Direct Response consists of two primary components: insert media and direct mail. Insert media targets primarily the adult market. It involves placing insurance solicitations as advertising inserts into a variety of media, such as coupon packets, newspapers, bank statements, and billings. Direct mail focuses primarily on young middle-income households with children. The juvenile life insurance policy is a key product for this group. Not only is the juvenile market an important source of sales, but it also is a vehicle to reach the parents and grandparents of the juvenile policyholders. Parents and grandparents of these juvenile policyholders are more likely to respond favorably to a Direct Response solicitation for life coverage on themselves than is the general adult population. Also, both the juvenile policyholders and their parents are low acquisition-cost targets for sales of additional coverage over time. At this time, we believe that the Direct Response unit is the largest U.S. writer of juvenile direct mail life insurance. We expect that sales to this demographic group will continue as one of Direct Response’s premier markets.
The Liberty Agency’s net sales declined 19% to $36 million in 2011, after also having declined 19% a year earlier. As noted above, in the case of all of our agencies, the size of the agency drives product sales. This agency had 1,345 producing agents at December 31, 2011, compared with 2,001 a year earlier, a decline of 33%. The agent count at Liberty had also declined 19% in 2010 from 2,471. The decrease in agent count has been due in part to the closing of several offices which had low production. In addition, agent compensation issues that arose in 2009 have negatively impacted agent counts. The bonus thresholds proved more difficult for producing agents to meet than anticipated. Management reduced the bonus threshold later in 2009. Also, due to deteriorating first-year persistency, management modified compensation incentives in 2009 to place more emphasis on the persistency of newly issued policies. These changes resulted in the departure of a number of the less productive agents in 2010 and 2011. While these modifications caused a loss of agents, they resulted in improved persistency and margins, and contributed to Torchmark’s overall improvement in life insurance margins.
Annuities. As described in Note 3-Discontinued Operations, we sold our subsidiary United Investors. United Investors was our carrier of variable annuities and a primary carrier of fixed annuities. As a result of the sale, we disposed of approximately 37% of our annuity deposit balance as of December 31, 2010, including all of our variable annuities. Accordingly, we do not expect that annuities will be a significant portion of our business or marketing strategy going forward.
Insurance administrative expenses have trended upwards and rose 2% in 2011, after having increased 4% in 2010. As a percentage of premium, they increased .1% in each successive year to 6.0% in 2011. Employee costs increased 25% in 2010, primarily as a result of unusually high employee health insurance costs in that year. Partially offsetting the increase in 2010 employee costs was a decline in legal costs, as we favorably settled certain previously reserved litigation during 2010. In 2011, however, legal expenses returned to normal levels. Expenses for 2011 correlated more closely by expense component to 2009 expenses, as 2010 expenses reflected the aforementioned unusual items. Parent Company expense declined in 2011 primarily as a result of the decline in certain employee benefit liabilities related to retired employees. Stock compensation expense has risen in each successive year as the value of Torchmark stock has increased, resulting in higher values for grants of stock and options. As stated in Note 14-Business Segments in the Notes to Consolidated financial Statements, management views stock compensation expense as a corporate expense, and therefore treats it as a Parent Company expense.
Investments. We manage our capital resources including investments, debt, and cash flow through the investment segment. Excess investment income represents the profit margin attributable to investment operations. It is the measure that we use to evaluate the performance of the investment segment as described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income less both the required interest attributable to net policy liabilities and the interest cost associated with capital funding or “financing costs.” We also view excess investment income per diluted share as an important and useful measure to evaluate the performance of the investment segment. It is defined as excess investment income divided by the total diluted weighted average shares outstanding, representing the contribution by the investment segment to the consolidated earnings per share of the Company. Since implementing our share repurchase program in 1986, we have used over $5 billion of cash flow to repurchase Torchmark shares after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the foregone earnings on the cash that would otherwise have been invested in interest-bearing assets, but they also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, we believe that excess investment income per diluted share is an appropriate measure of the investment segment.
The largest component of excess investment income is net investment income, which rose 3% to $707 million in 2011. It increased 8% to $685 million in 2010 from $632 million in 2009. Presented in the following chart is the growth in net investment income compared with the growth in mean invested assets.
Parent Company Liquidity. Cash flows from the insurance subsidiaries are used to pay interest and principal repayments on Parent Company debt, operating expenses of the Parent, and Parent Company dividends to Torchmark shareholders. In 2011, the Parent received $790 million of dividends and transfers from its insurance subsidiaries, as compared with $401 million in 2010 and $392 million in 2009. The 2011 dividend included $305 million of additional dividends available as a result of the sale of United Investors. After paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2011 of approximately $672 million, including the $305 million from the sale of United Investors. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2012, it is expected that the Parent Company will receive approximately $470 million in dividends and transfers from subsidiaries, and that approximately $360 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 12-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. As additional liquidity, the Parent held $27 million of cash and short-term investments at December 31, 2011, compared with $63 million a year earlier. The Parent also had available a $51 million receivable from subsidiaries at December 31, 2011.
Capital Resources. Torchmark’s capital structure consists of short-term debt (the commercial paper facility described in Note 11-Debt in the Notes to Consolidated Financial Statements), long-term funded debt, Junior Subordinated Debentures supporting its Trust Preferred Securities, and shareholders’ equity. The Junior Subordinated Debentures are payable to Torchmark’s Capital Trust III which is liable for its Trust Preferred Securities. In accordance with GAAP, these instruments are included in “Due to affiliates” on the Consolidated Balance Sheets. A complete analysis and description of long-term debt issues outstanding is presented in Note 11-Debt in the Notes to Consolidated Financial Statements.
Stock Split: Torchmark declared a three-for-two stock split paid in the form of a 50% stock dividend on all of the Company’s outstanding common stock. The record date for the split was the close of business on June 1, 2011. On July 1, 2011, the payment date, holders of Torchmark common stock as of the record date received one additional share of stock for every two shares held. The Company paid $123 thousand in cash to acquire 2,841 fractional shares as a result of the split. All share and per share amounts have been adjusted to reflect this split for all periods presented in these consolidated financial statements. “Common stock” and “Retained earnings” presented for all prior periods in the accompanying Consolidated Balance Sheet and Consolidated Statements of Shareholders’ Equity have also been retroactively adjusted to reflect this split.
The collateral underlying collateralized debt obligations for which fair values are reported as Level 3 consists primarily of trust preferred securities issued by banks and insurance companies. None of the collateral is subprime or Alt-A mortgages (loans for which the typical documentation was not provided by the borrower).
Torchmark has determined that certain of its holdings in fixed maturity investments were other-than-temporarily impaired during the three years ended December 31, 2011. Included in the impairments were collateralized debt obligations in which the impairment was bifurcated in accordance with accounting guidance. As a result of this guidance, the portion of an impairment considered to be a credit loss is other-than-temporarily impaired and the amount of the credit loss is charged to net income. Any portion of the impairment considered to be temporary is charged to other comprehensive income. The credit loss portion of an impairment is determined as the difference between the security’s amortized cost and the present value of expected future cash flows discounted at the securities’ original effective yield rate. The temporary portion is the difference between this present value of expected future cash flows and fair value (as discounted by a market yield). The expected cash flows are determined using judgment and the best information available to the Company. Inputs used to derive expected cash flows include expected default rates, current levels of subordination, and loan-to-collateral value ratios. Management believes that the present value of future cash flows at the original effective yield is a better measure of valuation, because fair value is based on limited observable market data, and the market for these securities is neither active nor orderly. The following table presents the writedowns recorded due to these impairments in accordance with accounting guidance and whether the writedown was charged to earnings or other comprehensive income.
Torchmark’s entire fixed-maturity and equity portfolio consisted of 1,373 issues at December 31, 2011 and 1,430 issues at December 31, 2010. The weighted-average quality rating of all unrealized loss positions as of December 31, 2011 was BBB-, compared with BBB+ a year earlier. The weighted-average quality ratings are based on amortized cost.
Net periodic pension cost for the defined benefit plans by expense component was as follows:
Trust III is a variable interest entity in which Torchmark is not the primary beneficiary. Therefore, Torchmark is prohibited by accounting rules from consolidating Trust III even though it has 100% ownership, complete voting control, and has guaranteed the performance of Trust III. Accordingly,
No equity awards were cash settled during the three years ended December 31, 2011.
Concentrations of Credit Risk: Torchmark maintains a diversified investment portfolio with limited concentration in any given issuer. At December 31, 2011, the investment portfolio, at fair value, consisted of the following: