 7,448                                      |                                       |           |  7,430 |   |   |  7,341 |   |   | 1,423 |   |   | 1,308 |   |   | 1,099 |
| Expected return on plan assets                    |                                  |     (9,456)                 |                                       |           | (8,537) |   |   | (8,064) |   |   |       (53) |   |   |       (54) |   |   |       (57) |
| Amortization of:                                  |                                  |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                              | Unrecognized actuarial loss           |                                       | 2,303                                      |           |   |  3,000 |   |   |  2,731 |   |   | 176 |   |   | 115 |   |   | 6 |
|                                              | Unrecognized prior service cost       |                                       |        (647) |           |   |    (647) |   |   |   (647) |   |   |     (378) |   |   |     (378) |   |   |     (204) |
| Net periodic benefits cost                        |                                  | 1,958                                      |                                       |           |   3,503 |   |   |   3,607 |   |   | 1,957 |   |   | 1,806 |   |   | 1,442 |
| Total recognized in other comprehensive income    |                                  |        (528) |                                       |           | - |   |   | - |   |   | 2,204 |   |   | - |   |   | - |
| Total recognized in net periodic benefit cost and |                                  |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                              | other comprehensive income            | $                                          | 1,430                                      |           | $ | - |   | $ | - |   | $ | 4,161 |   | $ | - |   | $ | - |
|                                              |                                  |                                       |                                       |           |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

The            estimated net loss and prior service cost for the pension plans that will be amortized            from accumulated other comprehensive income into net periodic benefit cost over the            next fiscal year is $2,226 and ($647), respectively.

 

 

**-70-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

The            estimated net loss and prior service cost for the other postretirement plans that will            be amortized from accumulated other comprehensive income into net periodic benefit cost            over the next fiscal year is $240 and ($378), respectively.

 

| ***8.*** | ***SHARE-BASED PAYMENT*** |
|----------|---------------------------|

 

The            Company has a long-term incentive plan for senior management that awards participants            for the increase in the share price of the Company’s common stock through units            (phantom shares) assigned by the Board of Directors. The awards are calculated over            three-year intervals on a calendar year basis. At the conclusion of each three-year            interval, participants will receive awards based on the increase in the share price            during a defined measurement period, times the number of units. The increase in the            share price will be determined based on the change in the share price from the            beginning to the end of the three-year interval. Dividends are accrued and paid at the            end of each three-year interval to the extent that they exceed negative stock price            appreciation. Plan payments are contingent on the continued employment of the            participant unless termination is due to a qualifying event such as death, disability            or retirement.

 

Information about the outstanding three-year intervals as of December            31, 2007, were as follows:

 

| Defined     |   |     |   |   |
|-------------|--------|----------|--------|--------|
| Measurement |   | Number   |   | Grant  |
| Period      |   | of Units |   | Price  |
| 2005-2007   |   | 98,860   |   | $      | 48.86 |
| 2006-2008   |   | 169,634  |   | $      | 50.21 |
| 2007-2009   |   | 179,488  |   | $      | 52.10 |
| 2008-2010   |   | 178,133  |   | $      | 44.33 |

 

 

During 2007, the plan made a payment of $1.0 million to plan            participants for the three-year interval ended December 31, 2006. During 2006, the plan            made a payment of $1.5 million to plan participants for the three-year interval ended            December 31, 2005. No payments were made in 2005. The cost of compensation that reduced            operating expense for 2007 was $564 and the associated tax benefit was $197. The cost            of compensation charged as an operating expense was $1,145 for 2006 (2005-$1,157) and            the associated tax benefit was $401 for 2006 (2005-$405).

 

***9. SEGMENT INFORMATION***

 

The            Company has three reportable business segments, which are defined based on the nature            of the products and services offered: Individual Insurance, Group Insurance and Old            American. The Individual Insurance segment consists of individual insurance products            for both Kansas City Life and Sunset Life. The Individual Insurance segment is marketed            through a nationwide sales force of independent general agents. The Group Insurance            segment consists of sales of group life, dental, vision and disability products. This            segment is marketed through a nationwide sales force of independent general agents,            group brokers and third-party marketing arrangements. Old American consists of            individual insurance products designed primarily as final expense products. These            products are marketed through a nationwide general agency sales force with exclusive            territories, using direct response marketing to supply agents with leads.

 

Insurance revenues, as shown in the Consolidated Statements of Income,            consist of premiums and contract charges, less reinsurance ceded. Other revenues            include other sources of customer revenue, such as supplemental contract            considerations, accumulated policyholder dividend receipts and third-party            administrative and service fees related to the Company’s Group Insurance Segment.            It is preferable to consider the sum of both insurance revenues and other revenues in            evaluating total revenues from all customer relationships and we define this as            “customer revenues” for segment reporting purposes. Customer revenues are            added to net investment income and realized investment gains (losses) to reconcile to            the Company’s total revenues.

 

Separate investment portfolios are maintained for each of the three life            insurance companies of the Company. However, investments are allocated to the Group            Insurance segment based upon its cash flows. Its investment income is modeled using the            year of investment method. Home office functions are fully integrated for the three            companies in order to maximize economies of scale. Therefore, operating expenses are            allocated to the segments based upon internal cost studies, which are consistent with            industry cost methodologies.

 

**-71-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

Inter-segment revenues are not material. The Company operates solely in            the United States and no individual customer accounts for 10% or more of the Company's            revenue.

 

|                                              |                                                                      |                                       | Individual               |          | Group                        |                         | Old      | Intercompany                                                              |                   |          |
|---------------------------------------------------|---------------------------------------------------------------------------|--------------------------------------------|--------------------------|---------------|------------------------------|------------------------------|----------|---------------------------------------------------------------------------|------------------------|---------------|
|                                              |                                                                      |                                       | Insurance                |          | Insurance                    |                         | American |                                                                      |                   | Eliminations  |   | Total |
| **2007:**                                         |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |
| Insurance revenues                                | $                                                                         | 124,190                                    |                     | $             | 45,776                       |                         | $        | 62,479                                                                    |                   | $             | (551) |   | $ | 231,894 |
| Other revenues                                    |                                                                      |   11,214                              |                     |          |      278 |                         |     |                                 7 |                   |          | - |   |   |   11,499 |
|                                              | Customer revenues                                                         |                                       | 135,404                  |          |                         | 46,054                       |     |                                                                      | 62,486                 |          |   | (551) |   |   | 243,393 |
|                                              | Net investment income                                                     |                                       | 176,666                  |          |                         |      426 |     |                                                                      | 13,313                 |          |   | - |   |   | 190,405 |
|                                              | Realized investment gains (losses)                                        |                                       |     5,820 |          |                         | -                            |     |                                                                      |   (394)           |          |   | - |   |   |     5,426 |
|                                              |                                                                      | Total revenues                             |                     | 317,890       |                         |                         | 46,480   |                                                                      |                   | 75,405        |   |   | (551) |   |   | 439,224 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
|                                              | Policyholder benefits                                                     |                                       |   93,200            |          |                         | 30,061                       |     |                                                                      | 43,197                 |          |   | - |   |   | 166,458 |
|                                              | Interest credited to policyholder account                        balances |                                       |   91,215            |          |                         | -                            |     |                                                                      | -                      |          |   | - |   |   |   91,215 |
|                                              | Amortization of deferred acquisition costs                                |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |
|                                              |                                                                      | and value of business acquired             |                     |   27,568 |                         |                         | -        |                                                                      |                   | 12,765        |   |   | - |   |   |  40,333 |
|                                              | Operating expenses                                                        |                                       |   55,283            |          |                         | 19,309                       |     |                                                                      | 14,266                 |          |   | (551) |   |   |   88,307 |
|                                              |                                                                      | Total benefits and expenses                |                     | 267,266       |                         |                         | 49,370   |                                                                      |                   | 70,228        |   |   | (551) |   |   | 386,313 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
| Income (loss) before income tax expense (benefit) |                                                                      | 50,624                                     |                     |          | (2,890)                      |                         |     |   5,177                                                              |                   |          | - |   |   |  52,911 |
| Income tax expense (benefit)                      |                                                                      |  15,822                               |                     |          |   (867)                 |                         |     |   2,295                                                              |                   |          | - |   |   |  17,250 |
| Segment net income (loss)                         | $                                                                         |  34,802                               |                     | $             | (2,023)                      |                         | $        |  2,882                                                               |                   | $             | - |   | $ | 35,661 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
| Segment assets                                    | $                                                                         | 3,977,585                                  |                     | $             | 8,410                        |                         | $        | 366,113                                                                   |                   | $             | - |   | $ | 4,352,108 |
| Interest expense                                  | $                                                                         |        1,364 |                     | $             | -                            |                         | $        |        264                                  |                   | $             | - |   | $ |        1,628 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
| **2006:**                                         |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |
| Insurance revenues                                | $                                                                         | 127,218                                    |                     | $             | 44,577                       |                         | $        | 64,043                                                                    |                   | $             | (574) |   | $ |   235,264 |
| Other revenues                                    |                                                                      | 10,717                                     |                     |          |      608 |                         |     |       24                                         |                   |          | - |   |   |     11,349 |
|                                              | Customer revenues                                                         |                                       | 137,935                  |          |                         | 45,185                       |     |                                                                      | 64,067                 |          |   | (574) |   |   | 246,613 |
|                                              | Net investment income                                                     |                                       | 182,766                  |          |                         |      272 |     |                                                                      | 13,242                 |          |   | - |   |   |   196,280 |
|                                              | Realized investment gains                                                 |                                       |    5,300       |          |                         | -                            |     |                                                                      |     321 |          |   | - |   |   |       5,621 |
|                                              |                                                                      | Total revenues                             |                     | 326,001       |                         |                         | 45,457   |                                                                      |                   | 77,630        |   |   | (574) |   |   |   448,514 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
|                                              | Policyholder benefits                                                     |                                       |  95,603             |          |                         | 28,596                       |     |                                                                      | 43,706                 |          |   | - |   |   |  167,905 |
|                                              | Interest credited to policyholder account                        balances |                                       |   94,648       |          |                         | -                            |     |                                                                      | -                      |          |   | - |   |   |    94,648 |
|                                              | Amortization of deferred acquisition costs                                |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |
|                                              |                                                                      | and value of business acquired             |                     |   30,581 |                         |                         | -        |                                                                      |                   | 11,730        |   |   | - |   |   |   42,311 |
|                                              | Operating expenses                                                        |                                       |   59,952            |          |                         | 19,114                       |     |                                                                      |   14,588          |          |   | (574) |   |   |   93,080 |
|                                              |                                                                      | Total benefits and expenses                |                     | 280,784       |                         |                         | 47,710   |                                                                      |                   |   70,024 |   |   | (574) |   |   | 397,944 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
| Income (loss) before income tax expense (benefit) |                                                                      |  45,217                               |                     |          | (2,253)                      |                         |     |   7,606                                                         |                   |          |   |   |   |  50,570 |
| Income tax expense (benefit)                      |                                                                      |  12,049                               |                     |          |   (676)                 |                         |     |    2,279                                                        |                   |          |   |   |   | 13,652 |
| Segment net income (loss)                         | $                                                                         |  33,168                               |                     | $             | (1,577)                      |                         | $        |    5,327                                                        |                   | $             | - |   | $ |  36,918 |
|                                              |                                                                      |                                       |                     |          |                         |                         |     |                                                                      |                   |          |   |   |   |   |   |   |
| Segment assets                                    | $                                                                         | 4,085,189                                  |                     | $             | 6,066                        |                         | $        | 366,540                                                                   |                   | $             | - |   | $ | 4,457,795 |
| Interest expense                                  | $                                                                         |        1,191 |                     | $             | -                            |                         | $        |        226                                  |                   | $             | - |   | $ |        1,417 |

 

1 Elimination entries to remove intercompany transactions                for life and accident and health insurance were as follows: insurance revenues from                the Group Insurance segment, and operating expenses from the Individual Insurance                segment, to arrive at Consolidated Statements of Income.

 

 

**-72-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

|                                                                         |                                                                          |                                       | Individual               |          | Group                        |                         | Old      | Intercompany                             |                     |         |
|------------------------------------------------------------------------------|-------------------------------------------------------------------------------|--------------------------------------------|--------------------------|---------------|------------------------------|------------------------------|----------|------------------------------------------|--------------------------|--------------|
|                                                                         |                                                                          |                                       | Insurance                |          | Insurance                    |                         | American |                                     |                     | Eliminations |   | Total |
| **2005:**                                                                    |                                                                          |                                       |                     |          |                         |                         |     |                                     |                     |         |   |   |   |   |
| Insurance revenues                                                           | $                                                                             | 132,162                                    |                     | $             | 40,870                       |                         | $        | 66,015                                   |                     | $            | (544) |   | $ | 238,503 |
| Other revenues                                                               |                                                                          |     9,641                   |                     |          |      661 |                         |     |        10  |                     |         | - |   |   |   10,312 |
|                                                                         | Customer revenues                                                             |                                       | 141,803                  |          |                         | 41,531                       |     |                                     | 66,025                   |         |   | (544) |   |   | 248,815 |
|                                                                         | Net investment income                                                         |                                       | 181,311                  |          |                         |      233 |     |                                     | 13,064                   |         |   | - |   |   | 194,608 |
|                                                                         | Realized investment gains (losses)                                            |                                       |     6,488 |          |                         | -                            |     |                                     |     (375) |         |   | - |   |   |     6,113 |
|                                                                         |                                                                          | Total revenues                             |                     | 329,602       |                         |                         | 41,764   |                                     |                     | 78,714       |   |   | (544) |   |   | 449,536 |
|                                                                         |                                                                          |                                       |                     |          |                         |                         |     |                                     |                     |         |   |   |   |   |   |   |
|                                                                         | Policyholder benefits                                                         |                                       |   99,294            |          |                         | 25,950                       |     |                                     | 44,457                   |         |   | - |   |   | 169,701 |
|                                                                         | Interest credited to policyholder account                            balances |                                       |   98,637            |          |                         | -                            |     |                                     | -                        |         |   | - |   |   |   98,637 |
|                                                                         | Amortization of deferred acquisition costs                                    |                                       |                     |          |                         |                         |     |                                     |                     |         |   | - |   |   |   |
|                                                                         |                                                                          | and value of business acquired             |                     |   29,640 |                         |                         | -        |                                     |                     | 13,418       |   |   | - |   |   |   43,058 |
|                                                                         | Operating expenses                                                            |                                       |   56,638            |          |                         | 19,220                       |     |                                     | 13,830                   |         |   | (544) |   |   |   89,144 |
|                                                                         |                                                                          | Total benefits and expenses                |                     | 284,209       |                         |                         | 45,170   |                                     |                     | 71,705       |   |   | (544) |   |   | 400,540 |
|                                                                         |                                                                          |                                       |                     |          |                         |                         |     |                                     |                     |         |   |   |   |   |   |   |
| Income (loss) before income tax expense                            (benefit) |                                                                          |   45,393                              |                     |          | (3,406)                      |                         |     |   7,009                             |                     |         | - |   |   |   48,996 |
| Income tax expense (benefit)                                                 |                                                                          |   11,754                              |                     |          | (1,022)                      |                         |     |   2,080                             |                     |         | - |   |   |   12,812 |
| Segment net income (loss)                                                    | $                                                                             |   33,639                              |                     | $             | (2,384)                      |                         | $        |   4,929                             |                     | $            | - |   | $ |   36,184 |
|                                                                         |                                                                          |                                       |                     |          |                         |                         |     |                                     |                     |         |   |   |   |   |   |   |
| Segment assets                                                               | $                                                                             | 4,170,536                                  |                     | $             | 6,671                        |                         | $        | 378,172                                  |                     | $            | - |   | $ | 4,555,379 |
| Interest expense                                                             | $                                                                             |        1,824 |                     | $             | -                            |                         | $        |        593 |                     | $            | - |   | $ |        2,417 |

 

 

1 Elimination entries to remove intercompany transactions for            life and accident and health insurance were as follows: insurance revenues from the            Group Insurance segment, and operating expenses from the Individual Insurance segment,            to arrive at Consolidated Statements of Income.

 

| **Enterprise-Wide Disclosures**        |                                           |              |          |    |   |          |    |   |
|----------------------------------------|------------------------------------------------|-------------------|---------------|---------|--------|---------------|---------|--------|
|                                   |                                           |              | 2007          |    | 2006   |          | 2005    |
| Customer revenues by line of business: |                                           |              |          |    |   |          |    |   |
|                                   | Traditional individual insurance products, net | $                 |   74,696 |    | $      |   76,191 |    | $      |   82,888 |
|                                   | Interest sensitive products                    |              |   93,993 |    |   |   97,177 |    |   |   97,506 |
|                                   | Variable life insurance and annuities          |              |   17,429 |    |   |   17,319 |    |   |   17,239 |
|                                   | Group life and disability products, net        |              |   45,776 |    |   |   44,577 |    |   |   40,870 |
|                                   | Insurance revenues                             |              | 231,894       |    |        | 235,264       |    |        | 238,503 |
|                                   | Other revenues                                 |              |   11,499 |    |   |   11,349 |    |   |   10,312 |
|                                   |                                           | Customer revenues | $             | 243,393 |   | $             | 246,613 |   | $ | 248,815 |
|                                   |                                           |              |          |    |   |          |    |   |   |

 

 

 

**-73-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***10. PROPERTY and EQUIPMENT***

 

Property and equipment are stated at cost and depreciated over estimated            useful lives using the straight-line method. The home office is depreciated over 25 to            50 years and furniture and equipment is depreciated over 3 to 10 years. The table below            provides information as of December 31.

 

|                          | 2007   |                          | 2006   |
|-------------------------------|--------|-------------------------------|--------|
|                          |   |                          |   |   |   |
| Land                          | $      |       766 |   | $ |       766 |
| Home office complex           |   |  20,375                  |   |   |  20,427 |
| Furniture and equipment       |   |  45,460                  |   |   |  45,843 |
|                          |   |  66,601                  |   |   |  67,036 |
|                          |   |                          |   |   |   |
| Less accumulated depreciation |   | (38,820)                      |   |   | (37,672) |
|                          |   |                          |   |   |   |
|                          | $      |  27,781                  |   | $ |  29,364 |
|                          |   |                          |   |   |   |

 

 

**-74-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***11. REINSURANCE***

 

The            table below provides information about reinsurance for the years ended December            31.

|                                    |    |   | 2007               |   | 2006   |               | 2005   |
|-----------------------------------------|---------|--------|--------------------|--------|--------|--------------------|--------|
|                                    |    |   |               |   |   |               |   |   |   |   |
| Life insurance in force (in millions) : |    |   |               |   |   |
|                                    | Direct  | $      |  29,406       |   | $      |  29,398       |   | $ |  28,943 |
|                                    | Ceded   |   | (14,315)           |   |   | (13,836)           |   |   | (13,354) |
|                                    | Assumed |   |    1,729 |   |   |    1,863 |   |   |    2,006 |
|                                    |    |   |               |   |   |               |   |   |   |   |
|                                    |    | Net    | $                  | 16,820 |   | $                  | 17,425 |   | $ |  17,595 |
|                                    |    |   |               |   |   |               |   |   |   |   |
| Premiums:                               |    |   |               |   |   |               |   |   |
| Life insurance:                         |    |   |               |   |   |               |   |   |
|                                    | Direct  | $      | 125,667            |   | $      | 125,147            |   | $ | 131,475 |
|                                    | Ceded   |   | (46,291)           |   |   | (45,406)           |   |   | (45,512) |
|                                    | Assumed |   |    3,616 |   |   |    4,031 |   |   |    4,144 |
|                                    |    |   |               |   |   |               |   |   |   |   |
|                                    |    | Net    | $                  | 82,992 |   | $                  | 83,772 |   | $ |  90,107 |
|                                    |    |   |               |   |   |               |   |   |   |   |
| Accident and health:                    |    |   |               |   |   |               |   |   |
|                                    | Direct  | $      | 46,177             |   | $      | 46,748             |   | $ |   43,947 |
|                                    | Ceded   |   | (8,697)            |   |   | (9,752)            |   |   | (10,296) |
|                                    | Assumed |   | -                  |   |   | -                  |   |   | - |
|                                    |    |   |               |   |   |               |   |   |   |   |
|                                    |    | Net    | $                  | 37,480 |   | $                  | 36,996 |   | $ | 33,651 |
|                                    |    |   |               |   |   |               |   |   |   |   |

 

 

Old            American has a coinsurance agreement that reinsures certain whole life policies issued            by Old American prior to December 1, 1986. These policies had a face value of $51.0            million as of December 31, 2007. The reserve for future policy benefits ceded under            this agreement was $26.2 million (2006 – $28.4 million).

 

Kansas City Life acquired a block of traditional life and universal life            products in 1997. As of December 31, 2007, the block had $1.7 billion of life insurance            in force (2006 – $1.8 billion). The block generated life insurance premiums of            $2.1 million net of reinsurance (2006 – $2.7 million).

 

Sunset Life entered into a yearly renewable term reinsurance agreement            January 1, 2002, whereby it ceded 80% of its retained mortality risk on traditional and            universal life policies. As of December 31, 2007, the insurance in force ceded            approximates $2.0 billion (2006 – $2.1 billion) and premiums totaled $8.9            million.

 

Reinsurance receivables were $162.3 million at year end 2007, consisting            of reserves ceded of $149.5 million and claims ceded of $12.8 million.

 

The            maximum retention on any one life is $350 thousand for ordinary life plans and $100            thousand for group coverage. A contingent liability exists with respect to reinsurance,            which may become a liability of the Company in the unlikely event that the reinsurers            should be unable to meet obligations assumed under reinsurance contracts. Reinsurers'            solvency is reviewed annually.

**-75-** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***12. COMPREHENSIVE INCOME***

 

Comprehensive income is comprised of net income and other comprehensive            income (loss). Other comprehensive income (loss) includes the unrealized investment            gains or losses on securities available for sale (net of reclassification adjustments            for realized investment gains or losses) net of adjustments to DAC, VOBA and            policyholder account balances. In addition, other comprehensive income (loss) includes            the change in the additional minimum pension liability, and the adjustment to adopt            SFAS 158. The adjustment to adopt SFAS 158 consists of pension and postretirement net            losses and prior service costs. Other comprehensive income (loss) also includes            deferred income taxes on these items. The table below provides information about            comprehensive income for the years ended December 31.

|                                         |                 |                        | Unrealized    |   |                   | Pension   |   |                              |   |
|----------------------------------------------|----------------------|-----------------------------|---------------|--------|------------------------|-----------|--------|-----------------------------------|--------|
|                                         |                 |                        | Gain (Loss)   |   |                   | and Other |   |                              |   |
|                                         |                 |                        | on Securities |   |                   | Benefits  |   |                              | Total  |
| **2007:**                                    |                 |                        |          |   |                   |      |   |                              |
| Unrealized gains arising during the year     | $                    |   8,907                |          | $      | -                      |      | $      |   8,907                      |
| Less: Realized losses included in net income |                 | (1,650)                     |          |   | -                      |      |   | (1,650)                           |
| Net unrealized gain                          |                 | 10,557                      |          |   | -                      |      |   | 10,557                            |
| Increase in minimum pension liability        |                 | -                           |          |   | (1,676)                |      |   | (1,676)                           |
| Effect on DAC                                |                 |   (687)                |          |   | -                      |      |   |    (687)                |
| Effect on VOBA                               |                 |      85 |          |   | -                      |      |   |       85 |
| Policyholder account balances                |                 |   (115)                |          |   | -                      |      |   |    (115)                |
| Deferred income taxes                        |                 | (3,444)                     |          |   |     587 |      |   | (2,857)                           |
| Other comprehensive income (loss)            | $                    |   6,396                |          | $      | (1,089)                |      |   |   5,307                      |
|                                         | Net income           |                        |          |   |                   |      |   |                              | 35,661 |
|                                         | Comprehensive income |                        |          |   |                   |      |   | $                                 | 40,968 |
|                                         |                 |                        |          |   |                   |      |   |                              |   |

 

|                                        |                 |                          | Unrealized    |   |                                  | Minimum   |   |                               |         |
|---------------------------------------------|----------------------|-------------------------------|---------------|--------|---------------------------------------|-----------|--------|------------------------------------|--------------|
|                                        |                 |                          | Gain (Loss)   |   |                                  | Pension   |   |                               |         |
|                                        |                 |                          | on Securities |   |                                  | Liability |   |                               | Total        |
| **2006:**                                   |                 |                          |          |   |                                  |      |   |                               |
| Unrealized losses arising during the year   | $                    | (30,716)                      |          | $      | -                                     |      | $      | (30,716)                           |
| Less: Realized gains included in net income |                 |    1,816            |          |   | -                                     |      |   |    1,816                 |
| Net unrealized losses                       |                 | (32,532)                      |          |   | -                                     |      |   | (32,532)                           |
| Decrease in minimum pension liability       |                 | -                             |          |   | 5,620                                 |      |   |    5,620                 |
| Effect on DAC                               |                 |    2,056            |          |   | -                                     |      |   |    2,056                 |
| Effect on VOBA                              |                 |       851 |          |   | -                                     |      |   |       851 |
| Policyholder account balances               |                 |    4,603       |          |   | -                                     |      |   |    4,603                 |
| Deferred income taxes                       |                 |    8,782            |          |   |      (1,968) |      |   |    6,814                 |
| Other comprehensive loss                    | $                    | (16,240)                      |          | $      | 3,652                                 |      |   | (12,588)                           |
|                                        | Net income           |                          |          |   |                                  |      |   |                               |  36,918 |
|                                        | Comprehensive income |                          |          |   |                                  |      |   | $                                  |  24,330 |
|                                        |                 |                          |          |   |                                  |      |   |                               |

 

 

**-76** 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

|                                         |                 |                                          | Unrealized    |   |   | Minimum   |   |                                                                            |               |
|----------------------------------------------|----------------------|-----------------------------------------------|---------------|--------|--------|-----------|--------|---------------------------------------------------------------------------------|--------------------|
|                                         |                 |                                          | Gain (Loss)   |   |   | Pension   |   |                                                                            |               |
|                                         |                 |                                          | on Securities |   |   | Liability |   |                                                                            | Total              |
| **2005:**                                    |                 |                                          |          |   |   |      |   |                                                                            |
| Unrealized losses arising during the year    | $                    | (66,050)                                      |          | $      | -      |      | $      | (66,050)                                                                        |
| Less: Realized losses included in net income |                 |   (1,613)                           |          |   | -      |      |   |   (1,613)                                                                  |
| Net unrealized losses                        |                 | (64,437)                                      |          |   | -      |      |   | (64,437)                                                                        |
| Increase in minimum pension liability        |                 | -                                             |          |   | (6)    |      |   |                                     (6) |
| Effect on DAC                                |                 |    4,689                            |          |   | -      |      |   |    4,689                                                              |
| Effect on VOBA                               |                 |         95 |          |   | -      |      |   |         95                                   |
| Policyholder account balances                |                 |    6,408                            |          |   | -      |      |   |    6,408                                                              |
| Deferred income taxes                        |                 |  18,612                                  |          |   | 2      |      |   |  18,614                                                                    |
| Other comprehensive loss                     | $                    | (34,633)                                      |          | $      | (4)    |      |   | (34,637)                                                                        |
|                                         | Net income           |                                          |          |   |   |      |   |                                                                            |  36,184       |
|                                         | Comprehensive income |                                          |          |   |   |      |   | $                                                                               |    1,547 |
|                                         |                 |                                          |          |   |   |      |   |                                                                            |               |

 

 

The            following table provides accumulated balances related to each component of accumulated            other comprehensive loss.

 

|                              |   |               | Unrealized    |   |                                  | Minimum   |   |                     |   |
|-----------------------------------|--------|--------------------|---------------|--------|---------------------------------------|-----------|--------|--------------------------|--------|
|                              |   |               | Gain (Loss)   |   |                                  | Pension   |   |                     |   |
|                              |   |               | on Securities |   |                                  | Liability |   |                     | Total  |
| **2006:**                         |   |               |          |   |                                  |      |   |                     |
| Beginning of year                 | $      |   17,489      |          | $      |    (25,895)                 |      | $      |   (8,406)           |
| Other comprehensive income (loss) |   | (16,240)           |          |   | 3,652                                 |      |   | (12,588)                 |
| Adjustment to adopt SFAS 158      |   | -                  |          |   |      (4,124) |      |   |   (4,124)           |
|                              |   |               |          |   |                                  |      |   |                     |   |
| End of year                       |   |    1,249 |          |   |    (26,367)                 |      |   | (25,118)                 |
|                              |   |               |          |   |                                  |      |   |                     |   |
| **2007:**                         |   |               |          |   |                                  |      |   |                     |
| Other comprehensive income (loss) |   |    6,396 |          |   |      (1,089)      |      |   |     5,307 |
|                              |   |               |          |   |                                  |      |   |                     |   |
| End of year                       | $      |    7,645 |          | $      |    (27,456)            |      | $      | (19,811)                 |
|                              |   |               |          |   |                                  |      |   |                     |   |

 

 

**-77-** 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

| ***13. FAIR VALUE of FINANCIAL                            INSTRUMENTS*** |
|--------------------------------------------------------------------------|

 

The            carrying amounts for cash, short-term investments and policy loans, as reported in the            accompanying balance sheet, approximate their fair values. The fair values for            securities were based on quoted market prices, where available. For those securities            not actively traded, fair values were estimated using values obtained from independent            pricing services or, in the case of private placements, were estimated by discounting            expected future cash flows using a current market rate applicable to the yield, credit            quality and maturity of the investments. Fair values for mortgage loans were based upon            discounted cash flow analyses using an interest rate assumption above comparable U.S.            Treasury rates. The fair value of bank deposits, checking, savings and money market            accounts was the amount payable on demand.

 

Fair            values for liabilities under investment-type insurance contracts, included with            policyholder account balances for fixed deferred annuities and with other policyholder            funds for supplementary contracts without life contingencies, were estimated to be            their cash surrender values.

 

Fair            values for the Company's insurance contracts other than investment contracts were not            required to be disclosed. However, the fair values of liabilities under all insurance            contracts were taken into consideration in the Company's overall management of interest            rate risk.

 

At            year-end 2007, all of the Company’s notes payable had a carrying value which            approximated their fair value. The Company’s other liabilities are generally            short-term in nature and their carrying value approximates their fair value.

 

Following are the carrying amounts and fair values of financial            instruments as of December 31.

 

|             |                           |                       | 2007                            |                            | 2006   |
|------------------|--------------------------------|----------------------------|---------------------------------|---------------------------------|--------|
|             |                           |                       |                            | Carrying                        |   |   | Fair |   |   | Carrying |   |   | Fair |
|             |                           |                       |                            | Amount                          |   |   | Value |   |   | Amount |   |   | Value |
| **Investments:** |                           |                       |                            |                            |   |   |   |   |   |   |   |
|             | Securities available for sale  | $                          | 2,690,222                       |                            | $      | 2,690,222 |   | $ | 2,771,790 |   | $ | 2,771,790 |
|             | Mortgage loans                 |                       |    450,148            |                            |   |    464,211 |   |   |    472,019 |   |   |    471,680 |
| **Liabilities:** |                           |                       |                            |                            |   |   |   |   |   |   |   |
|             | Individual and group annuities | $                          |    987,014            |                            | $      |    963,626 |   | $ | 1,068,286 |   | $ | 1,038,533 |
|             | Notes payable                  |                       |      10,400 |                            |   |      10,400 |   |   |      14,700 |   |   |      14,700 |
|             | Bank deposits                  |                       | -                               |                            |   | - |   |   |      37,799 |   |   |      37,799 |
|             | Supplementary contracts        |                       |                            |                            |   |   |   |   |   |   |   |   |
|             |                           | without life contingencies |                            |      67,258 |   |   |      67,296 |   |   |      67,908 |   |   |      67,927 |
|             |                           |                       |                            |                            |   |   |   |   |   |   |   |   |   |

 

 

***14. QUARTERLY CONSOLIDATED FINANCIAL DATA**(unaudited)*

 

The            unaudited quarterly results of operations for the years ended December 31, 2007 and            2006 are summarized in the table below.

 

|              |              |               | First  |   |          | Second |   |                     | Third  |   |                     | Fourth |
|-------------------|-------------------|--------------------|--------|--------|---------------|--------|--------|--------------------------|--------|--------|--------------------------|--------|
| **2007:**         |              |               |   |   |          |   |   |                     |   |   |                     |
| Total revenues    | $                 | 113,027            |   | $      | 109,885       |   | $      | 108,791                  |   | $      | 107,521                  |
|              |              |               |   |   |          |   |   |                     |   |   |                     |   |
| Net income        |              |    8,306 |   |   |   11,812 |   |   |     9,131 |   |   |     6,412 |
|              |              |               |   |   |          |   |   |                     |   |   |                     |   |
| Per common share, |              |               |   |   |          |   |   |                     |   |   |                     |
|              | basic and diluted |               | 0.70   |   |          | 1.00   |   |                     | 0.77   |   |                     | 0.54   |
|              |              |               |   |   |          |   |   |                     |   |   |                     |   |
| **2006:**         |              |               |   |   |          |   |   |                     |   |   |                     |
| Total revenues    | $                 | 111,092            |   | $      | 112,521       |   | $      | 111,227                  |   | $      | 113,674                  |
|              |              |               |   |   |          |   |   |                     |   |   |                     |   |
| Net income        |              |    7,189 |   |   |   10,109 |   |   |     9,526 |   |   |   10,094            |
|              |              |               |   |   |          |   |   |                     |   |   |                     |   |
| Per common share, |              |               |   |   |          |   |   |                     |   |   |                     |
|              | basic and diluted |               | 0.60   |   |          | 0.85   |   |                     | 0.80   |   |                     | 0.86   |

 

 

**-78-** 

 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -            (Continued)**

 

***15. COMMITMENTS***

 

In            the normal course of business, the Company has open purchase and sale commitments. At            December 31, 2007, the Company had purchase commitments to fund mortgage loans and            other investments of $10.5 million. Subsequent to December 31, 2007, the Company            entered into commitments to fund additional mortgage loans of $7.9 million, purchase            real estate investments of $4.4 million, sales of real estate investments for $1.1            million and construction of real estate investments of $2.8 million.

 

***16. CONTINGENT LIABILITIES***

 

The            life insurance industry, including the Company, has been subject to an increase in            litigation in recent years. Such litigation has been pursued on behalf of purported            classes of policyholders and other claims and legal actions in jurisdictions where            juries often award punitive damages, which are grossly disproportionate to actual            damages.

 

Although no assurances can be given and no determinations can be made at            this time, management believes that the ultimate liability, if any, with respect to            these claims and actions, would have no material effect on the Company’s            business, results of operations or financial position.

 

***17. GUARANTEES AND INDEMNIFICATIONS***

 

The            Company is subject to various indemnification obligations issued in conjunction with            certain transactions, primarily assumption reinsurance agreements, stock purchase            agreements, mortgage servicing agreements, construction and lease guarantees and            borrowing agreements whose terms range in duration and often are not explicitly            defined. Generally, a maximum obligation is not explicitly stated; therefore, the            overall maximum amount of the obligation under the indemnifications cannot be            reasonably estimated. While we are unable to estimate with certainty the ultimate legal            and financial liability with respect to these indemnifications, we believe the            likelihood is remote that material payments would be required under such            indemnifications, and therefore such indemnifications would not result in a material            adverse effect on the Company’s business, financial position or results of            operations.

 

 

 

**-79-** 

 

|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            |                            | Schedule I |
|--------------------------------------------------------------------------------|-----------------------------|-----------------------------------------|--------------------------------------------|---------------------------------|---------------------------|-------------------------------------------|---------------------|---------------------|---------------------------------------|---------------------------------|---------------------------------|---------------------------------|------------|
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            |                            |       |
| **KANSAS CITY LIFE INSURANCE COMPANY AND                        SUBSIDIARIES** |
| **SUMMARY OF INVESTMENTS - OTHER THAN**                                        |
| **INVESTMENTS IN RELATED PARTIES**                                             |
| **DECEMBER 31, 2007**                                                          |
| (amounts in thousands)                                                         |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            | Amount at                       |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            | Which Shown                     |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            | in Consolidated                 |
| **Type of Investment**                                                         |                        | Cost                                    |                                       |                            | Fair Value                |                                      | Balance Sheet       |
| Fixed maturity securities, available for sale:                                 |                        |                                    |                                       |                            |                      |                                      |                |                |
|                                                                           | Bonds:                      |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            |
|                                                                           |                        | United States government and government |                                       |                            |                      |                                      |                |                |                                  |                            |
|                                                                           |                        |                                    | agencies and authorities                   | **$**                           |     19,865 |                                      | $                   |    20,264 |                                  | **$**                           |      20,264 |
|                                                                           |                        | Mortgage-backed securities              |                                       |    551,863            |                      |                                      |   545,962      |                |                                  |    545,962            |
|                                                                           |                        | Public utilities                        |                                       |                            |    178,811 |                                      |                |   185,368      |                                  |                            |    185,368            |
|                                                                           |                        | Corporate                               |                                       |                            | 1,733,710                 |                                      |                | 1,742,993           |                                  |                            | 1,742,993                       |
|                                                                           |                        | All other bonds                         |                                       |                            |    129,808      |                                      |                |   131,559 |                                  |                            |    131,559            |
|                                                                           | Redeemable preferred stocks |                                    |        5,052 |                            |                      |       4,927 |                |                |        4,927 |
|                                                                           |                        | Total                                   |                                       |                            |                      | 2,619,109                                 |                | $                   | 2,631,073                             |                            |                            | 2,631,073                       |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            |                            |       |
| Equity securities, available for sale:                                         |                        |                                    |                                       |                            |                      |                                      |                |                |
|                                                                           | Common stocks               |                                    |                                       |      36,228 |                      |                                      |    37,976 |                |                                  |      37,976 |
|                                                                           | Perpetual preferred stocks  |                                    |      21,678            |                            |                      |    21,173                       |                |                |      21,173       |
|                                                                           |                        | Total                                   |                                       |                            |                      |      57,906           |                | $                   |    59,149                   |                            |                            |      59,149 |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |                            |                            |                            |       |
| Mortgage loans                                                                 |                        |                                    |   450,148                             |                            |                      |                                      |                |                |    450,148                  |
| Real estate                                                                    |                        |                                    |                                       |     96,049       |                      |                                      |                |                |                                  |      96,049      |
| Policy loans                                                                   |                        |                                    |                                       |     92,803       |                      |                                      |                |                |                                  |      92,803 |
| Short-term investments                                                         |                        |                                    |     36,522                  |                            |                      |                                      |                |                |      36,522       |
|                                                                           |                        | Total investments                       |                                       | **$**                           | 3,352,537                 |                                      |                |                |                                  | **$**                           | 3,365,744                       |
|                                                                           |                        |                                    |                                       |                            |                      |                                      |                |                |                                  |

 

 

 

 

 

 

 

 

 

 

 

 

See            accompanying Report of Independent Registered Public Accounting Firm.

 

**-80-** 

|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      | Schedule II                          |
|--------------------------------------------------------------------------|------------------------------------------------------------------------------------|-------------------------------------------|--------------------------------------------|---------------------------------|--------------------------------------|---------------------------------|---------------------------|--------------------------------------|
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
| **KANSAS CITY LIFE INSURANCE COMPANY**                                   |
| **CONDENSED FINANCIAL INFORMATION OF                        REGISTRANT** |
| **BALANCE SHEETS**                                                       |
| (amounts in thousands, except share data)                                |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
|                                                                     |                                                                               |                                      |                                       |                            | December 31                          |
|                                                                     |                                                                               |                                      |                                       |                            | 2007                                 |                            | 2006                      |
| **ASSETS**                                                               |                                                                               |                                      |                                       |                            |                                 |                            |                      |
| Investments:                                                             |                                                                               |                                      |                                       |                            |                                 |                            |
|                                                                     | Fixed maturity securities available for sale, at fair                        value | $                                         | 2,099,251                                  |                            | $                                    | 2,128,865                       |
|                                                                     | Equity securities available for sale, at fair                        value         |                                      |                                       |                            |                                 |                            |
|                                                                     |                                                                               | Investment in unconsolidated subsidiaries |                                       |    187,951            |                                 |                            |    205,553      |
|                                                                     |                                                                               | Other                                     |                                       |                            |      50,192      |                            |                      |      43,344      |
|                                                                     | Mortgage loans                                                                     |                                      |                                       |    379,823            |                                 |                            |    379,267      |
|                                                                     | Real estate                                                                        |                                      |                                       |      91,364 |                                 |                            |   104,827            |
|                                                                     | Policy loans                                                                       |                                      |                                       |      72,214 |                                 |                            |     75,208 |
|                                                                     | Short-term investments                                                             |                                      |      18,774            |                            |                                 |      35,864 |
|                                                                     |                                                                               |                                      | Total investments                          |                            | 2,899,569                            |                            |                      | 2,972,928                            |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
| Cash                                                                     |                                                                               |                                      |                                       |                            |       8,072 |                            |                      |       3,234 |
| Accrued investment income                                                |                                                                               |    29,044                       |                                       |                            |     30,227            |
| Deferred acquisition costs                                               |                                                                               |   110,990                            |                                       |                            |   109,434                       |
| Value of business acquired                                               |                                                                               |     63,325                 |                                       |                            |     70,033            |
| Reinsurance receivables                                                  |                                                                               |     91,571                 |                                       |                            |     82,070            |
| Property and equipment                                                   |                                                                               |     27,285                 |                                       |                            |     28,603            |
| Other assets                                                             |                                                                               |                                      |     27,488                  |                            |                                 |     19,550       |
| Separate account assets                                                  |                                                                               |   420,393                            |                                       |                            |    400,749                 |
|                                                                     |                                                                               |                                      | Total assets                               | $                               | 3,677,737                            |                            | $                         | 3,716,828                            |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
| **LIABILITIES**                                                          |                                                                               |                                      |                                       |                            |                                 |                            |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
| Future policy benefits                                                   | $                                                                                  |    565,200                      |                                       | $                               |    566,804                 |
| Policyholder account balances                                            |                                                                               | 1,764,119                                 |                                       |                            | 1,837,330                            |
| Policy and contract claims                                               |                                                                               |      22,156           |                                       |                            |      22,194      |
| Other policyholder funds                                                 |                                                                               |      93,437      |                                       |                            |      77,658      |
| Notes payable                                                            |                                                                               |                                      |        7,200      |                            |                                 |      11,500      |
| Income taxes                                                             |                                                                               |                                      |      17,715            |                            |                                 |      14,743 |
| Other liabilities                                                        |                                                                               |                                      |   103,116                             |                            |                                 |    101,546            |
| Separate account liabilities                                             |                                                                               |    420,393                      |                                       |                            |    400,749                 |
|                                                                     |                                                                               |                                      | Total liabilities                          |                            | 2,993,336                            |                            |                      | 3,032,524                            |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
| **STOCKHOLDERS' EQUITY**                                                 |                                                                               |                                      |                                       |                            |                                 |
| Common stock, par value $1.25 per share                                  |                                                                               |                                      |                                       |                            |                                 |
|                                                                     | Authorized 36,000,000 shares,                                                      |                                      |                                       |                            |                                 |                            |
|                                                                     |                                                                               |                                      | issued 18,496,680 shares                   |                            |    23,121                  |                            |                      |    23,121                  |
| Additional paid in capital                                               |                                                                               |     30,244                 |                                       |                            |    25,852                  |
| Retained earnings                                                        |                                                                               |                                      |   783,175                        |                            |                                 |  781,884                   |
| Accumulated other comprehensive loss                                     |                                                                               |   (22,853)                      |                                       |                            |  (26,110)                       |
| Treasury stock, at cost (2007 - 6,731,643 shares;                        |                                                                               |                                      |                                       |                            |                                 |
|                                                                     | 2006 - 6,641,183 shares)                                                           |                                      | (129,286)                                  |                            |                                 | (120,443)                       |
|                                                                     |                                                                               |                                      | Total stockholders' equity                 |                            |   684,401                       |                            |                      |   684,304                       |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |
|                                                                     |                                                                               |                                      | Total liabilities and stockholders' equity | $                               | 3,677,737                            |                            | $                         | 3,716,828                            |
|                                                                     |                                                                               |                                      |                                       |                            |                                 |                            |                      |                                 |   |

 

See            accompanying Report of Independent Registered Public Accounting Firm.

 

**-81-** 

 

|                                                                      |                                        |                     |                        |                   |                     |                     |   |    | Schedule II |
|---------------------------------------------------------------------------|---------------------------------------------|--------------------------|-----------------------------|------------------------|--------------------------|--------------------------|--------|---------|-------------|
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    | (continued) |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| **KANSAS CITY LIFE INSURANCE COMPANY**                                    |
| **CONDENSED FINANCIAL INFORMATION OF                        REGISTRANT**  |
| **STATEMENTS OF INCOME**                                                  |
| (amounts in thousands)                                                    |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
|                                                                      |                                        |                     |                        | Year Ended December 31 |
|                                                                      |                                        |                     |                        | 2007                   |                     | 2006                     |   | 2005    |
| **REVENUES**                                                              |                                        |                     |                        |                   |                     |                     |   |    |
| Insurance revenues:                                                       |                                        |                     |                        |                   |                     |                     |   |    |
|                                                                      | Premiums                                    | $                        | 104,381                     |                   | $                        | 102,430                  |   | $       | 102,942     |
|                                                                      | Contract charges                            |                     |   91,154               |                   |                     |   93,643            |   |    | 92,530      |
|                                                                      | Reinsurance ceded                           |                     | (37,114)                    |                   |                     | (36,361)                 |   |    | (36,178)    |
|                                                                      |                                        |                     | Total insurance revenues    |                   | 158,421                  |                     |   | 159,712 |        |   | 159,294 |
| Investment revenues:                                                      |                                        |                     |                        |                   |                     |                     |   |    |
|                                                                      | Net investment income                       |                     | 151,587                     |                   |                     | 153,715                  |   |    | 151,579     |
|                                                                      | Realized investment gains                   |                     |     5,653    |                   |                     |     4,759 |   |    | 6,374       |
| Other revenues                                                            |                                        |     5,631 |                        |                   |     5,907 |                     |   | 6,207   |
|                                                                      |                                        |                     | Total revenues              |                   | 321,292                  |                     |   | 324,093 |        |   | 323,454 |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| **BENEFITS AND EXPENSES**                                                 |                                        |                     |                        |                   |                     |                     |   |    |
| Policyholder benefits                                                     |                                        | 119,848                  |                        |                   | 119,210                  |                     |   | 120,350 |
| Interest credited to policyholder account                        balances |                                        |   76,941            |                        |                   |   79,215            |                     |   | 82,338  |
| Amortization of deferred acquisition costs                                |                                        |                     |                        |                   |                     |                     |   |    |
|                                                                      | and value of business acquired              |                     |   21,545               |                   |                     |   25,326            |   |    | 24,276      |
| Operating expenses                                                        |                                        |   66,824            |                        |                   |   70,541            |                     |   | 66,668  |
|                                                                      |                                        |                     | Total benefits and expenses |                   | 285,158                  |                     |   | 294,292 |        |   | 293,632 |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| Income before income tax expense and equity                               |                                        |                     |                        |                   |                     |                     |   |    |
|                                                                      | in undistributed net income of subsidiaries |                     | 36,134                      |                   |                     | 29,801                   |   |    | 29,822      |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| Income tax expense                                                        |                                        | 11,571                   |                        |                   | 7,398                    |                     |   | 7,083   |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| Income before equity in undistributed net                                 |                                        |                     |                        |                   |                     |                     |   |    |
|                                                                      | income of subsidiaries                      |                     | 24,563                      |                   |                     | 22,403                   |   |    | 22,739      |
| Equity in undistributed net income of                        subsidiaries |                                        | 11,098                   |                        |                   | 14,515                   |                     |   | 13,445  |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |   |
| **NET INCOME**                                                            | $                                           | 35,661                   |                        | $                      | 36,918                   |                     | $      | 36,184  |
|                                                                      |                                        |                     |                        |                   |                     |                     |   |    |        |   |

 

 

 

 

 

 

 

 

 

 

See            accompanying Report of Independent Registered Public Accounting Firm.

 

 

 

 

|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     | Schedule II               |
|--------|---------------------------------------------------------------------------|-------------------------------------|--------------------------------------------|-----------------------------------|--------------------------|------------------------------------------|--------------------------------|-------------------------------------|--------------------------|---------------------------|
|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     | (continued)               |
|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     |                      |   |   |
|   | **KANSAS CITY LIFE INSURANCE COMPANY**                                    |
|   | **CONDENSED FINANCIAL STATEMENT OF                        REGISTRANT**    |
|   | **STATEMENTS OF CASH FLOWS**                                              |
|   | (amounts in thousands)                                                    |
|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     |                      |   |   |
|   |                                                                      |                                |                                       |                              |                     | Year Ended December 31                   |
|   |                                                                      |                                |                                       |                              | 2007                     |                                     | 2006                           |                                | 2005                     |
|   | **OPERATING ACTIVITIES**                                                  |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   | Net income                                                                | $                                   |    35,661                        |                              | $                        |   36,918                            |                           | $                                   |   36,184            |
|   | Equity in undistributed net income of                        subsidiaries |                                | (11,098)                                   |                              |                     | (14,515)                                 |                           |                                | (13,445)                 |
|   | Adjustments to reconcile net income to                                    |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   |                                                                      | net cash from operating activities: |                                       |                              |                     |                                     |                           |                                |                     |                      |
|   |                                                                      |                                | Amortization of investment premium         |                              |     5,070 |                                     |                           |     6,625            |                     |                      |     8,999 |
|   |                                                                      |                                | Depreciation                               |                              |     3,288 |                                     |                           |     4,174            |                     |                      |     4,231 |
|   |                                                                      |                                | Acquisition costs capitalized              |                              | (17,027)                 |                                     |                           | (16,257)                            |                     |                      | (16,651) |
|   |                                                                      |                                | Amortization of deferred acquisition costs |                              |    14,829      |                                     |                           |    20,667                 |                     |                      |    19,547 |
|   |                                                                      |                                | Amortization of value of business acquired |                              |     6,717      |                                     |                           |      3,981           |                     |                      |      4,101 |
|   |                                                                      |                                | Realized investment gains                  |                              |   (4,287)      |                                     |                           |   (4,759)                      |                     |                      |    (6,374) |
|   |                                                                      |                                | Changes in assets and liabilities:         |                              |                     |                                     |                           |                                |                     |                      |   |
|   |                                                                      |                                |                                       | Future policy benefits            |                     |  (1,603)                            |                           |                                |   (2,857)           |                      |   |      (228) |
|   |                                                                      |                                |                                       | Policyholder account balances     |                     | (14,870)                                 |                           |                                | (20,901)                 |                      |   |   (9,270) |
|   |                                                                      |                                |                                       | Income taxes payable and deferred |                     |        631 |                           |                                |     4,003 |                      |   |        571 |
|   |                                                                      |                                | Other, net                                 |                              |   (5,012)           |                                     |                           |       (78) |                     |                      |      (583) |
|   |                                                                      |                                | Net cash provided                          |                              |   12,299       |                                     |                           |   17,001                       |                     |                      |    27,082 |
|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     |                      |   |   |
|   | **INVESTING ACTIVITIES**                                                  |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   | Purchases of investments:                                                 |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   |                                                                      | Fixed maturity securities           |                                       | (264,728)                         |                     |                                     | (216,514)                      |                                |                     | (445,907)                 |
|   |                                                                      | Equity securities                   |                                       |  (13,807)                    |                     |                                     |    (8,745)           |                                |                     |    (4,813) |
|   |                                                                      | Mortgage loans                      |                                       |  (50,229)                    |                     |                                     |  (57,618)                 |                                |                     |  (92,458)            |
|   |                                                                      | Real estate                         |                                       |   (4,507)                    |                     |                                     |  (45,005)                 |                                |                     |  (17,804)            |
|   |                                                                      | Other investment assets             |                                       | -                                 |                     |                                     |   (1,458)                 |                                |                     |    (4,129)      |
|   | Sale of investments:                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   |                                                                      | Fixed maturity securities           |                                       |  134,649                     |                     |                                     |    75,888            |                                |                     | 138,640                   |
|   |                                                                      | Equity securities                   |                                       |      3,369    |                     |                                     |      3,531 |                                |                     |     3,746  |
|   |                                                                      | Real estate                         |                                       |    22,445               |                     |                                     |    18,487            |                                |                     |   32,873        |
|   |                                                                      | Other investment assets             |                                       |    25,084               |                     |                                     |      5,155 |                                |                     |   26,800             |
|   | Maturities and principal paydowns of investments:                         |                                |                                       |                              |                     |                                     |                           |                                |
|   |                                                                      | Fixed maturity securities           |                                       |  153,063                     |                     |                                     | 213,330                        |                                |                     | 306,515                   |
|   |                                                                      | Equity securities                   |                                       |      2,806         |                     |                                     |     7,175       |                                |                     |     8,027  |
|   |                                                                      | Mortgage loans                      |                                       |    49,673               |                     |                                     |   42,281                  |                                |                     |   60,993             |
|   | Net additions to property and equipment                                   |                                |   (1,184)                             |                              |                     |  (2,241)                            |                           |                                |  (1,291)            |
|   | Non insurance business sold                                               |                                |   10,104                              |                              |                     | -                                        |                           |                                | -                        |
|   |                                                                      |                                | Net cash provided                          |                              |   66,738            |                                     |                           |  34,266                        |                     |                      |  11,192 |
|   |                                                                      |                                |                                       |                              |                     |                                     |                           |                                |                     |                      |   |   |
|   | **FINANCING ACTIVITIES**                                                  |                                |                                       |                              |                     |                                     |                           |                                |                     |
|   | Proceeds from borrowings                                                  |                                | 285,773                                    |                              |                     |  34,641                             |                           |                                |  32,264             |

 

|   | Repayment of borrowings                                                                              |   | (290,073)                      |   |               | (41,209)                  |   |                | (63,051)                       |
|--------|------------------------------------------------------------------------------------------------------|--------|--------------------------------|--------|--------------------|---------------------------|--------|---------------------|--------------------------------|
|   | Deposits on policyholder account balances                                                            |   |  183,642                  |   |               |  176,533             |   |                |  211,100                  |
|   | Withdrawals from policyholder account                            balances                            |   | (249,543)                      |   |               | (233,859)                 |   |                | (212,969)                      |
|   | Net transfers to separate accounts                                                                   |   |    11,706            |   |               |    16,451       |   |                |      5,213 |
|   | Change in other deposits                                                                             |   |      9,257 |   |               |  (12,721)            |   |                |    (4,678)           |
|   | Cash dividends to stockholders                                                                       |   | (36,420)                       |   |               |  (12,833)            |   |                | (12,876)                       |
|   | Dividends from subsidiaries                                                                          |   |  15,910                   |   |               |     16,630 |   |                |    14,950            |
|   | Net acquisition of treasury stock                                                                    |   |   (4,451)                 |   |               |    (3,288)      |   |                |   (1,349)            |
|   |                                                                                                 |   | Net cash used                  |   | (74,199)           |                      |   |  (59,655)      |                           |   |  (31,396) |
|   |                                                                                                 |   |                           |   |               |                      |   |                |                           |   |   |   |
|   | Increase (decrease) in cash                                                                          |   |    4,838             |   |               |  (8,388)             |   |                |     6,878       |
|   | Cash at beginning of year                                                                            |   |    3,234             |   |               |   11,622             |   |                |     4,744       |
|   |                                                                                                 |   |                           |   |               |                      |   |                |                           |   |
|   |                                                                                                 |   | Cash at end of year            | $      |    8,072 |                      | $      |     3,234 |                           | $ |   11,622 |
|   |                                                                                                 |   |                           |   |               |                      |   |                |                           |   |   |   |
|   | See accompanying Report of Independent Registered Public                            Acocunting Firm. |

 

 

 

 

 

 

**-83-** 

 

|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     | Schedule III |
|--------------------------------------------------------------------------------|--------|------------------|---------------------|---------------------|---------------|----------------------|--------------------------------------------|-------------------|-------------------|--------|--------|--------------------------|--------------|
| **KANSAS CITY LIFE INSURANCE COMPANY AND                        SUBSIDIARIES** |
| **SUPPLEMENTARY INSURANCE INFORMATION**                                        |
| (amounts in thousands)                                                         |
|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     |         |
|                                                                           |   |             |                |                |          | Future policy        |                                       |              |              |   |   |                     |
|                                                                           |   |             |                |                |          | benefits, policy-    |                                       |              |              |   |   |                     |
|                                                                           |   |             |                |                |          | holder account       |                                       |              |              |   |   |                     |
|                                                                           |   |             | Deferred            |                | balances, and |                 |                                       |              |              | Other  |
|                                                                           |   |             | acquisition         |                | policy and    |                 | Unearned                                   |              | policyholder      |
| Segment                                                                        |   | costs            |                | contract claims     |          | premiums             |                                       | funds             |
| December 31, 2007:                                                             |   |             |                |                |          |                 |                                       |              |              |   |   |                     |
| Individual                                                                     |   |             | $                   | 143,298             |          | $                    | 2,718,405                                  |              | $                 | 404    |   | $                        | 102,804      |
| Group                                                                          |   |             |                | -                   |          |                 |        8,407 |              |              | 282    |   |                     | -            |
| Old American                                                                   |   |             |   74,214       |                |          |    244,172 |                                       |              | 211               |   |   |     3,408 |
|                                                                           | Total  |             | $                   | 217,512             |          | $                    | 2,970,984                                  |              | $                 | 897    |   | $                        | 106,212      |
|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     |         |
| December 31, 2006:                                                             |   |             |                |                |          |                 |                                       |              |              |   |   |                     |
| Individual                                                                     |   |             | $                   | 147,281             |          | $                    | 2,827,217                                  |              | $                 | 362    |   | $                        |  84,306 |
| Group                                                                          |   |             |                | -                   |          |                 |        6,054 |              |              | 280    |   |                     | -            |
| Old American                                                                   |   |             |   73,314       |                |          |    243,124 |                                       |              | 214               |   |   |    1,932       |
|                                                                           | Total  |             | $                   | 220,595             |          | $                    | 3,076,395                                  |              | $                 | 856    |   | $                        |  86,238 |
|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     |         |
|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     |         |
|                                                                           |   |             | Policyholder        |                |          |                 |                                       |              |              |   |   |                     |
|                                                                           |   |             | benefits and        |                |          |                 |                                       |              |              |   |   |                     |
|                                                                           |   |             | interest            |                |          |                 |                                       |              |              |   |   |                     |
|                                                                           |   |             | credited to         |                |          |                 |                                       |              |              |   |   |                     |
|                                                                           |   |             | policyholder        |                | Operating     |                 |                                       |              |              |   |   |
| Segment                                                                        |   | account balances |                | expenses*           |          |                 |                                       |              |              |   |
| Year Ended December 31,2007:                                                   |   |             |                |                |          | * Allocations of     |                                       |
| Individual                                                                     |   |             | $                   | 184,415             |          | $                    | 55,283                                     |              | operating         |   |   |                     |
| Group                                                                          |   |             |                |   30,061  |          |                 | 19,309                                     |              | expenses are      |   |   |
| Old American                                                                   |   |             |  43,197        |                |          | 14,266               |                                       | based on a number |
| Intercompany Eliminations1                                                     |   | -                |                |                |   (551)  |                 | of assumptions                             |              |
|                                                                           | Total  |             | $                   | 257,673             |          | $                    | 88,307                                     |              | and estimates,    |   |
|                                                                           |   |             |                |                |          |                 |                                       |              | and the results   |   |
| Year Ended December 31,2006:                                                   |   |             |                |                |          | may change if        |                                       |
| Individual                                                                     |   |             | $                   | 190,251             |          | $                    | 59,952                                     |              | different methods |
| Group                                                                          |   |             |                |    28,596 |          |                 | 19,114                                     |              | were applied.     |   |   |
| Old American                                                                   |   |             |    43,706 |                |          | 14,588               |                                       |              |              |   |   |                     |
| Intercompany Eliminations1                                                     |   | -                |                |                |   (574)  |                 |                                       |              |              |   |   |
|                                                                           | Total  |             | $                   |  262,553       |          | $                    | 93,080                                     |              |              |   |   |                     |         |
|                                                                           |   |             |                |                |          |                 |                                       |              |              |   |   |                     |         |
| Year Ended December 31, 2005:                                                  |   |             |                |                |          |                 |                                       |              |              |   |
| Individual                                                                     |   |             | $                   |  197,931       |          | $                    | 56,638                                     |              |              |   |   |                     |         |
| Group                                                                          |   |             |                |    25,951 |          |                 | 19,220                                     |              |              |   |   |                     |         |
| Old American                                                                   |   |             |   44,456       |                |          | 13,830               |                                       |              |              |   |   |                     |
| Intercompany Eliminations1                                                     |   | -                |                |                |   (544)  |                 |                                       |              |              |   |   |
|                                                                           | Total  |             | $                   | 268,338             |          | $                    | 89,144                                     |

 

 

1 Elimination entries to remove intercompany transactions for            life and accident and health insurance were as follows: operating expenses from the            Individual Insurance segment to arrive at Consolidated Statements of Income.

 

                                                            See accompanying Report of Independent Registered Public Accounting Firm.

 

**-84-** 

 

|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    | Schedule IV |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|-------------------------|--------|------------------------------------|------------------------------|--------|------------------------------------|--------------|--------|--------------------------|---------|--------|--------------------|---------|-------------|
| **KANSAS CITY LIFE INSURANCE COMPANY AND                            SUBSIDIARIES**                                                                                              |
| **REINSURANCE INFORMATION**                                                                                                                                                     |
| Year Ended December 31                                                                                                                                                          |
|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |   |
|                                                                                                                                                                            |   |                                    | Life Insurance Premiums |   |                               | Accident and Health Premiums |
|                                                                                                                                                                            |   | 2007                                    |                    | 2006   |                               | 2005                         |   | 2007                               |         | 2006   |                     | 2005    |
|                                                                                                                                                                            |   |                                    | (in thousands)          |
| Direct                                                                                                                                                                          |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |
| Individual                                                                                                                                                                      | $      |    50,894                     |                    | $      |   48,679                      |                         | $      |   52,404                      |         | $      |      946  |    | $      |   1,130       |    | $           |   1,515 |
| Group                                                                                                                                                                           |   |    10,612                     |                    |   |   10,524                      |                         |   |   10,788                      |         |   | 43,406                   |    |   | 43,492             |    |        | 39,933 |
| Old American                                                                                                                                                                    |   |    64,470                     |                    |   |   66,266                      |                         |   |   68,589                      |         |   |   2,067        |    |   |   2,378       |    |        |   2,737 |
| Intercompany Eliminations1                                                                                                                                                      |   |       (309)    |                    |   |      (322)     |                         |   |      (306)     |         |   |     (242) |    |   |    (252) |    |        |    (238) |
|                                                                                                                                                                            | Total  |                                    | 125,667                 |   |                               | 125,147                      |   |                               | 131,475      |   |                     | 46,177  |   |               | 46,748  |        |   | 43,947 |
|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |   |
| Ceded                                                                                                                                                                           |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |
| Individual                                                                                                                                                                      |   | (41,730)                                |                    |   | (40,024)                           |                         |   | (39,308)                           |         |   |    (914)       |    |   | (1,045)            |    |        |   (1,276) |
| Group                                                                                                                                                                           |   |   (1,849)                          |                    |   |   (2,303)                     |                         |   |   (2,686)                     |         |   | (6,437)                  |    |   | (7,185)            |    |        |   (7,227) |
| Old American                                                                                                                                                                    |   |   (2,712)                          |                    |   |   (3,079)                     |                         |   |   (3,518)                     |         |   | (1,346)                  |    |   | (1,522)            |    |        |   (1,793) |
|                                                                                                                                                                            | Total  |                                    | (46,291)                |   |                               | (45,406)                     |   |                               | (45,512)     |   |                     | (8,697) |   |               | (9,752) |        |   | (10,296) |
|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |   |
| Assumed                                                                                                                                                                         |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |
| Individual                                                                                                                                                                      |   |   3,572                            |                    |   |   3,982                       |                         |   |   4,082                       |         |   | -                        |    |   | -                  |    |        | - |
| Group                                                                                                                                                                           |   |        44 |                    |   |        49 |                         |   |        62 |         |   | -                        |    |   | -                  |    |        | - |
| Old American                                                                                                                                                                    |   | -                                       |                    |   | -                                  |                         |   | -                                  |         |   | -                        |    |   | -                  |    |        | - |
|                                                                                                                                                                            | Total  |                                    |   3,616            |   |                               |   4,031                 |   |                               |   4,144 |   |                     | -       |   |               | -       |        |   | - |
| Net                                                                                                                                                                             | $      | 82,992                                  |                    | $      | 83,772                             |                         | $      | 90,107                             |         | $      | 37,480                   |    | $      | 36,996             |    | $           | 33,651 |
|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |   |
| % of Assumed to Net                                                                                                                                                             |   | 4                                       |                    |   | 5                                  |                         |   | 5                                  |         |   | -                        |    |   | -                  |    |        | - |
|                                                                                                                                                                            |   |                                    |                    |   |                               |                         |   |                               |         |   |                     |    |   |               |    |        |   |   |
| All other information required by this Schedule is shown                            in Note 11-Reinsurance in the Consolidated Financial                            Statements. |

 

 

1 Elimination entries to remove intercompany transactions for            life and accident and health insurance were as follows: insurance revenues from the            Group Insurance segment to arrive at Consolidated Statements of Income.

 

 

                                                             See accompanying Report of Independent Registered Public Accounting Firm.

 

 

 

**-85-** 

 

|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                | Schedule IV |
|--------|--------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------|--------|--------|-------------------------------|--------|--------|-------------------------------|--------|--------|-------------------------------------|-------------|
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                | (continued) |
|   | **KANSAS CITY LIFE INSURANCE COMPANY AND                        SUBSIDIARIES** |
|   | **REINSURANCE INFORMATION**                                                    |
|   | Year Ended December 31                                                         |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           |                                                                                                   |   |   | Life Insurance In Force       |   |
|   |                                                                           |                                                                                                   |   | 2007   |                          | 2006   |   | 2005                          |   |
|   |                                                                           |                                                                                                   |   |   | (in millions)                 |   |
|   |                                                                           | Direct                                                                                                 |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | Individual                                                                                             |   | $      | 25,016                        |   | $      | 24,915                        |   | $      | 24,893                              |        |
|   |                                                                           | Group                                                                                                  |   |   |   3,511                  |   |   |   3,593                  |   |   |   3,130                        |        |
|   |                                                                           | Old American                                                                                           |   |   |      879  |   |   |      890  |   |   |      920        |        |
|   |                                                                           | Total                                                                                                  |   |   | 29,406                        |   |   | 29,398                        |   |   | 28,943                              |        |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | Ceded                                                                                                  |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | Individual                                                                                             |   |   | (13,877)                      |   |   | (13,449)                      |   |   | (12,909)                            |        |
|   |                                                                           | Group                                                                                                  |   |   |   (386)                  |   |   |     (330)      |   |   |     (382)            |        |
|   |                                                                           | Old American                                                                                           |   |   |      (52) |   |   |      (57) |   |   |       (63) |        |
|   |                                                                           | Total                                                                                                  |   |   | (14,315)                      |   |   | 13,836)                       |   |   | (13,354)                            |        |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | Assumed                                                                                                |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | Individual                                                                                             |   |   |   1,729                  |   |   |   1,863                  |   |   |   2,006                        |        |
|   |                                                                           | Group                                                                                                  |   |   | -                             |   |   | -                             |   |   | -                                   |        |
|   |                                                                           | Old American                                                                                           |   |   | -                             |   |   | -                             |   |   | -                                   |        |
|   |                                                                           | Total                                                                                                  |   |   |   1,729                  |   |   |   1,863             |   |   |   2,006                        |        |
|   |                                                                           | Net                                                                                                    |   | $      | 16,820                        |   | $      | 17,425                        |   | $      | 17,595                              |        |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | % of Assumed to Net                                                                                    |   | 10     |                          |   | 11     |                          |   | 11     |                                |
|   |                                                                           |                                                                                                   |   |   |                          |   |   |                          |   |   |                                |        |
|   |                                                                           | All other information required by this Schedule is shown in                        Note 11-Reinsurance |
|   |                                                                           | in the Consolidated Financial Statements.                                                              |   |   |                          |   |

See            accompanying Report of Independent Registered Public Accounting Firm.

 

 

**-86-** 

|                                                                           |                                 |              |   |                        |   |   |             |   |   | Schedule V  |
|--------------------------------------------------------------------------------|--------------------------------------|-------------------|--------|-----------------------------|--------|--------|------------------|--------|--------|-------------|
|                                                                           |                                 |              |   |                        |   |   |             |   |   |        |   |   |   |   |   |   |   |
| **KANSAS CITY LIFE INSURANCE COMPANY AND                        SUBSIDIARIES** |
| **VALUATION AND QUALIFYING ACCOUNTS**                                          |
| (amounts in thousands)                                                         |
|                                                                           |                                 |              |   |                        |   |   |             |   |   |        |   |   |   |   |   |   |   |
|                                                                           |                                 |              |   | Year Ended December 31      |   |   |             |   |   |        |   |
|                                                                           |                                 |              | 2007   |                        | 2006   |   | 2005             |   |   |        |   |   |   |   |
|                                                                           | Mortgage loan valuation account      |              |   |                        |   |   |             |   |   |        |   |   |   |   |   |   |
|                                                                           |                                 | Beginning of year | $      |  3,600                 |   | $      | 3,478            |   | $      |  4,368 |   |   |   |   |   |   |   |
|                                                                           |                                 | Additions         |   | -                           |   |   |    122 |   |   | -           |   |   |   |   |   |   |   |
|                                                                           |                                 | Deductions        |   | (190)                       |   |   | -                |   |   |  (890) |   |   |   |   |   |   |   |
|                                                                           |                                 | End of year       | $      | 3,410                       |   | $      | 3,600            |   | $      | 3,478       |   |   |   |   |   |   |   |
|                                                                           |                                 |              |   |                        |   |   |             |   |   |        |   |   |   |   |   |   |   |
|                                                                           | Allowance for uncollectible accounts |              |   |                        |   |   |             |   |   |        |   |   |   |   |   |   |
|                                                                           |                                 | Beginning of year | $      | 2,966                       |   | $      | 2,975            |   | $      |  2,978 |   |   |   |   |   |   |   |
|                                                                           |                                 | Additions         |   |      22 |   |   |    102 |   |   | 49          |   |   |   |   |   |   |   |
|                                                                           |                                 | Deductions        |   |  (120)                 |   |   | (111)            |   |   |  (52)  |   |   |   |   |   |   |   |
|                                                                           |                                 | End of year       | $      | 2,868                       |   | $      | 2,966            |   | $      |  2,975 |   |   |   |   |   |   |   |
|                                                                           |                                 |              |   |                        |   |   |             |   |   |

See            accompanying Report of Independent Registered Public Accounting Firm.

 

**-87-** 

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING            FIRM**

 

***The Board of Directors and Stockholders***

***Kansas City Life Insurance Company***

 

We have audited the accompanying consolidatedbalance sheets of Kansas City Life Insurance Company and            subsidiaries (the Company) as of December 31, 2007 and 2006, and the relatedconsolidatedstatements of income, stockholders' equity, and cash            flows for each of the years in the three-year period ended December 31, 2007. In            connection with our audits of the consolidated financial statements, we also have            audited financial statement schedules I-V. We also have audited the Company’s            internal control over financial reporting as of December 31, 2007, based oncriteria established in*Internal Control - Integrated Framework*issued by the Committee of Sponsoring Organizations of            the Treadway Commission (COSO). The Company's management is responsible for            theseconsolidatedfinancial statements and financial statement schedules,            for maintaining effective internal control over financial reporting, and for its            assessment of the effectiveness of internal control over financial reporting, included            in the accompanying Management’s Annual Report on Internal Control over Financial            Reporting (Item 9A). Our responsibility is to express an opinion on theseconsolidatedfinancial statements and financial statement schedules,            and an opinion on the Company's internal control over financial reporting based on our            audits.                          We conducted our audits in accordance with the standards of the Public Company            Accounting Oversight Board (United States). Those standards require that we plan and            perform the audits to obtain reasonable assurance about whether the financial            statements are free of material misstatement and whether effective internal control            over financial reporting was maintained in all material respects. Our audits of the            consolidated financial statements included examining, on a test basis, evidence            supporting the amounts and disclosures in the financial statements, assessing the            accounting principles used and significant estimates made by management, and evaluating            the overall financial statement presentation. Our audit of internal control over            financial reporting included obtaining an understanding of internal control over            financial reporting, assessing the risk that a material weakness exists, and testing            and evaluating the design and operating effectiveness of internal control based on the            assessed risk. Our audits also included performing such other procedures as we            considered necessary in the circumstances. We believe that our audits provide a            reasonable basis for our opinions.                          A company's internal control over financial reporting is a process designed to provide            reasonable assurance regarding the reliability of financial reporting and the            preparation of financial statements for external purposes in accordance            with generally accepted accounting principles. A company's internal control over            financial reporting includes those policies and procedures that (1) pertain to the            maintenance of records that, in reasonable detail, accurately and fairly reflect the            transactions and dispositions of the assets of the company; (2) provide reasonable            assurance that transactions are recorded as necessary to permit preparation of            financial statements in accordance with generally accepted accounting principles, and            that receipts and expenditures of the company are being made only in accordance with            authorizations of management and directors of the company; and (3) provide reasonable            assurance regarding prevention or timely detection of unauthorized acquisition, use, or            disposition of the company's assets that could have a material effect on the financial            statements.                          Because of its inherent limitations, internal control over financial reporting may not            prevent or detect misstatements. Also, projections of any evaluation of effectiveness            to future periods are subject to the risk that controls may become inadequate because            of changes in conditions or that the degree of compliance with the policies or            procedures may deteriorate.                          In our opinion, theconsolidatedfinancial statements referred to above present fairly, in            all material respects, the financial position of Kansas City Life Insurance Company and            subsidiaries as of December 31, 2007 and 2006, and the results of its operations and            its cash flows for each of the years in the three-year period ended December 31, 2007,            in conformity with accounting principles generally accepted in the United States of            America. Also, in our opinion, the related financial statement schedules, when            considered in relation to the basic consolidated financial statements taken as a whole,            present fairly, in all material respects, the information set forth therein.                          As discussed in note 1 to the consolidated financial statements, the Company adopted            American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP)            05-01, “*Accounting by Insurance            Enterprises for Deferred Acquisition Costs in Connection with Modifications or            Exchanges in Insurance Contracts*”,            effective January 1, 2007 and Financial Accounting Standards Board Interpretation (FIN)            No. 48, “*Accounting for Uncertainty in            Income Taxes – an interpretation of FASB Statement            109*”, effective January 1,            2007.

 

**-88-** 

 

 

Also in our opinion, Kansas City Life Insurance Company            and Subsidiaries maintained, in all material respects, effective internal control over            financial reporting as of December 31, 2007, based oncriteria established in*Internal Control - Integrated Framework*issued by COSO of the Treadway Commission.

 

(signed) KPMG LLP

 

 

Kansas City, MO

February 29, 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**-89-** 

 

 

**Item 9****.****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND            FINANCIAL DISCLOSURE**

 

|   | Not Applicable. |
|--------|-----------------|

 

| **Item                            9A****.****CONTROLS AND PROCEDURES**  |
|------------------------------------------------------------------------------|

 

As            required by Exchange Act Rule 13a-15(b), Kansas City Life Insurance Company management,            including the Chief Executive Officer and Chief Financial Officer, conducted an            evaluation as of the end of the period covered by this report, of the effectiveness of            the Company’s disclosure controls and procedures as defined in Exchange Act Rule            13a-15(e). Based on that evaluation, the Chief Executive Officer and Chief Financial            Officer concluded that the Company’s disclosure controls and procedures were            effective as of the end of the period covered by this report. As required by Exchange            Act 13a-15(d), Kansas City Life Insurance Company management, including the Chief            Executive Officer and Chief Financial Officer, also conducted an evaluation of the            Company’s internal control over financial reporting to determine whether any            changes occurred during the period covered by this report that have materially            affected, or are reasonably likely to materially affect the Company’s internal            control over financial reporting. Based on that evaluation, there has been no such            change during the period covered by this report.

 

**Management’s Assessment of Internal Control Over Financial            Reporting**

 

Management of Kansas City Life Insurance Company and subsidiaries (the            Company) is responsible for establishing and maintaining effective internal control            over financial reporting. Management of the Company has conducted an assessment of the            Company’s internal control over financial reporting at December 31, 2007, based            on the criteria established in*Internal Control –            Integrated Framework*issued by the Committee of Sponsoring            Organizations of the Treadway Commission (COSO). Based upon that assessment, Management            concluded that the Company’s internal control over financial reporting was            effective at December 31, 2007.

 

**Limitations on the Effectiveness of Controls**

 

The            Company’s internal control over financial reporting is a process designed to            provide reasonable assurance regarding the reliability of financial reporting and the            preparation of financial statements for external purposes in accordance with U. S.            generally accepted accounting principles. The Company’s internal control over            financial reporting includes those policies and procedures that (1) pertain to the            maintenance of records that, in reasonable detail, accurately and fairly reflect the            transactions and dispositions of the assets of the Company; (2) provide reasonable            assurance that transactions are recorded as necessary to permit preparation of            financial statements in accordance with generally accepted accounting principles, and            that receipts and expenditures of the Company are being made only in accordance with            authorizations of management and directors of the Company; and (3) provide reasonable            assurance regarding prevention or timely detection of unauthorized acquisition, use, or            disposition of the Company’s assets that could have a material effect on the            financial statements.

 

Because of its inherent limitations, internal control over financial            reporting cannot provide absolute assurance of achieving financial reporting            objectives, and may not prevent or detect misstatements. Also, projections of any            evaluation of effectiveness to a future period are subject to the risk that controls            may become inadequate because of changes in conditions, or that the degree of            compliance with the policies or procedures may deteriorate.

 

**Item 9B****.****Other Information**

 

|   | Not Applicable. |
|--------|-----------------|

 

**-90-** 

 

 

**PART III**

 

**Item 10****.****DIRECTORS AND EXECUTIVE OFFICERS OF THE            REGISTRANT**

 

The            information appearing under the captions “Information Concerning            Directors,” “Code of Ethics,” “Executive Officers,” and            “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy            Statement relating to our 2008 Annual Meeting of Stockholders, is incorporated herein            by reference.

 

**Item 11****.****EXECUTIVE COMPENSATION**

 

The            information appearing in our Proxy Statement relating to our 2008 Annual Meeting of            Stockholders under the captions “Executive Officer Compensation” is            incorporated herein by reference.

 

**Item 12****.****SECURITY OWNERSHIP BY CERTAIN BENEFICIAL OWNERS AND** 

**MANAGEMENT** 

 

The            information appearing under the captions “Security Ownership by Certain            Beneficial Owners and Management” in our Proxy Statement relating to our 2008            Annual Meeting of Stockholders, is incorporated herein by reference.

 

**Item 13****.****CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The            information appearing under the caption “Certain Relationships and Related            Transactions” in the Company’s Proxy Statement relating to our 2008 Annual            Meeting of Stockholders, is incorporated herein by reference.

 

**Item 14****.****PRINCIPAL ACCOUNTING FEES AND SERVICES**

             

The            information appearing under the caption “Independent Registered Public Accounting            Firm Fees and Services” in the Company’s Proxy Statement relating to our            2008 Annual Meeting of Stockholders, is incorporated herein by reference.

             

**PART IV**

 

**Item 15****.****EXHIBITS, FINANCIAL STATEMENT SCHEDULES**

             

 

|                                                                                                                                                     | Page   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                     | Number |
| (a)(1)Financial                            Statements(See Item 8: Financial Statements                            and Supplementary Data)............... | 40     |
|                                                                                                                                                     |   |
| (a)(2)Supplementary Data and                            Financial Statement Schedules                                                                    |   |

 

|   | Schedules are included at the following                            pages: |
|--------|---------------------------------------------------------------------------|

 

|                                                                                                                                       | Page   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                       | Number |
| I - Summary of Investments - Other than Investments in                            Related Parties, December 31, 2007.....................  | 75     |
| II - Condensed Financial Information of Registrant,                            Years ended December 31, 2007, 2006 and 2005...........     | 76     |
| III - Supplementary Insurance Information, Years ended                            December 31, 2007, 2006 and 2005 .....................   | 79     |
| IV - Reinsurance Information, Years ended December                            31, 2007, 2006 and 2005 .................................... | 80     |
| V - Valuation and Qualifying Accounts, Years ended                            December 31, 2007, 2006 and 2005 .......................     | 82     |

All other schedules are omitted as the required information is            inapplicable or the information is presented in the financial statements or related            notes.

 

|   | (b)Exhibits |
|--------|-------------|

 

 

**-91-** 

 

 

| Exhibit |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|---------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Number: | Basic Documents:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3(a)    | Articles of Incorporation (as Restated in 1986 and                            Amended in 1999). [Filed as                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|         | Exhibit 3(a) to the Company’s 10-Q Report for the                            quarter ended September 30, 1999                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|    | and incorporated herein by reference]                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3(b)    | Bylaws as Amended and Restated October 29, 2007.                            [Filed as Exhibits 3.1 and 3.2 to the Company's 8-K Report for October                            30, 2007 and incorporated herein by reference]                                                                                                                                                                                                                                                                                                                                                      |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4(a)    | Specimen copy of Stock Certificate. [Filed as Exhibit                            4(a) to the Company’s 10-Q Report                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|    | for the quarter ended September 30, 1999 and                            incorporated herein by reference]                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10(a)   | Tenth Amendment, Kansas City Life Deferred Compensation                            Plan. [Filed as Exhibit                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|    | 10(a) to the Company's 10-K Report for 2001 and                            incorporated herein by reference]                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10(b)   | Twenty-eighth Amendment, Kansas City Life Insurance                            Company Savings and Profit Sharing Plan. [Filed as Exhibit 10(b) to the                            Company’s 10-K Report for 2006 and incorporated herein by                            reference, and the Amended and Restated Kansas City Life Insurance                            Company Savings and Profit Sharing Plan filed as Exhibit 10(b) to the                            Company’s 10-K Report for 2001 and incorporated herein by                            reference] |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10(c)   | Fourteenth Amendment, Kansas City Life Employee Stock                            Plan. [Filed as Exhibit 10(c) to the Company’s 10-K Report for                            2006 and incorporated herein by reference, and the Amended and Restated                            Kansas City Life Insurance Company Stock Plan filed as Exhibit 10(c) to                            the Company’s 10-K Report for 2001 and incorporated herein by                            reference]                                                                                  |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10(d)   | Second Amendment, Kansas City Life Excess Benefit Plan.                            [Filed as Exhibit 10(d) to the                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|    | Company’s 10-K Report for 1999 and incorporated                            herein by reference]                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 14      | Kansas City Life Insurance Company Code of Ethics for                            Officers, Directors and Employees                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|    | [Filed as Exhibit 14 to the Company’s 10-K Report                            for 2006 and incorporated herein by reference]

                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 21      | Subsidiaries.

                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 23      | Consent of Independent Registered Public Accounting                            Firm.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31(a)   | Section 302 Certification.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 31(b)   | Section 302 Certification.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32(a)   | Section 1350 Certification.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 99(a)   | Prospectus for Kansas City Life Insurance Company                            Savings and Investment Plan. [Filed as Exhibit 99(a) to the                            Company’s 10-K Report for 2005 and incorporated herein by                            reference]                                                                                                                                                                                                                                                                                                         |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |

 

**-92-** 

 

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities            Exchange Act of 1934, the Registrant has duly caused this report to be signed on its            behalf by the undersigned, thereunto duly authorized.

 

 

**KANSAS CITY LIFE INSURANCE COMPANY**

 

 

| By:/s/ David A.                            Laird |
|--------------------------------------------------|

|   | David A. Laird |
|--------|----------------|

|   | Vice President and Controller |
|--------|-------------------------------|

|   | (Principal Accounting Officer) |
|--------|--------------------------------|

Date:            February 29, 2008

 

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934,            this report has been signed below by the following persons on behalf of the Registrant            and in the capacities and on the dates indicated.

 

 

| By:/s/ R. Philip                            Bixby   | By:/s/ Tracy W.                            Knapp        |
|-----------------------------------------------------|---------------------------------------------------------|
| R. Philip Bixby                                     | Tracy W. Knapp                                          |
| Director; President, Chief                          | Director; Senior Vice President, Finance                |
| Executive Officer and Chairman                      | (Principal Financial Officer)                           |
| of the Board                                        | Date: February 29, 2008                                 |
| (Principal Executive Officer)                       |                                                    |
| Date: February 29, 2008                             | By:/s/ William A.                            Schalekamp |
|                                                | William A. Schalekamp                                   |
| By:/s/ Walter E.                            Bixby   | Director; Senior Vice President,                        |
| Walter E. Bixby                                     | General Counsel and Secretary                           |
| Director and Vice Chairman                          | Date: February 29, 2008                                 |
| of the Board                                        |                                                    |
| Date: February 29, 2008                             | By:/s/ Cecil R.                            Miller       |
|                                                | Cecil R. Miller                                         |
| By:/s/E. Larry Winn,                            Jr. | Director                                                |
| E. Larry Winn, Jr.                                  | Date: February 29, 2008                                 |
| Director                                            |                                                    |
| Date: February 29, 2008                             | By:/s/Webb R.                            Gilmore        |
|                                                | Webb R. Gilmore                                         |
| By:/s/ Richard L.                            Finn   | Director                                                |
| Richard L. Finn                                     | Date: February 29, 2008                                 |
| Director                                            |                                                    |
| Date: February 29, 2008                             |                                                    |

 

 

 

**-93-**