American Income owns and is the sole occupant of an office building located at 1200 Wooded Acres Drive, Waco, Texas. The building is a two-story structure containing approximately 72,000 square feet of usable floor space. American Income also owns a 43,000 square foot facility located at 1001 Jewell Drive in Waco, which houses a direct response operation.
3) The after-tax gain or loss from the redemption of Torchmark debt as follows: a loss of $2 thousand in 2002, a loss of $277 thousand in 2001, and a gain of $202 thousand in 2000;
The redemption of Torchmark’s debt and MIPS are discussed under the caption Capital Resources beginning on page 34 of this report. Because of Torchmark’s adoption in 2003 of Statement of Financial Accounting Standards No. 145 (SFAS 145) which amends certain previously issued accounting rules, Torchmark will include gains and losses on the redemption of its debt and preferred securities as a component of realized gains and losses in future income statements. Prior periods will be restated for comparability.
The following table is a summary of Torchmark’s net operating income by source.
Net investment income rose 5% to $519 million in 2002. In 2001, net investment income increased 4% to $492 million after having increased 6% in 2000. On a tax-equivalent basis, in which the yield on tax-exempt securities is adjusted to produce a yield equivalent to the pretax yield on taxable securities, investment income rose 5% in 2002. Tax-equivalent investment income rose 3% in 2001 and increased 5% in 2000. The increase in both 2002 and 2001 was caused by the growth in mean invested assets, which rose 5% during each year to $6.9 billion in 2001 and $7.3 billion in 2002. Mean invested assets are computed on the basis of book value. The average tax-equivalent yield on the portfolio stabilized in 2002 at 7.16%. The average yield declined approximately 14 basis points during 2001 to 7.17% from 7.31%, since rates have generally declined on investments acquired during this period. This decline in yield partially offset the benefit to net investment income from the larger asset base in 2001. The growth in mean invested assets was achieved in both 2002 and 2001 even though $182 million and $159 million were used to buy back Torchmark stock under its ongoing share repurchase program in 2002 and 2001, respectively.
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. In the past two years, due to the economic downturn and other factors, the securities of many industry sectors especially affected have suffered increased credit risk. As a result, many securities have been downgraded by credit-rating agencies to below-investment grade status. Thus, the likelihood the issuers will honor their securities’ terms has been reduced and the securities’ market values have been impaired. As Torchmark continues to invest in corporate bonds with relatively long maturities, credit risk is a concern. Torchmark mitigates this ongoing risk, in part, by only acquiring investment-grade bonds, and also by investigating the financial fundamentals of each prospective issuer. The table below demonstrates the credit rankings of Torchmark’s fixed income portfolio.
The following table illustrates the market risk sensitivity of Torchmark’s interest-rate sensitive fixed-maturity portfolio at December 31, 2002, 2001, and 2000. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of Torchmark’s fixed-maturity portfolio. The data is prepared through a model which incorporates various assumptions and estimates to measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points. It takes into account the effect that special option features such as call options, put options, and unscheduled repayments could have on the portfolio, given the changes in rates. The valuation of these option features is dependent upon assumptions about future interest rate volatility that are based on past performance.
Liquidity of the parent company is affected by the ability of the subsidiaries to pay dividends. The parent receives dividends from subsidiaries in order to meet dividend payments on common and preferred stock, interest and principal repayment requirements on parent-company debt, and operating expenses of the parent company. Dividends from insurance subsidiaries of Torchmark are limited to the greater of statutory net gain from operations, excluding capital gains and losses, on an annual noncumulative basis, or 10% of surplus, in the absence of special approval. Distributions are not permitted in excess of statutory net worth. Subsidiaries are also subject to certain minimum capital requirements. Although these restrictions exist, dividend availability from subsidiaries historically has been and is expected to be more than adequate to meet the cash flow needs for parent company operations. During the year 2003, a maximum amount of $283 million is expected to be available to Torchmark from insurance subsidiaries without regulatory approval.
Torchmark’s ratio of earnings before interest, taxes and discontinued operations to interest requirements was 21.4 times in 2002, compared with 14.5 times in 2001 and 11.3 times in 2000. If realized
Under its share repurchase program, Torchmark continues to make share purchases in the open market when market conditions are favorable. In 2002, Torchmark acquired 4.8 million shares at a cost of $182 million. Purchases of 7.8 million shares at a cost of $303 million were made in 2001 and 6.1 million shares were acquired at a cost of $147 million in 2000. Torchmark plans to continue to make share purchases when prices are attractive.
Torchmark has entered into two loan agreements with First Command, a construction loan agreement and a collateral loan agreement. The construction loan was entered into in 2001 and had an outstanding balance of $19.4 million at December 31, 2002. The loan was made at a rate of 7.55% and is collateralized by a four-story building in Fort Worth, Texas. In addition to the office building as collateral, in the event of default, Torchmark has the right of offset to any commission due First Command. The maximum amount of borrowing allowed on this loan is $22.5 million. Interest is added to the loan balance until the building is completed. The agreement calls for Torchmark to permanently finance the building with a fifteen-year mortgage at a rate of 2.25% over the ten-year treasury rate at inception, but not less than 7%.
As discussed in Note 1 to the consolidated financial statements, Torchmark Corporation and subsidiaries changed its method of accounting for goodwill in 2002, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
Future Policy Benefits: The liability for future policy benefits for universal life-type products according to SFAS 97 is represented by policy account value. The liability for future policy benefits for all other life and health products is provided on the net level premium method based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were appropriate at the time the policies were issued. Assumptions used are based on Torchmark’s experience as adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. If it is determined future experience will probably differ significantly from that previously assumed, the estimates are revised.
In November 2001, Torchmark established two Capital Trusts, which, in turn, sold trust preferred securities (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. Both trust preferreds pay a quarterly dividend at an annual 7 3/4% rate which is equivalent to an annual rate of $1.9375 per share. All dividends are cumulative. The trust preferreds are subject to a mandatory redemption on November 2, 2041, but Torchmark has the option to redeem in part or whole the securities on or after November 2, 2006. All payments by the Capital Trusts regarding the trust preferreds are guaranteed by Torchmark. The Capital Trusts are wholly-owned consolidated subsidiaries of Torchmark. The two offerings resulted in net proceeds of $145 million to the Capital Trusts. The Capital Trusts in turn used the proceeds to buy 7 3/4% Junior Subordinated Debentures from Torchmark in like amount. Torchmark used these proceeds to redeem its outstanding 9.18% monthly income preferred securities (MIPS) in 2001 in the approximate amount of $110 million, with the remaining proceeds used to pay down short-term debt. In a related transaction, Torchmark entered into a ten year swap agreement to exchange a variable rate payment for the 7 3/4% fixed dividend obligation. The variable rate is based on the three-month LIBOR plus 221 basis points and resets each quarter in arrears when payments are made. The variable rate was projected to be 3.60% at December 31, 2002. The swap derivative does not qualify as a hedge for accounting purposes and is carried on the balance sheet at fair market value. The fair market value of the swap agreement was a benefit of $16.2 million at December 31, 2002 and zero at December 31, 2001.
Earnings Per Share: A reconciliation of basic and diluted weighted-average shares outstanding is as follows:
Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2.5 million per life. Life insurance ceded represents 1.2% of total life insurance in force at December 31, 2002. Insurance ceded on life and accident and health products represents .5% of premium income for 2002. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represents 1.9% of life insurance in force at December 31, 2002 and reinsurance assumed on life and accident and health products represents .9% of premium income for 2002.
investments was $704 million, amortized cost was $657 million, and fair market value was $562 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value.
Litigation: Torchmark and its subsidiaries continue to be named as parties to pending or threatened legal proceedings. These lawsuits involve tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. Many of these lawsuits involve claims for punitive damages in state courts of Alabama, a jurisdiction particularly recognized for its large punitive damage verdicts. A number of such actions involving Liberty also name Torchmark as a defendant. In 1999, Alabama enacted legislation limiting punitive damages in non-physical injury cases to the greater of $500,000 or three times compensatory damages. Since this legislation has not undergone scrutiny by appellate courts regarding its constitutionality and a jury’s discretion regarding the amount of compensatory damages (including mental anguish) awarded in any given case is not precisely defined,