Torchmark believes that its owned and leased properties are suitable and adequate for its current business operations.
(1) Includes 7 3/4% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at each year end in the amount of $154.6 million.
(2) SFAS 115 is an accounting rule requiring fixed maturities to be revalued at fair value each period. The effect of SFAS 115 on diluted equity per share reflects the amount added or (deducted) under SFAS 115 to produce GAAP Shareholders’ equity per share. Please see the explanation and discussion under the caption Capital Resources in Management’s Discussion and Analysis in this report concerning the effect this rule has on Torchmark’s equity.
How Torchmark Views Its Operations: Torchmark is the holding company for a group of insurance companies which market primarily individual life and supplemental health insurance, and to a limited extent annuities, to middle income households throughout the United States. Torchmark views its operations by segments, which are the major insurance product lines of life, health, and annuities, and the investment segment that supports the product lines. Segments are aligned based on their common characteristics, comparability of the profit margins, and management techniques used to operate each segment.
Insurance Product Line Segments. As fully described in Note 13-Business Segments in the Notes to the Consolidated Financial Statements, the product line segments involve the marketing, underwriting, and benefit administration of policies. Each product line is further segmented by the various distribution units that market the insurance policies. Each distribution unit operates in a niche market offering insurance products designed for that particular market. Whether analyzing profitability of a segment as a whole, or the individual distribution units within the segment, the measure of profitability used by management is the underwriting margin, which is:
Investment Segment. The investment segment involves the management of Torchmark’s capital resources, including investments and the management of corporate debt and liquidity. Torchmark’s measure of profitability for the investment segment is excess investment income, which is:
Pretax health profits rose 6% in 2004 to $175 million but rose 1% in 2005 to $177 million. Health premium declined 3% in 2005, as competition in Torchmark’s Medicare Supplement business has continued to dampen health sales. Health premium income rose 1% in 2004. Premium collected in the first policy year rose 13% in 2004, but declined 11% in 2005. Health underwriting margin was flat in 2005 after having improved in 2004. The 2004 improvements were largely a result of reductions in loss ratios on a closed block of cancer business. This block had contributed to declines in margins in recent years prior to 2004. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
In each of the years 2003 through 2005, Torchmark’s net income was affected by certain significant, unusual, and nonrecurring nonoperating items. Torchmark management does not view these items as components of its core operating results because they are not indicative of past performance or future prospects of the insurance operations. A discussion of these items follows.
In 2005, Torchmark recorded an after-tax charge of $955 thousand ($1.5 million pretax) pertaining to litigation. This litigation involved net settlements after expenses primarily in three significant legal matters: Torchmark’s race-distinct mortality/dual-pricing litigation, its class-action cancer case, and the Waddell & Reed litigation. All of these cases relate to litigation arising many years ago and are not considered by management to relate to Torchmark’s current operations. Of this pre-tax amount, $13.5 million is recorded as “Other income” and $15 million is recorded as “Other operating expense” in the 2005 Consolidated Statement of Operations. For more information on these litigation items, see Note 14-Commitments and Contingencies in the Notes to Consolidated Financial Statements. Also in 2005, Torchmark recorded a $16 million settlement benefit from an Internal Revenue Service examination covering several years. More information on this tax settlement is provided in Note 8-Income Taxes in the Notes to the Consolidated Financial Statements. Additionally, a noncash after-tax charge of $369 thousand was recorded as a result of the extension in the term of a previously granted stock option for a senior officer upon retirement. The option extension expense was recorded as administrative expense in the 2005 Consolidated Statement of Operations. The tax settlement reduced tax expense.
Life insurance premium rose 5% to $1.5 billion in 2005 and 6% in 2004 to $1.4 billion. Life insurance products are marketed through several distribution channels. Premium by channel for each of the last three years is as follows.
The Direct Response Group is Torchmark’s leading writer of life insurance. Marketing is conducted primarily through direct mail, but also through co-op mailings, television and consumer magazine advertising, and direct mail solicitations endorsed by groups, unions and associations. This group markets a line of life products primarily to juveniles, their parents, and other adults over age 50. The Direct Response operation accounted for almost 29% of Torchmark’s life insurance premium during 2005, the largest of any distribution group. Life premium rose 10% in 2005 and 10% in 2004.
This group’s focus is on its juvenile life product. 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 insureds. Parents and grandparents of juvenile policyholders are more likely to respond favorably to a solicitation by Direct Response for life coverage on themselves than is the general adult population. Also, both the juveniles and their parents are low-acquisition cost targets for sales of additional coverage over time. Torchmark
Growth in the Liberty Agency’s sales and premium volume are highly dependent on growth in the agency force. However, this agency has experienced volatility in its agency force in the past two years. Liberty had 1,781 producing agents at year end 2005, compared with 1,638 at year end 2004, an increase of 9%. But producing agents declined approximately 15% in 2004, the primary factor in sales declines in both 2004 and 2005. In the latter part of 2003, the agent’s compensation system was restructured to not only reward production and policy persistency, but also to encourage retention of productive agents. However, the recruiting of new agents was neglected, a primary cause in the 2004 decline in agent count. In late 2004, Liberty implemented initiatives similar to those of American Income to recruit new agents, primarily through use of the internet. The 2005 increase in producing agents is believed to have resulted from these efforts. As these agents become more seasoned, they should become more productive. Management believes that the continued recruiting of new agents and the retention of productive agents are critical to growing the sales in controlled agency distribution systems. Management also expects that the increased sales from a larger and more productive agency force will lead to an acceleration in premium growth.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 8% in 2005 to $382 million after rising 9% in 2004. As a percentage of life insurance premium, gross margins have increased slightly each year. Improvements in life margins have resulted from several factors. The previously-mentioned changes in Liberty’s agent compensation system and premium collection method have contributed to notable increases in Liberty’s margins. Additionally, the percentage of American Income premium to total premium continues to grow, and that has caused life margins to increase because that agency’s margins are Torchmark’s highest, exceeding 30% in 2005. Direct Response margins have grown to above 25% in 2005, as it has emphasized sales of its higher-margin juvenile policy.
Health Insurance. Health products sold by Torchmark insurance companies consist of supplemental plans that include limited benefit hospital/surgical plans, cancer, and accident plans sold to people under age 65, as well as Medicare Supplements sold to enrollees in the Federal Medicare program. Health premium represented 40% of Torchmark’s total premium income in 2005, compared with 42% in 2004 and 44% in 2003. Health underwriting margin accounted for 31% of the total, compared with 32% in 2004 and 33% in 2003. These declines in the health percentages indicate the growth in Torchmark’s life segment in relation to the health segment. The following table indicates health insurance premium income by distribution channel for each of the last three years.
relatively unchanged at $323 million in 2005, due to the slow decline in premium from the in force Medicare Supplement block. Health premium for 2004 increased 2% from $316 million in 2003. At year end 2005, the UA Branch office had 2,166 producing agents compared with 1,677 at year end 2004, a 29% increase. This agency had 1,510 agents at year end 2003.
American Income Exclusive Agency, also predominately a life insurance distribution channel, is Torchmark’s fourth largest health insurance distributor based on 2005 premium collected. Its health plans are comprised of various limited-benefit plans for which almost two thirds of the agency’s 2005 health premium was from accident policies. Sales of the health plans by this agency are generally made in conjunction with a life policy being sold to the same customer.
Health insurance underwriting margin before other income and administrative expense increased 1% in 2005 from $175 million to $177 million even though there was a 3% decline in premium. In 2004, health underwriting income rose 6% from $164 million in 2003. As a percentage of premium, underwriting income before other income and administrative expense rose in 2005 to 17.5% and in 2004 to 16.6% from 15.9% in 2003, largely as a result of the reduced loss ratios in the previously-mentioned closed block of cancer business at Liberty. Liberty’s health margins increased $7 million or 36% in 2005, or 17% of health premium. Liberty’s health margins were 11% of premium in 2004 and 6% in 2003.
Annuities. Fixed and variable annuity products are sold on a limited basis by Torchmark subsidiaries. Annuities represented 1% of Torchmark’s 2005 premium revenue and less than 3% of insurance underwriting margin. Torchmark does not emphasize this segment.
Annuities generate earnings from periodic policy fees and charges based on the average account balances, reduced by net policy obligations, less acquisition costs. For fixed annuities, net required interest on reserves is the required interest credited to the accounts and is offset by investment income.
Administrative expenses. Torchmark’s operating expenses, as included in the Other and Corporate Segments, are classified in two categories: insurance administrative expenses and expenses of the parent company. A reconciliation of “Other operating expenses” per the Consolidated Statements of Operations to operating expenses per the segment analysis is as follows:
As noted in the Summary of Operations in this discussion, the costs of settling certain significant litigation in 2005 relate to prior periods and are not considered by management to relate to current insurance operations.
* Revenues include realized gains of $.3 million in 2005 and $22.2 million in 2004, and losses of $3.3 million in 2003. Additionally, revenues in 2005 include a one-time litigation settlement of $13.5 million and revenues in 2003 also include a nonrecurring nonoperating interest income benefit of $4.3 million related to interest received on a tax settlement. Because realized gains and losses and nonoperating items bear no relationship to core operations in the view of management, Torchmark removes the effect of these items from revenue when evaluating expense ratios.
Insurance administrative expenses as a percentage of premium and total operating expenses as a percentage of total revenue rose slightly in both 2005 and 2004. The 2005 increase was primarily due to increased employee cost and a $1.3 million payroll tax charge related to the option exercise and restoration program incurred in 2005, which program is discussed under the caption Capital Resources in this report. Litigation expense in 2004 increased $3.7 million, affecting the 2004 increase.
The largest component of excess investment income is net investment income, which rose 5% to $603 million in 2005. It rose 3% to $577 million in 2004 from $558 million in 2003. Included in 2003 investment income was a nonrecurring interest income item resulting from a tax settlement of $4.3 million pretax. Management excludes nonrecurring items when it views investment income. After excluding this item, investment income rose 4% in 2004. As presented in the following chart, the growth in net investment income in both periods was not as great as the growth in mean invested assets.
Excess investment income is also impacted by financing costs. Financing costs for the investment segment primarily consist of interest on Torchmark’s various debt instruments and are deducted from excess investment income. The table below reconciles interest expense per the Consolidated Statements of Operations to financing costs.
(1) See Note 10-Debt in the Notes to Consolidated Financial Statements for explanation of deconsolidation.
Financing costs rose 62% or $20 million in 2005. They increased 11% or $3 million in 2004. Both the 2005 and 2004 increases primarily resulted from the expiration in September 2004 of a profitable interest-rate swap, on which Torchmark had earned over $3 million per quarter during the first three quarters of 2004 and the full year 2003. The interest-rate swaps are agreements between Torchmark and certain banks for which Torchmark receives from the banks fixed-rate payments that match the coupons that it pays to its debt holders, and makes floating-rate payments based on LIBOR rates to the banks. While new swaps were entered into in August of 2004, the spreads on the new swaps were not as great as the expired swap, and accounted for more than a $2 million reduction in swap benefit per quarter when compared against the expired swap. These new swaps were sold in September, 2005 because of a change in management’s outlook for short-term rates. During the thirteen-month period the swaps were held, Torchmark earned approximately $3.7 million in reduced interest cost. Also affecting financing costs in the latter part of 2004 and the full year 2005 were rising short-term rates. These rising rates reduced the positive effect of Torchmark’s other swaps and increased short-term borrowing costs. A full description of these swaps is disclosed in Note 10-Debt in the Notes to the Consolidated Financial Statements.
Torchmark’s investment strategy is to maintain a positive spread between the yield on investments and the yield on the interest-bearing policy liabilities and debt. It is this positive spread that results in excess investment income. At the same time, Torchmark desires to invest predominately in investment-grade corporate fixed maturities. In prolonged periods of low long-term interest rates, maintaining sufficient spread while limiting new investments to high quality securities becomes more challenging. Torchmark addressed this issue of low long-term rates prior to 2005 by lengthening the maturities of new investment purchases to maximize the yield, and by revising the crediting rates downward on various products. Even though yields on new long-term investments declined, there was still a significant spread of long-term yields over short-term yields.
However, the lower long-term interest rates combined with rising short-term rates experienced in late 2004 and 2005 have restricted the growth of excess investment income. As the yield curve flattened, with rising short-term rates but with no meaningful change in long-term rates, compensation for investing long-term has been significantly diminished. Therefore, in mid-2005, Torchmark revised its investment strategy to shorten the maturity of most new investments, while maintaining its policy to acquire only investment grade securities. The Company believes that investing in shorter-term maturities is the best strategy because the reduced spreads between long and short maturities are not enough to justify investing solely in long-term bonds. The lower yields could result in reduced excess investment income spreads over the short-term.
Torchmark continues to invest exclusively in investment-grade bonds. As previously discussed, Torchmark attempted to maximize yield on new investments in the low-interest environment in 2003, 2004, and early 2005 by lengthening maturities. As a result, the average life of new fixed maturity acquisitions was 23.4 years in 2004 and 23.1 years in 2003, and the effective annual yield on new investments was 6.47% in 2004 and 6.55% in 2003. In 2005, however, as Torchmark’s investment strategy changed, the effective annual yield on new investments declined to 5.90% and the average life fell to 15.3 years. Management believes that because of the long-term, fixed-rate characteristics of its policy liabilities, the Company does not have to strictly match assets and liabilities.
Portfolio Analysis. Torchmark’s emphasis has been on bond investments over alternative investments. Therefore, the relative percentage of Torchmark’s investments by type varies from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2005 with the latest industry data.
For an analysis of Torchmark’s fixed-maturity portfolio by component at December 31, 2005 and 2004, see Note 3-Investments in the Notes to Consolidated Financial Statements.
Torchmark calculates the average life and duration of the fixed-maturity portfolio two ways: (1) based on the same date used to calculate the yield, which is the call date producing the lowest yield (“worst call” date) for callable bonds and the maturity date for all other bonds, and (2) based on the maturity date of all bonds, whether callable or not.
The following table illustrates the market risk sensitivity of Torchmark’s interest-rate sensitive fixed-maturity portfolio at December 31, 2005 and 2004. 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 are 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.
Because Torchmark holds this large and diverse investment portfolio, investments are occasionally sold or called, resulting in a realized gain or loss. These gains and losses occur only incidentally, usually as the result of sales because of deterioration in investment quality of issuers or calls by the issuers. Investment losses are also caused by writedowns due to impairments. Torchmark does not engage in trading investments for profit. Therefore, gains or losses which occur in protecting the portfolio or its yield or which are beyond the control of management are only secondary to Torchmark’s core insurance operations of providing insurance coverage to policyholders. Unlike investment income, they are not considered in determining premium rates or product profitability of Torchmark’s insurance products.
views its operations. For these reasons, Torchmark management removes the effects of realized gains and losses when evaluating its overall insurance operating results.
The following table summarizes Torchmark’s tax-effected realized gains (losses) by component for each of the years in the three-year period ended December 31, 2005.
Accounting rules require Torchmark to value its interest-rate swaps at their fair value at the end of each accounting period. The fair values of these instruments fluctuate with interest rates in financial markets and diminish with the passage of time so that their value will be zero when they ultimately expire. These period-to-period fluctuations can be substantial. However, Torchmark management does not consider these period-to-period fluctuations in value in managing its ongoing operations because their cumulative result will be zero if held to expiration. These temporary unrealized changes in swap values are included as a component of “Realized Investment Gains (Losses)” in the Consolidated Statements of Operations. This fair value adjustment for all swaps on an after-tax basis was a negative $5 million in 2005 and 2004, compared with a negative $10 million in 2003.
Torchmark has historically held its swaps to maturity. However, in the third quarter of 2005, two swaps were sold because of an expectation of higher short-term rates in the future. The swaps sold were the $99 million notional amount related to the 8.25% Senior Debentures and the $100 million notional amount associated with the 7.375% Notes. Proceeds of $239 thousand were received on the sales.
Operating cash inflows significantly exceed cash outflows primarily because life insurers, such as Torchmark, expect to pay the majority of their policyholder benefits in future periods, sometimes many years later. A liability is actuarially computed and recorded for these future benefits which increases as insurance in force grows so that Torchmark can “save” for these future payments. Earnings are charged for the increase in this reserve each period, but there is no corresponding cash outlay. Therefore, cash provided from operations is generally expected to significantly exceed net income in any given period. Cash flows are also generated by the maturities and scheduled repayments of Torchmark’s investment portfolio. Cash flows in excess of immediate requirements are invested to fund future requirements. Available cash flows are also used to repay debt, to buy back Torchmark shares, to pay shareholder dividends, and for other corporate uses. While Torchmark’s cash flows have historically been positive and very strong, a material reduction in cash flow could negatively affect its liquidity.
Cash flows provided from operations increased in each of the three years ended December 31, 2005 over their respective prior year. They were $857 million in 2005, $767 million in 2004, and $740 million in 2003. In addition, Torchmark received $473 million in investment maturities, repayments, and calls in 2005, adding to available cash flows. Such repayments were $574 million in 2004 and $682 million in 2003.
Torchmark has in place a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. For a detailed discussion of this line of credit facility, see the commercial paper section of Note 10-Debt in the Notes to Consolidated Financial Statements.
December 31, 2004 and are indicated as a capital resource to Torchmark under the caption Capital Resources in this report. The 7 3/4% preferred dividends due to the preferred shareholders are funded by Torchmark’s 7 3/4% interest payment on its debt to the trusts. As described in Note 14-Commitments and Contingencies in the Notes to Consolidated Financial Statements, Torchmark has guaranteed the performance of the Capital Trusts to meet its financial obligations to the Trust Preferred shareholders.
During 2005, Torchmark subsidiary American Income entered into an agreement to guarantee certain personal loans of American Income employees and agents with First Command Bank. First Command Bank is a subsidiary of First Command Financial Services, Inc. (First Command) of which Lamar C. Smith is Chairman and CEO. He is also a director of Torchmark. At December 31, 2005, the balance subject to this guarantee was $182 thousand. These guarantees are secured by vested commissions due the employees and agents. See Note 15-Related Party Transactions in the Notes to Consolidated Financial Statements for more information on this guarantee.
As of December 31, 2005, Torchmark had no other significant unconsolidated affiliates and no guarantees of the obligations of third-party entities other than as described above. All of Torchmark’s guarantees, other than the Trust Preferred guarantee and the First Command Bank guarantee, were guarantees of the performance of consolidated subsidiaries, as disclosed in Note 14-Commitments and Contingencies. All of Torchmark’s derivative instruments were recorded at fair value on the balance sheet.
(2) Pension obligations are primarily liabilities in trust funds that are not reflected on Torchmark’s Consolidated Balance Sheets. At December 31, 2005, these pension obligations were $220 million, but there were also assets of $221 million in the pension entities, consisting of investments of $185 million and unrecognized losses of $36 million. The schedule of pension benefit payments covers ten years and is based on the same assumptions used to measure the pension obligations, except there is no interest assumption because the payments are undiscounted. Please refer to Note 9-Postretirement Benefits in the Notes to Consolidated Financial Statements for more information on pension obligations.
(3) Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force and separate account obligations at December 31, 2005. These estimated payments were computed using assumptions for future mortality, morbidity and persistency. The actual amount and timing of such payments may differ significantly from the estimated amounts shown. Management believes that the assets supporting the liability of $8.6 billion at December 31, 2005, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Capital Resources. Torchmark’s capital structure consists of short-term debt (the commercial paper facility described in Note 10-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 Trusts which are 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 10-Debt in the Notes to Consolidated Financial Statements.
Torchmark maintains a significant available-for-sale fixed-maturity portfolio to support its insurance policyholders’ liabilities. Torchmark is required by an accounting rule (SFAS 115) to revalue this portfolio to fair market value at the end of each accounting period. The period-to-period changes in fair value, net of their associated impact on deferred acquisition costs and income tax, are reflected directly in shareholders’ equity. Changes in the fair value of the portfolio result from changes in interest rates in financial markets. While SFAS 115 requires invested assets to be revalued, accounting rules do not permit interest-bearing insurance policy liabilities to be valued at fair value in a consistent manner. Due to the size of Torchmark’s policy liabilities in relation to its shareholders’ equity, this inconsistency in measurement usually has a material impact in 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 Torchmark’s shareholders’ equity, capital structure, and financial ratios which would be essentially removed if interest-bearing liabilities were valued in the same manner as assets. For this reason, Torchmark’s management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users prefer to remove the effect of SFAS 115 when analyzing Torchmark’s balance sheet, capital structure, and financial ratios.
*** Torchmark’s debt covenants require that the effect of SFAS 115 be removed to determine this ratio
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 13.0 times in 2005, compared with 13.8 times in 2004, and 12.6 times in 2003. A discussion of Torchmark’s interest expense is included in the discussion of financing costs under the caption Investments in this report.
In the second quarter of 2005, Torchmark executed a voluntary stock option exercise and restoration program in which 120 directors, employees and consultants exercised vested options of the Company’s common stock and received a lesser number of new options at the current market price. As a result, the Company issued 5.8 million new shares to the participants. However, a substantial number of the new shares were immediately sold through the open market by the participants to cover the option exercise price of their new shares and their related income taxes. As a result of the program, management’s ownership in Torchmark increased and the Company received a significant tax benefit from the exercise of the options. Torchmark received $213 million in proceeds for the exercise price and $37 million in tax benefits, both of which added to shareholder’s equity. However, as previously mentioned, Torchmark generally uses the proceeds of option exercises to repurchase shares on the open market to reduce the dilution caused by option exercises. As a result, the total impact on shareholder’s equity and cash flow from the transaction was immaterial. More information on stock options and this program is found in Note 1-Significant Accounting Policies and in Note 12-Stock Options in the Notes to Consolidated Financial Statements.
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, 2005.
A.M. Best states that it assigns A+ (Superior) ratings to those companies which, in its opinion, have demonstrated superior overall performance when compared to the norms of the life/health insurance industry. A+ (Superior) companies have a superior ability to meet their obligations to policyholders over a long period of time.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement 123R, Share-Based Payment, originally effective for Torchmark as of July 1, 2005 but later deferred by the Securities and Exchange Commission to January 1, 2006. The provisions of this Statement will require Torchmark to record an expense in the financial statements for stock options based on the “fair value” method, whereby a value is assigned to each option granted and to recognize an expense as this value is amortized over the period that the option vests. This expense will be deducted from earnings and earnings per share in addition to the option cost already being reflected in the dilution computation described above.
While restatement of prior periods is permitted, the Statement also permits a “modified prospective” method of adoption, whereby the expense of all unvested options as of January 1, 2006 and options granted after January 1, 2006 are expensed in accordance with the Statement after that date. Torchmark will elect the modified prospective method of adoption.
Impairments of Investments: The FASB issued FASB Staff Position FAS 115-1 and FAS 124-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” effective for Torchmark January 1, 2006. This statement clarifies certain previously unresolved issues regarding accounting for investment impairments. No significant impact is expected from adoption.
While every effort is made to make the best estimate of status and value with the information available regarding an other-than-temporary impairment, it is difficult to predict the future prospects of a distressed or impaired security.
Defined benefit pension plans. Torchmark maintains funded defined benefit plans covering most full-time employees. It also has unfunded nonqualified defined benefit plans covering certain key and other employees. Torchmark’s obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are partially offset by the growth in value of the assets in the funded plans.
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2005
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2005
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries (“Torchmark”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In December 2003, the Financial Accounting Standards Board (FASB) revised its previously issued FASB Interpretation 46 (FIN46R) to clarify the definition of a variable interest and the instructions for consolidating variable interest entities (VIE’s). Primary beneficiaries only are required to consolidate VIE’s. Therefore, a company may have voting control of a VIE, but if it is not the primary beneficiary of the VIE in accordance with FIN46R, it is not permitted to consolidate the VIE. The trusts that are liable for Torchmark’s Trust Preferred Securities meet the definition of VIE’s. However, Torchmark is not the primary beneficiary because its interest is not variable. Therefore, Torchmark is not permitted to consolidate its interest in these trusts, even though it owns 100% of the voting equity of the Trusts. For this reason, Torchmark reports its 7 3/4% Junior Subordinated Debentures due to the Trusts as “Due to Affiliates” each period at its carrying value of $155 million.
Gains and losses realized on the disposition of investments are determined on a specific identification basis. Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark’s net income. Investment income attributable to all other insurance policies and products is included in Torchmark’s net investment income. Net investment income for the years ended December 31, 2005, 2004, and 2003, included $393 million, $370 million, and $351 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocated to insurance policyholders’ liabilities.
Impairment of Investments: In March, 2004, the Emerging Issues Task Force reached a consensus concerning Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). It calls for evaluation of all of Torchmark’s fixed-maturity and equity investments for other-than-temporary impairment each reporting period using a three-step approach. First, evaluate if the investment is impaired (fair value is less than cost or amortized cost). Second, determine whether the impairment is other-than-temporary. While specific procedures are outlined, this step requires
considerable evidence-based judgment as to the ultimate recoverability of amounts due, taking into account the severity and duration of the impairment. An assessment of the ability and intent to hold the security to recovery is also a factor. In the event there is an other-than-temporary impairment, the third step involves a writedown of the cost basis of the security to fair value, which becomes the new cost basis. EITF 03-1 also calls for certain disclosures.
This new accounting rule was to be effective for Torchmark beginning July 1, 2004. However, in the third quarter of 2004, the FASB deferred the effective date of certain portions of this rule until it could be further considered. The portions deferred relate to steps two and three in the impairment analysis above. In November, 2005, the FASB released FASB Staff Position 115-1 and 124-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” providing further guidance on the impairment issues. This document is effective for Torchmark as of January 1, 2006. It essentially retains the three-step model of EITF 03-1, replacing only the step two procedures with guidance previously in effect before EITF 03-1 was issued. This guidance was historically utilized by Torchmark in evaluating other-than-temporary impairment. The disclosures called for by EITF 03-1 were maintained, and appear in Note 3-Investments. At the present time, Torchmark evaluates securities for other-than-temporary impairment as described in Note 3. If a security is determined to be other-than-temporarily impaired, the cost basis of the security is written down to fair value and is treated as a realized loss. Historically, investment income on other-than-temporarily impaired investments which is past due has not been recorded until received. Under the new FSP, the written-down security will be amortized and revenue recognized in accordance with estimated future cash flows.
Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to SFAS 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Variable life and annuity products are also assessed an investment management fee and a sales charge. Life premium includes policy charges of $57.6 million, $60.9 million, and $64.7 million for the years ended December 31, 2005, 2004, and 2003, respectively. Other premium includes annuity policy charges for the years ended December 31, 2005, 2004, and 2003, of $24.5 million, $27.5 million, and $31.2 million, respectively. Profits are also earned to the extent that investment income exceeds policy liability interest requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
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 considered appropriate at the time the policies were issued. Assumptions used are based on Torchmark’s previous experience with similar products. For the majority of Torchmark’s insurance products, the assumptions used were those considered to be appropriate at the time the policies were issued. Once established, assumptions are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions assumed. 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. Additionally, significantly different assumptions could result in materially different reported amounts.
Deferred Acquisition Costs and Value of Insurance Purchased: The costs of acquiring new business are generally deferred and recorded as an asset. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new insurance sales. Additionally, deferred acquisition costs include the value of insurance purchased, which are the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies. Deferred acquisition costs and the value of insurance purchased are amortized in a systematic manner which matches these costs with the associated revenues. Policies other than universal life-type policies are amortized with interest over the estimated premium-paying period of the policies in a manner which charges each year’s operations in 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. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing. 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, this deficiency would be charged to expense as a component of amortization and the asset balance is reduced by a like amount. Different assumptions with regard to deferred acquisition costs could produce materially different amounts of amortization.
Property and Equipment: Property and equipment, included in “Other assets,” is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight line method over the estimated useful lives of these assets which range from two to ten years for equipment and five to forty years for buildings and improvements. Ordinary maintenance and repairs are charged to income as incurred. Impairments, if any, are accounted for in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Original cost of property and equipment was $111 million and $109 million at December 31, 2005 and 2004, respectively. Accumulated depreciation was $83 million and $79 million, respectively, at those same dates. Depreciation expense was $4.8 million in 2005, $4.1 million in 2004, and $4.1 million in 2003.
Torchmark’s pro forma earnings information is presented in the following table. The effects of applying SFAS 123 in the pro forma disclosures are not necessarily indicative of future amounts.
In the second quarter of 2005, Torchmark executed a voluntary option exercise and restoration program whereby directors and employees exercised their vested options and received a lesser number of new grants at the then current market price. All of these options vested during 2005. As a result of this transaction, Torchmark incurred $24.0 million in pro forma after-tax option expense in 2005. Additionally, a grant to executives made in December, 2004 vested in June, 2005. This grant accounted for $7.0 million of 2005 after-tax pro forma expense.
In December 2004, the FASB revised Statement 123, Share-Based Payment (SFAS 123R), originally effective for Torchmark as of July 1, 2005. In April, 2005, the Securities and Exchange Commission deferred the effective date applicable to Torchmark to January 1, 2006. This Statement will require Torchmark to record an expense in the financial statements for stock options based on the “fair value method,” as presented in the pro forma disclosure above. While restatement of prior periods is permitted, the Statement also permits a “modified prospective” method of adoption, whereby the expense of all unvested options as of January 1, 2006 and options granted subsequent to January 1, 2006 are expensed in accordance with the Statement after that date. Torchmark will elect the modified prospective method of adoption. Torchmark plans to continue to use the Black Scholes model to value its options under SFAS 123R.
The new Statement will cause minor changes to the option expense computations for Torchmark going forward from the pro forma expense computations previously reported as follows:
forfeiture credits are estimated at the time of grant instead of being reported when incurred.
Had these rules been in effect in each of the three years ended December 31, 2005, option expense or earnings per share would not have varied materially from the pro forma results presented above. Furthermore, Torchmark does not consider any of these new rules to materially affect option expense in future periods from that presented in the pro forma results, after removing the additional pro forma expense for the options granted in May, 2005 and in December, 2004 described above. The Company presently estimates 2006 after-tax stock option expense to be approximately $4 million or $.04 per diluted share.
Reclassifications: Certain amounts in the consolidated financial statements presented have been reclassified from amounts previously reported in order to be comparable between years. These reclassifications have no effect on previously-reported shareholders’ equity or net income for the periods involved.
(1) Carrying value of affiliated preferred stock limited to 2% of prior year admitted assets
A schedule of fixed maturities by contractual maturity at December 31, 2005 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions.
While all available information is taken into account, it is difficult to predict the ultimately recoverable amount of a distressed or impaired security. As of December 31, 2005, Torchmark has no information available to cause it to believe that any of its investments are other-than-temporarily impaired.
The interest cost reductions resulting from the cash settlements of Torchmark’s interest-rate swaps are netted against realized investment losses.
In 2005, 2004, and 2003, deferred income tax expense was incurred because of certain differences between net income before income taxes as reported on the Consolidated Statements of Operations and taxable income as reported on Torchmark’s income tax returns. As explained in Note 1-Significant Accounting Policies, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
The excess benefit pension plan provides the benefits that an employee would have otherwise received from a defined benefit pension plan in the absence of the Internal Revenue Code’s limitation on benefits payable under a qualified plan. This plan is limited to a select group of employees and was closed as of December 31, 1994. Although this plan is unfunded, pension cost is determined in the same manner as for the funded plans. Liability for the excess benefit plan was $5.8 million at December 31, 2005 and $5.8 million at December 31, 2004.
Plan assets in the funded plans consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair market value. The following table presents the assets of Torchmark’s defined benefit pension plans by component for the years ended December 31, 2005 and 2004.
(2) Junior Subordinated Debentures included in “Due to affiliates” on the Consolidated Balance Sheet.
The amount of debt that becomes due during each of the next five years is: 2006-$382,000; 2007-$0; 2008-$0; 2009-$99,450; 2010-$0; and thereafter-$417,601.
Funded debt: During 2001, Torchmark established two Capital Trusts, which, in turn, sold a total of six million shares of Trust Preferred Securities (trust preferreds) in separate public offerings. The trust
preferreds were issued at a face amount of $150 million (par value), and are junior and subordinated to all other Torchmark debt. They pay a quarterly dividend at an annual rate of 7 3/4% 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 the securities in part or whole at par value on or after November 2, 2006. All payments by the Capital Trusts regarding the trust preferreds are guaranteed by Torchmark. The Capital Trusts in turn used the proceeds to buy 7 3/4% Junior Subordinated Debentures from Torchmark.
(3) Quarterly payments on the second day of Feb., May, Aug., and Nov.
Interest rate swaps: Torchmark has entered into swap agreements in connection with certain debt instruments to swap fixed-rate interest commitments to floating rates. All swaps are carried at fair value and are classified as “Other long-term investments” on the Consolidated Balance Sheets. In August, 2004, Torchmark entered into two new swap agreements exchanging its fixed 8.25% interest rate of the Senior Debentures due 2009 and its fixed 7.375% interest rate of the Notes due 2013 for variable rates.
These swaps were disposed of in September, 2005 for proceeds of $239 thousand. As of September 30, 2004, the swap on the 9.18% Monthly Income Preferred Securities expired. The swap related to the 6 1/4% Senior Notes qualifies as a hedge under accounting rules, as did the sold swap on the 8 1/4% Senior Debentures. Changes in the fair value of these swaps are offset by an adjustment of the carrying value of the related Notes in like amount each period. The following tables summarize selected information about interest rate swaps.
* $200 million of Monthly Income Preferred Securities were redeemed in full in 2001, but the related swap was retained until expiration.
Commercial Paper: On November 18, 2004, Torchmark entered into a credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. The five-year facility matures on November 18, 2009. Interest is charged at variable rates. In addition, Torchmark can request up to $175 million letters of credit to be issued against the facility. The line of credit is further designated as a back-up credit line for a commercial paper program, which cannot exceed $600 million. Torchmark may borrow from the credit facility or issue commercial paper, with total borrowings and commercial paper outstanding not to exceed $600 million. At December 31, 2005, Torchmark had $202 million face amount ($202 million carrying amount) of commercial paper outstanding, $152 million of letters of credit issued, and no borrowings under the line of credit. During 2005, the short term borrowings under the combined facilities averaged approximately $219 million, and were made at an average yield of 3.3%, compared with 1.54% a year earlier. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire $600 million facility at a rate of 8 basis points. For letters of credit issued, there is an issuance fee of 22 basis points and a fronting fee of 7.5 basis points. Additionally, if borrowings on both the line of credit and letters of credit exceed 50% of
There was no capitalized interest during the three years ended December 31, 2005.
Acquisition of Common Shares: Torchmark shares are acquired from time to time through open market purchases under the Torchmark stock repurchase program when it is believed to be the best use of Torchmark’s excess cash flows. Share repurchases under this program were 5.6 million shares at a cost of $300 million in 2005, 5.2 million shares at a cost of $268 million in 2004, and 5.9 million shares at a cost of $225 million in 2003. When stock options are exercised, proceeds from the exercises are generally used to repurchase approximately the number of shares available with those funds, closely simulating the treasury stock method of accounting for dilution. Shares repurchased for dilution purposes were 4.7 million shares costing $255 million in 2005 and 314 thousand shares at a cost of $17 million in 2004. There were no such purchases in 2003.
Stock options to purchase 6.1 million shares, 946 thousand shares, and 3.3 million shares as of December 31, 2005, 2004, and 2003, respectively, are considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
During 2005, Torchmark shareholders approved two new stock option plans, the 2005 Employee Plan for 5,625,000 shares and the 2005 Director Plan for 375,000 shares. Upon approval of these new plans, options previously available for grant under prior plans were cancelled and are no longer available for grant.
As described in Note 1-Significant Accounting Policies, the Company executed a voluntary option exercise and restoration program in the second quarter of 2005 whereby participants exercised vested options and received a lesser number of new options at the then current market price. As a result of this program, 5.8 million options were exercised resulting in that many shares being issued to participants, but 4.7 million shares were immediately sold by participants to pay their exercise price and their withholding taxes. Optionees retained 1.1 million shares and were issued 4.1 million new options granted at a price of $54.77 per Torchmark share.
APB 25 and permitted by SFAS 123. The fair value method requires the use of an option valuation model to value employee stock options, upon which compensation expense is based. As required by SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure, the pro forma earnings giving effect to the fair value method of option accounting has been reported in Note 1. The fair value for Torchmark’s employee stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2005, 2004, and 2003:
Life insurance products include traditional and interest-sensitive whole life insurance as well as term life insurance. Health products are generally guaranteed-renewable and include Medicare Supplement, cancer, accident, long-term care, and limited-benefit hospital and surgical coverages. Annuities include both fixed-benefit and variable contracts. Variable contracts allow policyholders to choose from a variety of mutual funds in which to direct their deposits.
Torchmark holds a sizeable investment portfolio to support its insurance liabilities, the yield from which is used to offset policy benefit, acquisition, administrative and tax expenses. This yield or investment income is taken into account when establishing premium rates and profitability expectations of its insurance products. In holding such a portfolio, investments are sold, called, or written down from time to time, resulting in a realized gain or loss. These gains or losses generally occur as a result of issuer calls, a downgrade in credit quality, or other reasons beyond management’s control. Unlike investment income, realized gains and losses are incidental to insurance operations, and are not considered when setting premium rates or insurance product profitability expectations. While these gains and losses are not relevant to segment profitability or core operating results, they can have a material positive or negative result on net income. For these reasons, management removes realized investment gains and losses when it views its segment operations.
Management has entered into swap derivative contracts to exchange certain of its fixed-rate debt securities to floating rates to reduce its interest cost. For this reason, management views the difference between the floating-rate interest paid and the fixed-rate interest received (the “spread”) as an adjustment to its financing cost in the Investment Segment and has reported it as such in this analysis. In accordance with current accounting rules, this spread on a non-hedged swap must be included in the same line item as the swap’s change in fair value each period. Because of this rule, Torchmark includes the spread on all
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 $2.0 million per life. Life insurance ceded represents 1.2% of total life insurance in force at December 31, 2005. Insurance ceded on life and accident and health products represents .5% of premium income for 2005. 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.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $5.6 million in 2005, $5.2 million in 2004, and $4.7 million in 2003. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2005 were as follows: 2006, $3.7 million; 2007, $2.7 million; 2008, $2.1 million; 2009, $1.6 million; 2010, $1.5 million and in the aggregate, $15.0 million.
Low-Income Housing Tax Credit Interests: As described in Note 1, Torchmark has committed to invest $122 million in entities which provide certain tax benefits. As of December 31, 2005, Torchmark remained obligated under these commitments for $65.8 million, of which $44.3 million is due in 2006, $15.1 million in 2007, and $6.4 million in 2008.
Concentrations of Credit Risk: Torchmark maintains a highly diversified investment portfolio with limited concentration in any given region, industry, or economic characteristic. At December 31, 2005, the investment portfolio, at fair value, consisted of the following:
Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Corporate debt and equity investments are made in a wide range of industries. At December 31, 2005, 2% or more of the portfolio was invested in the following industries:
Trust Preferred Securities: Torchmark entered into a performance guarantee for the obligations of the Torchmark Capital Trusts I and II when the trust preferred securities were issued by those trusts. It guarantees payment of distributions and the redemption price of the securities until the securities are redeemed in full, or all obligations have been satisfied should one or both of the Capital Trusts default on an obligation. The total redemption price of the trust preferred securities is $150 million.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks. The letters of credit were issued by TMK Re, Ltd., a wholly-owned subsidiary, to secure TMK Re, Ltd.’s obligation for claims on certain policies reinsured by TMK Re, Ltd. that were sold by other Torchmark insurance companies. These letters of credit facilitate TMK Re, Ltd.’s ability to reinsure the business of Torchmark’s insurance carriers. The agreement is a five-year contract expiring in 2009. The maximum amount of letters of credit available is $175 million. Torchmark (parent company) would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. At December 31, 2005, $152 million of letters of credit were outstanding.
Agent Receivables: Torchmark issued a guarantee to an unaffiliated third party, which has purchased certain agents’ receivables of Torchmark’s wholly-owned subsidiary American Income Life Insurance Company. The guarantee covers all obligations and recovery of capital to the third party under the receivables purchase agreement up to a maximum amount of $95 million. Under the terms of the revolving purchase arrangement, the third party has purchased the agents’ receivables and receives the earned commissions as they are applied to the balance. The term of the guarantee corresponds with the purchase arrangement, which is annually renewable. Torchmark would be liable to the extent that future commission collections were insufficient to repay the purchased amount. As of December 31, 2005, the present value of future commissions substantially exceeded the purchased balance.
Equipment leases: Torchmark has guaranteed performance of two subsidiaries as lessees under leasing arrangements for aviation equipment. The leases commenced in 2003 for lease terms of approximately 10 years. Lessees have certain renewal and early termination options, however. At December 31, 2005, total remaining undiscounted payments under the leases were approximately $6.2 million. Torchmark (parent company) would be responsible for any subsidiary obligation in the event the subsidiary did not make payments or otherwise perform under the terms of the lease.
Many of these lawsuits involve claims for punitive damages in state courts of Alabama and Mississippi. Torchmark’s management recognizes that large punitive damage awards continue to occur bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly Alabama and Mississippi, creating the potential for unpredictable material adverse judgments in any given punitive damage suit. As of December 31, 2005, Liberty was a party to approximately 76 active lawsuits (which included no employment-related cases and excluded interpleaders), 61 of which were Alabama proceedings and 4 of which were Mississippi proceedings in which punitive damages were sought.
The previously-reported December 5, 2005 trial date fixed by the U.S. District Court for Moore was reset by that Court to January 18, 2006. On January 18, 2006, all parties to Moore submitted a Joint Motion for Preliminary Approval of Settlement and a Stipulation and Agreement of Compromise and Settlement in that case to the District Court. After a hearing, the District Court entered an Order Preliminarily Approving Proposed Settlement on January 25, 2006. In the Order, the District Court preliminarily approved the Proposed Settlement Agreement; conditionally certified a settlement class defined as “All black Americans who have (or had at the time of the policy’s termination) an ownership or other legal interest in an industrial life insurance policy or burial policy issued by Liberty National Life Insurance Company, or one of its former subsidiaries, Service Insurance Company of Alabama, or Burial Service Insurance Company of Alabama on or before January 10, 1966, at a higher rate than similar plans offered to similarly situated white Americans”; certified the class representatives and class counsel; found that the claims in the case were primarily equitable and that the primary relief under the proposed Settlement was injunctive and equitable, with incidental monetary relief in the form of restitution not to
exceed $6 million in the aggregate; approved and directed the giving of notice to class members in the manner and form set out in the Proposed Settlement Agreement beginning February 3, 2006; and fixed March 31, 2006 as the date for the fairness hearing. Pursuant to the Order, Liberty commenced dissemination of notice to class members on February 3, 2006. If approved, the Settlement will substantially resolve all class action issues in race-distinct pricing litigation at Liberty, except for certain consolidated individual claims for mental anguish and punitive damages previously asserted by approximately 2,000 individual plaintiffs, which claims are expressly excluded from the proposed Settlement. The Company intends to vigorously defend those claims. Additional information regarding the race-distinct mortality/dual pricing litigation can be found in the Company’s prior Forms 10-K and Forms 10-Q.
Liberty National Life Insurance Company and an unrelated Glendale, California mortuary were named as defendants in a purported class action litigation filed December 8, 2005 in the Superior Court for Los Angeles County, California (Gibson v. Liberty National Life Insurance Company, Case No. BC344178) on behalf of California holders of certain funeral services insurance policies. The plaintiff in Gibson asserts claims for breach of contractual duty to pay a covered claim under a funeral services insurance policy, breach of the implied obligation of good faith and fair dealing by unreasonably failing to pay and/or delaying payments of insurance benefits, fraud, negligent misrepresentation, and unfair business practices in violation of California Business and Professions Code Section 17000 et seq. The plaintiff is seeking unspecified compensatory and general damages, exemplary damages, injunctive and declaratory relief and attorneys’ fees and costs.
As disclosed in Note 14-Commitments and Contingencies, Torchmark subsidiary American Income is a party to an agreement to guarantee certain personal loans of American Income employees and agents with First Command Bank, a subsidiary of First Command. At December 31, 2005, the balance subject to this guarantee was $182 thousand. These guarantees are secured by vested commissions due the employees and agents.
Executive share purchases. On January 3, 2005, two grantor-retained annuity trusts for the benefit of the adult sons of C. B. Hudson, Chief Executive Officer of Torchmark at that time, and of which trusts he serves as trustee, sold 41,470 shares of Torchmark common stock in a privately-negotiated transaction to Torchmark for $2.4 million. The purchases (20,735 shares from each of the trusts) were made at the average of the high and low prices of Torchmark stock on January 3, 2005 ($57.045 per share).
MidFirst Bank. Torchmark has engaged MidFirst Bank as the servicing agent for a portion of Torchmark’s subsidiaries’ commercial mortgages portfolios. George J. Records, a Torchmark director until April 27, 2005, was also an officer, director, and 38.3% beneficial owner of Midland Financial Co., the parent corporation of MidFirst Bank until December 31, 2003. After that date, he was no longer a beneficial owner. Fees paid for MidFirst Bank’s services were $90 thousand in 2004 and $110 thousand in 2003. No fees were paid in 2005.
Baxley. William J. Baxley is a partner in the law firm of Baxley, Dillard, Dauphin, McKnight & Barclift which performs legal services for Torchmark and certain of its subsidiaries. In 1997, Mr. Baxley was loaned $668 thousand on an unsecured basis at a rate of 6.02%. Repayments are made in the form of legal services at customary rates and are applied against the outstanding balance, amortizing the loan with interest over its remaining term. In October, 2001, the terms of the loan were revised and an additional amount of $395 thousand was loaned to Baxley. The interest rate was revised to 5.6% and the term of the loan was extended until July, 2013. The loan is being repaid in accordance with its amortization schedule and all payments are current. At December 31, 2005 and 2004, the outstanding balance of this loan was $572 thousand and $632 thousand, respectively.
Additionally, Liberty loaned Mr. Baxley’s wife $883 thousand secured by a mortgage on a building sold to her in 1997. Interest is charged at a rate of 7.7%. Scheduled cash payments are made to amortize the loan over thirty years. However, there is a balloon payment due at the end of ten years (2007) in the amount of $712 thousand less a credit of $18 thousand if all payments are made timely. To date, all payments have been timely. At December 31, 2005 and 2004, the outstanding balance of this loan was $751 thousand and $772 thousand, respectively.
Torchmark customarily grants options to certain consultants for their services in addition to their fees. Mr. Baxley received Torchmark options in 2005, 2004, and 2003.
The following is a summary of quarterly results for the two years ended December 31, 2005. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.
In 2005, Torchmark recorded settlements on three significant legal matters. The first settlement related to the Waddell & Reed litigation and resulted in $13.5 million of additional revenue in the second quarter. The other two cases were Torchmark’s race-distinct mortality/dual-pricing litigation and its class-action cancer case. These two cases involved charges of $4 million in the second quarter and $11 million in the fourth quarter. The after-tax effect of these items was a positive $6 million in the second quarter and a charge of $7 million in the fourth quarter. Also in the fourth quarter of 2005, Torchmark recorded a $16 million settlement benefit from an Internal Revenue Service examination covering several years. More information on these litigation and tax settlements is provided in Note 8-Income Taxes and Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements.