Effective May 31, 1995, the Company acquired substantially all of the assets and business operations of SBM. This acquisition was accounted for as a purchase, and the results of operations of the acquired businesses are included in the Company's historical financial information from the date of acquisition. Because 1997 and 1996 include full years of acquired SBM business operations compared to seven months in 1995, the results of operations for 1997, 1996, 1995, and 1994 are not completely comparable. "Historical Integrity Companies" refers to operations, for accounting and reporting purposes, prior to the Company's November 26, 1993 acquisition of the Integrity Companies. The Historical Integrity Companies' results of operations for 1993 are presented for purposes of comparison; however, because of purchase accounting adjustments, a new capital structure and new management team resulting from that acquisition, the Company's results have differed from the results of the Historical Integrity Companies.
(3) Shares and per share amounts have been restated, for all periods presented, to reflect the 706-for-1 stock split that occurred in conjunction with the initial public offering of the Company's common stock.
(4) "Operating earnings" is defined as net income applicable to common shareholders, excluding, net of tax, realized investment gains and losses, non-recurring charges and income from defined benefit pension plan asset management operations which were sold during November 1997.
The Company derives its earnings from the investment spread and fee income generated by the assets it manages. The Company earns a spread between what is earned on invested assets and what is credited to customer accounts with its retail spread products (primarily fixed annuities) and institutional spread products (funding agreements and GICs). The Company receives a fee in exchange for managing customers' deposits, and the customer accepts the investment risk with its retail variable products (variable annuities). The Company believes that market forces and population demographics are producing and will continue to generate strong consumer demand for long-term savings and retirement products, including variable, indexed and fixed annuity products. In addition, the Company expects to benefit from the growing institutional marketplace by increasing penetration in the stable value and fixed income markets and developing new products and applications. Although the Company's core business is developing and managing spread-based investment products, it has also focused on the development of its fee-based variable annuity business in addition to exploring other alternatives to increase the size of its fee-based business, such as expanded offerings of synthetic GICs. Fee-based business is less capital intensive than spread-based business and provides the Company with diversified sources of income.
The following discussion compares the results of operations for the Company for the three years ended December 31, 1997. As the Company acquired substantially all of the assets and business operations of SBM effective May 31, 1995, results for 1996 and 1997 each include a full year of
For certain financial information regarding the Company's business segments, see Note 13 of the consolidated financial statements included herein.
Fee income increased to $24.6 million in 1997 from $17.8 million in 1996. This increase is attributable to variable annuity fees, which are based on the market value of the mutual fund assets supporting variable annuity customer deposits in nonguaranteed separate accounts. Variable annuity fees increased to $14.6 million in 1997 from $10.8 million in 1996 principally due to asset growth from the receipt of variable annuity deposits and from a market-driven increase in the value of existing variable annuity deposits invested in mutual funds. Variable annuity deposits averaged $970.3 million in 1997, an increase from $728.2 million in 1996. In addition, asset management fees earned by ARM Capital Advisors on off-balance sheet assets, primarily related to defined benefit pension plans (and, in 1996 only, fees from the State Bond Mutual Funds which were sold by the Company in December 1996), increased to $8.6 million in 1997 from $5.8 million in 1996, reflecting a significant increase
Amortization of deferred policy acquisition costs related to operations was $10.4 million and $6.8 million in 1997 and 1996, respectively. This increase was primarily the result of growth in the deferred policy acquisition cost asset due to additional sales of retail fixed and variable annuity products. Amortization specifically attributable to variable annuity products increased $1.9 million during 1997. Variable costs of selling and issuing the Company's insurance subsidiaries' products (primarily commissions and certain policy issuance and marketing costs) are deferred and then amortized over the expected life of the contract.
Realized investment gains, which are reported net of related amortization of deferred policy acquisition costs and value of insurance in force, were $3.2 million in 1997 compared to $0.9 million in 1996. Realized investment gains in 1997 includes an estimated loss of $4.0 million related to the write-down to fair value of an investment in a fixed income security. Realized investment gains in 1996 includes an estimated loss of $15.2 million related to the write-down to fair value of an investment in a fixed income security and a gain of $4.5 million, before selling expenses, related to the transfer of the State Bond Mutual Funds management contracts. Other realized investment gains and losses were primarily interest-rate related and attributable to the ongoing management of the Company's fixed maturity securities classified as available-for-sale which can result in period-to-period swings in realized investment gains and losses since securities are sold during both rising and falling interest rate environments. The ongoing management of securities is a significant component of the Company's asset/liability management strategy. The ongoing portfolio management process involves evaluating the various asset sectors (i.e., security types and industry classes) and individual securities comprising the Company's investment portfolios and, based on market yield rates, repositioning holdings from sectors perceived to be relatively overvalued to sectors perceived to be undervalued with the aim of improving cash flows. The Company endeavors to accomplish this repositioning without materially changing the overall credit, asset duration, convexity, and liquidity characteristics of its investment portfolios.
Assets under management as of December 31, 1996 and 1995 were as follows:
* Does not include off-balance sheet assets managed by ARM Capital Advisors for institutional clients and off-balance sheet assets in the State Bond Mutual Funds. Including such assets, total assets under management at December 31, 1996 and 1995 were $7,553.0 million and $5,364.2 million, respectively.
The increase in total assets under management was primarily attributable to an increase in sales of funding agreements and GICs to institutional customers and, to a lesser extent, increased sales of retail variable products.
* Does not include new deposits related to off-balance sheet assets managed by ARM Capital Advisors for institutional clients and the State Bond Mutual Funds. Total retail sales for the years ended December 31, 1996 and 1995 were $342.8 million and $300.9 million, respectively, and total institutional sales for the years ended December 31, 1996 and 1995 were $2,401.5 million and $886.9 million, respectively, including such deposits.
The Company recorded a $5.0 million non-recurring charge in 1996 including $3.2 million related to the move of operations facilities from Columbus, Ohio to Louisville, Kentucky and costs of $1.8 million primarily related to mergers and acquisitions activities that did not result in a transaction.
Income tax expense was $5.2 million and $7.0 million in 1996 and 1995, respectively, reflecting effective tax rates of 18.1% and 37.1%. The lower effective tax rate in 1996 resulted primarily from the recognition of benefits associated with certain deferred tax assets established in connection with the Company's acquisition of the Integrity Companies on November 26, 1993 for which a full valuation allowance was originally provided. These deferred tax benefits are being recognized based on the taxable income generated by the Integrity Companies in the post-acquisition period and projections of future taxable income.
for the State Bond Mutual Funds to Federated Investors for $4.5 million. The State Bond Mutual Funds had aggregate assets of $236.9 million on December 13, 1996.
The Company's cash and investments as of December 31, 1997 are detailed as follows:
through structure. The underlying mortgages of agency CMOs are guaranteed by the U.S. government or U.S. government agencies. Of the Company's non-agency CMO investments at December 31, 1997, 90.2% used mortgage loans or mortgage loan pools, letters of credit, agency mortgage pass-through securities and other types of credit enhancement as collateral. The remaining 9.8% of the non-agency CMOs used commercial mortgage loans as collateral.
The Company manages prepayment exposure on CMO holdings by diversifying not only within the more stable CMO tranches, but across alternative collateral classes such as commercial mortgages and Federal Housing Administration project loans, which are generally less volatile than agency-backed, residential mortgages. Additionally, prepayment sensitivity is evaluated and monitored, giving full consideration to the collateral characteristics such as weighted average coupon rate, weighted average maturity and the prepayment history of the specific collateral. MBSs are subject to risks associated with prepayments of the underlying collateral pools. Prepayments cause these securities to have actual maturities different from those projected at the time of purchase. Securities that have an amortized cost that is greater than par (i.e., purchased at a premium) that are backed by mortgages that prepay faster than expected will incur a reduction in yield or a loss, versus an increase in yield or a gain if the mortgages prepay slower than expected. Those securities that have an amortized cost that is less than par (i.e., purchased at a discount) that are backed by mortgages that prepay faster than expected will generate an increase in yield or a gain, versus a decrease in yield or a loss if the mortgages prepay slower than expected. The reduction or increase in yields may be partially offset as funds from prepayments are reinvested at current interest rates. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. The Company has gross unamortized premiums and unaccreted discounts of MBSs of $44.5 million and $82.7 million, respectively, at December 31, 1997. Although the interest rate environment has experienced significant volatility during 1997, 1996 and 1995, prepayments and extensions of cash flows from MBSs have not materially affected investment income of the Company.
Asset-backed securities ("ABS") are securitized bonds which can be backed by, but not limited to, collateral such as home equity loans, second mortgages, automobile loans and credit card receivables. At December 31, 1997 home equity loan collateral represented 53.8% of the Company's investments in the ABS market. The typical structure of an ABS provides for favorable yields, high credit rating and stable prepayments.
Company's investment portfolio has minimal exposure to real estate, mortgage loans and common equity securities, which represent less than 1% of cash and investments as of December 31, 1997.
At December 31, 1997 the ratings assigned by the NAIC and comparable S&P ratings on the Company's fixed maturity portfolio, and the percentage of total fixed maturity investments classified in each category were as follows:
amortization of deferred policy acquisition costs and value of insurance in force and $2.0 million of deferred income taxes) at December 31, 1996. This change in net unrealized gains on available-for-sale securities for the year ended December 31, 1997 increased reported shareholders' equity by $16.6 million as compared to a decrease of $24.9 million for the year ended December 31, 1996. This volatility in reported shareholders' equity occurs as a result of SFAS No. 115, which requires that available-for-sale securities be carried at fair value while other assets and all liabilities are carried at historical values. At December 31, 1997 and 1996, shareholders' equity excluding the effects of SFAS No. 115 was $287.2 million and $178.3 million, respectively.
Assets held in the Company's guaranteed separate accounts include $1,255.5 million and $258.7 million of cash and investments at December 31, 1997 and 1996, of which approximately 87% and 89% were fixed maturities, respectively. Total guaranteed separate account cash and investments were 99% and 98% investment grade at December 31, 1997 and 1996, respectively. Separate accounts are investment accounts maintained by an insurer to which funds have been allocated for certain policies under provisions of relevant state law. The investments in each separate account are maintained separately from those in other separate accounts and from the general account.
The Company's principal need for liquidity has historically consisted of debt service obligations under its bank financing agreement, dividend payments on its preferred stock, operating expenses not absorbed by management fees charged to its subsidiaries, and corporate development expenditures. The Company is dependent on dividends from Integrity and management and service fee income from the Company's subsidiaries to meet ongoing cash needs, including amounts required to pay dividends on its common and preferred stock.
December 31, 1997. In addition, the Company has access to bank lines of credit totaling $37.0 million at December 31, 1997.
The primary sources of liquidity of the Company's insurance subsidiaries are investment income and proceeds from maturities and redemptions of investments. The principal uses of such funds are benefits, withdrawals and loans associated with customer deposits, commissions, operating expenses, and the purchase of new investments.
The Company develops cash flow projections under a variety of interest rate scenarios generated by the Company. The Company attempts to structure asset portfolios so that the interest and principal payments, along with other fee income, are more than sufficient to cover the cash outflows for benefits, withdrawals and expenses under the expected scenarios developed by the Company. In addition, the Company maintains other liquid assets and aims to meet unexpected cash requirements without exposure to material realized losses during a higher interest rate environment. These other liquid assets include cash and cash equivalents and high-grade floating-rate securities held by both the Company and its insurance subsidiaries.
During the years ended December 31, 1997, 1996 and 1995, the Company met its liquidity needs entirely by cash flows from operating activities and principal payments and redemptions of investments. At December 31, 1997, cash and cash equivalents totaled $228.2 million compared to $110.1 million at December 31, 1996. The Company's aim is to manage its cash and cash equivalents position in order to satisfy short-term liquidity needs. In connection with this management of cash and cash equivalents, the Company may invest idle cash in short-duration fixed maturities to capture additional yield when short-term liquidity requirements permit.
The Company generated cash flows of $216.1 million, $192.9 million and $138.4 million from operating activities during the years ended December 31, 1997, 1996 and 1995, respectively. These cash flows resulted principally from investment income, less commissions and operating expenses. Proceeds from sales, maturities and redemptions of investments generated $3,884.2 million, $2,214.3 million and $1,463.3 million in cash flows during 1997, 1996 and 1995, respectively, which were offset by purchases of investments of $4,782.6 million, $2,772.0 million and $1,506.5 million, respectively. An increase in investment purchases and sales activity during 1997 compared to 1996 reflects the Company's ongoing management of its fixed maturity portfolio which has increased in size due to sales of retail and institutional spread products.
At December 31, 1997, the Company reported an asset for deferred income taxes of $31.0 million on the carrying amount balance sheet. Such amount is net of a valuation allowance of $36.6 million. The net deferred tax asset represents deductible temporary differences and net operating loss carryforwards. Based on historical operating results and projections of future taxable ordinary income, management believes that the net tax benefit recorded will be fully utilized.
The Company has only limited involvement with derivative financial instruments and does not use them for trading purposes. They are used to manage specific interest rate risks and, with respect to the Company's equity-indexed annuity deposits, equity market risks.
The Company believes that inflation will not have a material adverse effect on results of operations. The Company manages its investment portfolios in part to reduce its exposure to interest rate fluctuations. In general, the fair value of the Company's fixed maturities portfolio increases or decreases inversely with fluctuations in interest rates, and the Company's investment income increases or decreases directly with interest rate changes. For example, if interest rates decline, the Company's fixed maturity investments generally will increase in fair value, while investment income will decrease as fixed income investments are sold or mature and proceeds are reinvested at declining rates. The converse will generally be true if interest rates rise.
The Company is currently evaluating, on an ongoing basis, its computer systems and the systems of other companies on which the Company's operations rely to determine if they will function properly with respect to dates in the year 2000 and beyond. These activities are designed to ensure that there is no adverse effect on the Company's core business operations. While the Company believes its planning efforts are adequate to address its Year 2000 concerns, there can be no guarantee that the systems of other companies on which the Company's operations rely will be converted on a timely basis and will not have a material effect on the Company. The cost of the Company's Year 2000 initiatives is not expected to be material to the Company's results of operations or financial condition.