Life insurance premium has grown steadily in each of the three years ending December 31, 2009, rising 3% in 2009 to $1.66 billion and also 3% in 2008. Margins as a percentage of premium have also held steady each year at 27% of premium. Life net sales rose 9% in 2009 to $327 million and 13% in 2008 to $298 million. Life insurance segment results are discussed further under the caption Life Insurance.
During the second quarter of 2009, we issued a new debt security, our 9 1/4% Senior Notes, par value $300 million. Funds from this offering were used to repay our 8 1/4% Senior Debentures which matured in the third quarter of 2009 in the amount of $99 million. We also used $175 million to strengthen the capital position of certain of our insurance subsidiaries in the form of capital contributions and surplus notes. The regulatory capital positions of these subsidiaries had been negatively affected by rating-agency downgrades of bonds in their investment portfolios. The subsidiaries in turn invested these funds in investment-grade fixed maturities. More information on these transactions can be found in Note 10-Debt in the Notes to Consolidated Financial Statements and in our discussion of Capital Resources in this report.
Life Insurance. Life insurance is our largest insurance segment, with 2009 life premium representing 62% of total premium. Life underwriting income before other income and administrative expense represented 72% of the total in 2009. Additionally, investments supporting the reserves for life products result in the majority of excess investment income attributable to the investment segment.
The Direct Response operation accounted for 32% of our life insurance premium during 2009, the largest of any distribution group. Life premium for this channel rose 5% in 2009 and 6% in 2008. Net sales rose 7% in 2009 to $132 million after an 8% gain in 2008 to $123 million. First-year collected premium increased 6% in 2009 to $85 million after a 5% gain in 2008.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 4% in 2009 to $447 million after also rising 4% in 2008. As a percentage of life insurance premium, gross margins have been stable each year at 27%. Margin growth in all periods was primarily the result of premium growth.
Health Insurance. Health products sold by Torchmark insurance companies consist of supplemental plans that include limited-benefit cancer, accident plans, and hospital/surgical plans sold to people under age 65. We also sell Medicare Supplements to enrollees in the Federal Medicare program, as well as providing coverage under the Medicare Part D prescription drug program. The limited-benefit health plans generally provide a per diem payment for each hospital inpatient day confined, a fixed-amount surgical schedule, outpatient coverage, and other miscellaneous hospital-related charges. They also contain caps on total per-illness benefits. Consumer interest in these products has increased as a result of growing unavailability or lack of affordability of individual major-medical plans and decreased coverage offered by employers. Minimum regulatory loss ratios on these limited-benefit plans are generally lower than those of Medicare Supplement; however, the Medicare Supplement product has historically had slightly higher persistency rates, resulting in both products having approximately the same underwriting margin as a percentage of premium. In recent years, sales of the under-age-65 limited-benefit product have exceeded Medicare Supplement sales, as customers demand for the limited-benefit product increased and price competition and reduced demand for Medicare Supplements dampened sales of that product. However, Medicare Supplement continues to be our largest health product in terms of premium income. Additionally, in the past two years, Medicare Supplement sales have grown steadily in relation to limited-benefit sales, due in part to changes in agent counts in our health distribution groups discussed below.
Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2009.
** Net of deferred acquisition costs, excluding the associated unrealized gains and losses thereon.
Credit Risk Sensitivity. Credit risk is the level of certainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. Approximately 89% of our fixed-maturity holdings at book value are in corporate securities (including redeemable preferred and asset-backed securities). As we continue to invest in corporate bonds with relatively long maturities, credit risk is a concern. We mitigate this ongoing risk, in part, by acquiring investment-grade bonds and by analyzing the financial fundamentals of each prospective issuer. We continue to monitor the status of issuers on an ongoing basis. We also seek to reduce credit risk by maintaining investments in a large number of issuers over a wide range of industry sectors.
Market Risk Sensitivity. Torchmark’s financial securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 93% of the book value of our investments is attributable to fixed-maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio exceeding the book value of the portfolio and increases in interest rates cause the fair value to decline below the book value. Under normal market conditions, we do not expect to realize these unrealized gains and losses because it is generally our investment strategy to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offset the impact of rates on the investment portfolio. However, in accordance with GAAP, these liabilities are not marked to market.
Parent Company Liquidity. An important source of cash flow to the parent company is dividends paid by the insurance subsidiaries noted above. These dividends are used to pay Parent Company dividends on common and preferred stock, interest and principal repayments on Parent Company debt, and operating expenses of the Parent. In 2009, $355 million in dividends were paid to the Parent Company, as compared with $404 million in 2008 and $458 million in 2007. After paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2009 of approximately $281 million. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2010, it is expected that the Parent Company will receive $360 million in dividends from subsidiaries and that approximately $270 million will be available as excess cash flow. Certain restrictions exist on the payment of these dividends. For more information on the restrictions on the payment of dividends by subsidiaries, see the restrictions section of Note 11-Shareholders’ Equity in the Notes to Consolidated Financial Statements. Although these restrictions exist, dividend availability from subsidiaries historically has been sufficient for the cash flow needs of the Parent Company.
Poor economic conditions experienced during 2009 caused the ratings of many bonds in our insurance subsidiaries’ portfolios to be downgraded and have also resulted in increased other-than-
shareholders’ equity, this inconsistency in measurement usually has a material impact on the reported value of shareholders’ equity. If these liabilities were revalued in the same manner as the assets, the effect on equity would be largely offset. Fluctuations in interest rates cause undue volatility in the period-to-period presentation of our shareholders’ equity, capital structure, and financial ratios which would be essentially removed if interest-bearing liabilities were valued in the same manner as assets. More recently, the market value of our fixed maturity portfolio has been depressed as a result of bond market illiquidity resulting in a significant decrease in shareholders’ equity. Because of the long-term nature of our fixed maturities and liabilities and the strong cash flows generated by our insurance subsidiaries, we have the intent and ability to hold our securities to maturity. As such, we do not expect to incur losses due to fluctuations in market value of fixed maturities caused by interest rate changes and temporarily illiquid markets. Accordingly, our management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users prefer to remove the effect of this accounting rule when analyzing our balance sheet, capital structure, and financial ratios.
Impairment of Investments. We continually monitor our investment portfolio for investments that have become impaired in value, where fair value has declined below carrying value. While the values of the investments in our portfolio constantly fluctuate due to market conditions, an other than temporary impairment charge is recorded only when a security has experienced a decline in fair market value which is deemed other than temporary. The policies and procedures that we use to evaluate and account for impairments of investments are disclosed in Note 1-Significant Accounting Policies and Note 3-Investments in the Notes to Consolidated Financial Statements and the discussions under the
Fair Value Measurements: Effective January 1, 2008, the FASB issued and Torchmark adopted new guidance surrounding fair value accounting. This new guidance clarified the definition of fair value, established a hierarchy for measuring fair value, and expanded disclosures about measurement methodology and its effects on fair value. It did not change which assets or liabilities are measured at fair
Torchmark elected to early adopt, as of January 1, 2009, new accounting rules concerning fair value disclosures. The new rules were effective for interim and annual periods ending after June 15, 2009, but early adoption was permitted. The new accounting rules require that the fair value of financial instruments be disclosed in the body or notes of an entity’s financial statements in both interim and annual periods. The new guidance also requires the disclosure of methods and assumptions used to estimate fair values. It does not require comparative disclosures for periods preceding adoption.
proportion to the receipt of premium income. Limited-payment contracts are amortized over the contract period. Universal life-type policies are amortized with interest in proportion to estimated gross profits. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest- sensitive and deposit-balance type products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. For all other products, amortization assumptions are generally not revised once established. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing to determine if there is a premium deficiency. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses taking inflation into account. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, the deficiency would be recognized by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future benefits, as described under the caption Future Policy Benefits.
The investment litigation receipts were included in “Other income” in the Consolidated Statement of Operations. The legal settlement costs in 2008 and 2007 were included in “Other operating expense.” The income tax settlements were included as reductions to “Income taxes.”
During 2009, the Company determined that certain of its holdings in fixed maturities were other-than-temporarily impaired, resulting in writedowns of $160 million ($105 million after tax) on CDOs and corporate bonds. The pretax writedown includes the writedowns of CDOs with a carrying amount of $117 million to a fair value of $13 million, resulting in a total pretax writedown of $104 million. However, in accordance with the newly revised accounting guidance regarding other-than-temporary impairments, $83 million of the writedown was determined to be the result of a credit loss and was charged to earnings while the remaining $21 million was charged to other comprehensive income. The credit loss portion on the CDOs was determined as the difference between the securities’ amortized cost and the present value of expected future cash flows. These expected cash flows were determined using judgment and the best information available to the Company, and were discounted at the securities’ original effective yield rate.
The other supplemental benefit pension plan is limited to a very select group of employees and was closed as of December 31, 1994. It provides the full benefits that an employee would have otherwise received from a defined benefit plan in the absence of the limitation on benefits payable under a qualified plan. This plan is unfunded. Liability for this closed plan was $4 million at December 31, 2009 and $5 million at December 31, 2008. Pension cost for both supplemental defined benefit plans is determined in the same manner as for the qualified defined benefit plans.
Short-term divergences due to rapid market movements are allowed. In recent periods, our holdings in equities declined while our holdings in fixed maturities increased. The $63 million contribution in 2008 and the $15 million contribution in 2009 were invested primarily in fixed maturities. The decline in equity values in both years was also a contributing factor. While equity values have recovered somewhat in 2009, fixed maturity values have also increased. Our asset allocation targets are currently under review.
A summary of restricted stock and restricted stock units granted during each of the years in the three year period ended December 31, 2009 is presented in the table below. Restricted stock holders are entitled to dividends on the stock and holders of restricted stock units are entitled to dividend equivalents. All grants vest over five years.
The following table summarizes the measures of segment profitability as determined in the three preceding tables for comparison with prior periods. The table also reconciles segment profits to net income.
Torchmark also holds funds on behalf of Mr. Baxley as a part of an agreement established in 2006. Interest is paid to Baxley based on a variable rate computed as the average yield for Aa corporate bonds less fifty basis points, which was 4.9% at December 31, 2009. This account balance was $58 thousand at year end 2009 and $42 thousand at year end 2008.