1) Changes in lapse rates and/or sales of Torchmark’s policies as well as levels of mortality, morbidity and utilization of healthcare services that differ from Torchmark’s assumptions;
Health premium income rose just 1% in each of the years and pretax health profits declined by 2% ($3 million) to $164 million in 2003 and 3% ($6 million) in 2002. Premium growth has been limited because of health sales declines in 2001 and 2002, while the high loss ratios on a closed block of cancer business contributed to the lower pretax health profits. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
Torchmark views the benefit of the reduced interest cost resulting from the swap of its fixed-rate interest obligations to variable rates as a reduction in interest costs. In addition to the beneficial impact on earnings from this interest cost differential, GAAP rules also require that all derivatives (including Torchmark’s swaps) must be valued at market value with period-to-period changes reflected in earnings. In accordance with GAAP, these changes in value are treated as realized gains and losses. In 2003, the Securities and Exchange Commission informally interpreted the GAAP rules affecting the reporting of Torchmark’s swap instruments stating that all income and expenses related to non-hedged derivatives must be reported in the same line item as the required fair value adjustment. For this reason, Torchmark reports the interest expense reduction in its Consolidated Statements of Operations as a realized investment gain, not as a reduction in interest expense. Torchmark continues to report this interest savings as a reduction in interest cost in its segment analysis and in management’s discussion, as this is the way Torchmark manages its investment segment.
At December 31, 2003, Medicare Supplement accounted for 65% of Torchmark’s annualized health premium in force. The Medicare Supplement market has become more difficult in recent periods due to regulatory pressures and increased competition, resulting in declines in sales and premium in force for this product. While Medicare Supplement still remains Torchmark’s dominant product in terms of annualized premium, hospital-surgical products have been growing rapidly in their contribution to health premium. This product line has risen from 11% of annualized health premium in force in 2001 to 18% in 2003. Growth in this line has more than offset the declines in Medicare Supplement premium in force in 2003.
Subsequently, United Investors and Waddell & Reed have engaged in litigation regarding the compensation dispute and Waddell’s replacement of the United Investors variable annuities. This litigation has been discussed in detail in prior years’ forms 10-K and 10-Q as well as in Item 3 - Legal Proceedings.
United American general agency and the transfers from United Investor variable policies to fixed annuities due to the deteriorating equity markets. The lower average crediting rate resulted from reductions made by the Company in response to the low interest-rate environment. The 2% increase in interest credited in 2002 resulted from a reduction in the average crediting rate from 5.86% to 5.64%, offsetting the 6% increase in average liabilities.
Included in the Consolidated Statements of Operations as a realized investment gain under the caption “Realized investment losses”.
Torchmark’s cash and short-term investments were $64 million at year-end 2003 and $80 million at year-end 2002. Additionally, Torchmark has a portfolio of marketable fixed and equity securities that are available for sale in the event of an unexpected need. These securities had a fair value of $8.2 billion at December 31, 2003.
The financial strength of Torchmark’s major insurance subsidiaries are also rated by Standard & Poor’s and A.M. Best. Standard and Poor’s lowered the insurance financial strength rating of United Investors to A+ from AA, noting that United Investors was no longer a strategic subsidiary to Torchmark. Also during 2003, A. M. Best upgraded American Income’s insurance financial strength rating to A+ (Superior) from A (Excellent). The following chart presents these ratings for Torchmark’s five largest insurance subsidiaries at December 31, 2003.
Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31, 2003
Investments: Torchmark classifies all of its fixed-maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Policy loans are carried at unpaid principal balances. Mortgage loans are carried at amortized cost. Investments in real estate are reported at cost less allowances for depreciation, which are calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities within twelve months. If a decline in the fair market value of an investment is deemed other than temporary, such impairment is treated as a realized loss and the investment’s cost basis is adjusted to fair market value. Investment income on other-than-temporarily impaired investments which are past due is not recorded until received.
In accordance with SFAS 142, Torchmark tested its goodwill as of December 31, 2001 and annually thereafter for impairment. As a result of the tests, Torchmark’s goodwill was not impaired in any of the periods. Therefore, Torchmark ceased amortizing goodwill in 2002 and thereafter and continues to carry goodwill at the December 31, 2001 balance of $378 million. The amortization of goodwill in 2001 was $12.1 million.
Depreciation expense on property and equipment used in the business was $4.1 million, $4.5 million, and $5.2 million in each of the years 2003, 2002, and 2001, respectively.
In November 2001, Torchmark established two Capital Trusts, which, in turn, sold the trust preferreds in separate public offerings. Capital Trust I sold 5 million shares while Capital Trust II sold 1 million shares at a combined face amount of $150 million (par value). Both trust preferreds pay a quarterly dividend at
Investment segment includes preferred distributions, net of swap benefit, on a pretax basis.
As part of the consideration for the transaction, Torchmark accepted a ten-year collateralized 8% note from Elgin Development in the amount of $12.4 million. Elgin Development made all interest payments and paid down $2.3 million in principal payments through December 31, 2002. As of that date