The principal operations of the insurance subsidiaries are conducted from Kansas City, Missouri; Dallas, Texas; and Columbus, Ohio. United Fidelity, College Life, National Farmers Union and Victory Life operate from approximately 45,000 square feet of leased office space located at 1055 Broadway, Kansas City, Missouri 64105. The property is leased from Broadway Square Partners, a Missouri limited partnership of which a corporation controlled by the Merriman family is a 50% partner. The lease expired on February 28, 1998 and current negotiations are in progress to renew this lease.
Great Southern's operations are conducted from approximately 57,000 square feet of leased office space located at 500 N. Akard, Dallas, Texas 75221. The lease expires in June 2007.
The historical financial information for the five years ended December 31, 1997 and at December 31, 1997, 1996, 1995, 1994 and 1993 has been derived from the audited Consolidated Financial Statements of the Company. The selected consolidated financial data set forth below is qualified in its entirety by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K.
Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company's control and many of which are subject to change. These uncertainties and contingencies could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable developments. Some may be national in scope, such as general economic conditions, changes in tax law and changes in interest rates. Some may be related to the insurance industry generally, such as pricing competition, regulatory developments and industry consolidation. Others may relate to the Company specifically, such as credit, volatility and other risks associated with the Company's investment portfolio. Investors are also directed to consider other risks and uncertainties discussed in documents filed by the Company with the SEC. The Company disclaims any obligation to update forward-looking information. This discussion should be read in conjunction with the accompanying consolidated financial statements and the notes thereto.
The Company's generation of new business increased in each of the three years ended December 31, 1997. Annualized annuity premiums increased significantly as a result of an increase in tax-qualified business written in connection with the Joint Venture arrangement entered into by the Company in 1993. The following table summarizes the Company's sales in terms of annualized premiums: The Company intends to continue its focus on the sale of interest-sensitive life insurance and annuity products through its marketing and distribution systems. In addition, the Company may also pursue selected acquisitions of blocks of life insurance policies and life insurance companies.
In each of the transactions with the Reinsurer, the invested assets related to the reinsured businesses are owned by the Reinsurer. At December 31, 1997, the insurance liabilities associated with these reinsurance transactions totaled $1.4 billion. Results from these reinsurance transactions and the Victory Life Acquisition and Ohio State Acquisition are included in the Company's results of operations from the respective dates of the transactions.
The other operating expenses in the above table include only the direct expenses related to providing administration for the policies and assets of the Acquisitions. The operating expenses shown do not include any allocation of indirect or overhead expenses.
Net realized investment gains. The Company recorded net realized investment gains of $2.9 million in 1997. During 1997, the Company recorded gains of $5.1 million from the sale of three real estate investment properties, which were offset by various other investment losses.
Other Income. Other income increased $8.7 million from $3.6 million in 1996 to $12.3 in 1997. Excluding other income related to the Acquisitions, other income increased $5.4 million from 1996 to 1997. The Company realized a gain of $4.8 million in 1997 from the sale of Loyalty Life Insurance Company ("Loyalty"), a former wholly-owned subsidiary of the Company. Prior to this sale, several of the Company's insurance subsidiaries entered into agreements with Loyalty for the assumption of Loyalty's insurance liabilities. Other income in 1997 includes a servicing fee paid to the Company associated with the reinsurance of 30% of the Ohio State and Investors Guaranty policies.
Amortization expense. Amortization expense increased $14.0 million from $29.7 million in 1996 to $43.7 million in 1997. Excluding the effects of the Acquisitions, amortization expense decreased $4.4 million from 1996 to 1997. Included in amortization expense are adjustments to decrease deferred policy acquisition costs and the cost of business acquired assets of $2.5 million in 1997 and $3.2 million in 1996. These adjustments result from revisions made to the Company's estimate of future gross profits from its interest sensitive life and annuity policies. Under GAAP, deferred policy acquisitions costs and the cost of business acquired assets on interest-sensitive life products are amortized based on the estimated future gross profits of the related policies.
Other operating expenses. Other operating expenses increased $20.3 million to $77.0 million in 1997 from $56.7 million in 1996. Excluding the effects of the Acquisitions, other operating expenses increased $6.1 million from 1996 to 1997. The primary reasons for the increase in operating expenses from 1996 to 1997 are expenses associated with a marketing office opening in California in September 1996, increased depreciation expense in 1997 resulting from purchases of computer equipment in 1996 and 1997, and increased legal and professional fees in 1997.
Management continually evaluates the expected prepayments of the mortgage-backed securities portfolio to more accurately reflect expected paydowns on the securities as market interest rates change. In 1996, interest rates increased, reducing the expected prepayment rate. In 1995, expected prepayments of the portfolio were accelerated as interest rates had declined. As a result of the changes in expected prepayments, amortization of premiums and accretion of discounts were accelerated in 1995, causing an increase in net investment income of $1.3 million in 1995. The decrease in investment income in 1996 resulting from the reduced expected prepayment rate was offset by discounts recognized upon the early repayment of certain of the Company's mortgage loans.
Gain on disposition of partnership interest. In December 1996, the Company liquidated its 50% interest in GSSW in exchange for cash of $22.6 million and 100% interests in several real estate limited partnerships then owned by GSSW resulting in a gain of $15.8 million.
Other income. Other income in 1996 and 1995 included $2.5 million and $1.2 million, respectively, of gains from the sales of blocks of accident and health business owned by the Company.
Policyholder benefits. Policyholder benefits were $49.5 million higher in 1996 than in 1995 as a result of the Acquisitions. Excluding the effects of such Acquisitions, policyholder benefits increased $0.2 million from 1995 to 1996. The Company experienced an unusually high level of death benefits during the first half of 1996, including a small number of policies with very large face amounts which had offsetting benefit reserve releases. These releases, together with lower benefit reserve increases in 1996 resulting from the decreasing traditional premiums, partially offset the increasing policyholder benefits resulting from the increased death benefits.
Amortization expense. Amortization expense increased $3.0 million in 1996 to $29.7 million, including an increase of $2.3 million related to the Acquisitions. Included in amortization expense is an adjustment to decrease deferred policy acquisition costs and the cost of business acquired assets of $3.2 million in 1996 and $4.0 million in 1995. These adjustments result from revisions made to the Company's estimate of future gross profits of its interest sensitive life and annuity policies. Under GAAP, deferred policy acquisitions costs and the cost of business acquired assets on interest-sensitive life products are amortized based on the estimated future gross profits of the related policies.
Interest expense. Interest expense increased $1.7 million to $12.3 million in 1996 from $10.6 million in 1995. Average outstanding indebtness was $133.5 million with an average cost of 9.19% in 1996 compared to average outstanding indebtness of $116.5 million with an average cost of 9.10% in 1995. Average outstanding indebtedness was higher in 1996 than 1995 due to the issuance of $32.9 million of notes in connection with the Victory Life Acquisition in July 1995.
Liquidity. The liquidity needs of Americo, whose principal assets are investments in its insurance subsidiaries, are dependent upon receipt of sufficient funds from its subsidiaries. The cash requirements of Americo consist of debt service requirements on notes payable, amounts due FHC under Advisory and Data Processing Agreements with FHC and its own operating expenses. These cash requirements are met by payments of principal and interest on surplus debentures issued by United Fidelity and dividends from United Fidelity. Americo also receives payments under investment advisory and data processing agreements with the insurance subsidiaries which permit Americo to recover a portion of the amounts paid by it under similar agreements with FHC. On a stand-alone basis, at December 31, 1997, Americo had $12.5 million of cash and cash equivalents and marketable equity securities available for debt service and other corporate requirements.
Americo's credit agreement, which was last amended in February 1997, is a revolving credit facility until December 1999, at which time amounts then outstanding convert into a term loan repayable in six, equal semi-annual installments commencing July 1, 2000. Amounts outstanding under the credit facility bear interest at either a bank prime rate or 7/8% over LIBOR.
The surplus debentures contain restrictions which prevent United Fidelity from making principal and interest payments if such payments reduce United Fidelity's statutory capital and surplus below an amount specified in the surplus debenture agreements. The most restrictive minimum surplus requirement contained in the surplus debentures is $37.5 million; United Fidelity's capital and surplus at December 31, 1997 was $97.7 million. Any future payment of principal or interest on such surplus debentures will be limited by the ability of the subsidiaries of United Fidelity to pay dividends to United Fidelity and may be further limited by United Fidelity's RBC requirements. See "Business: Regulation". The Company does not believe that United Fidelity will have any difficulty in meeting its obligations under these surplus debentures in the foreseeable future.
In order to meet its obligations under the surplus debentures, United Fidelity uses funds generated by its direct and assumed insurance operations and dividends from its insurance subsidiaries. The ability of the insurance subsidiaries to pay dividends is subject to regulatory restrictions. The insurance holding company statutes in each of the states in which the Company's insurance subsidiaries are domiciled regulate payment of dividends by an insurance company to its parent. Generally, without the consent of the state's insurance commissioner, an insurance company may not pay dividends to its parent in excess of the greater of (i) the insurer's prior year statutory net gain from operations, or (ii) 10% of its prior year ending statutory capital and surplus, subject in either case to sufficient earned statutory surplus from which such dividends may be paid. Additionally, an insurance company is required to notify the respective insurance department prior to the payment of ordinary dividends.
The Company has structured its interest-sensitive life insurance and annuity products to include substantial surrender charges so as to reduce the probability of unexpected increases in policy or contract surrenders, which would create a need for increased liquidity. At December 31, 1997, approximately 72% of the reserves for interest-sensitive life insurance products were for policies with surrender charges or otherwise not subject to discretionary withdrawal by the policyholder.
The Company believes that its investment portfolio will allow it to satisfy all existing contractual obligations to policyholders. At December 31, 1997, the Company's investment portfolio included cash and short-term investments totaling $36.9 million, marketable equity securities totaling $78.9 million as well as $359.7 million in U.S. Treasury and government securities, mortgage-backed securities and asset-backed securities and $401.4 million of corporate bonds classified as available for sale that management believes could be readily converted to cash.
Financial reinsurance treaties between National Farmers Union and unrelated parties contain statutory minimum surplus requirements and require National Farmers Union to place securities in an escrow account ($80.3 million at December 31, 1997) to secure National Farmers Union's obligations to the third party reinsurer.
The NAIC assigns securities quality ratings called "NAIC designations" that are used by insurers when preparing their annual statements. The NAIC assigns designations to publicly-traded as well as privately-placed securities. The designations assigned by the NAIC range from class 1 to class 6, with a rating in class 1 being of the highest quality. The following table sets forth the composition of the Company's fixed maturity securities according to NAIC designations and S&P and Moody's ratings at December 31, 1997:
(3) Carrying amounts market value. The amortized cost of available for sale securities at December 31, 1997 was $736.0 million.
The Company continually reviews its non-investment grade debt securities (NAIC designations 3 through 6) for evidence of declines in value which are other than temporary. The Company does not anticipate any material increase in its investments in non-investment grade debt securities. At December 31, 1997, the Company's investment portfolio contained no securities which were in default as to principal or interest.
Non-Insurance Subsidiaries. During 1996, Americo received a dividend from Argus consisting of $8.0 million of cash and a $1.5 million note receivable from Broadway Square Partners, a related party. Americo used $4.5 million of the cash received to purchase a 50% interest in Hereford LLP, which owns and manages the building leased by Argus. Hereford LLP was formed in 1996 to purchase the building which was previously owned by Argus.
In February 1997, the FASB issued SFAS No. 128 "Earnings per Share" and SFAS No. 129, "Disclosure of Information about Capital Structure". SFAS No. 128 specifies the computation, presentation and disclosure requirements for earnings per share. SFAS No. 129 does not establish new disclosure requirements, rather it codifies certain disclosure requirements contained in other statements previously issued. These statements are effective for financial statement periods ending after December 15, 1997. Adoption of these new accounting standards did not have an impact on the consolidated financial statements of the Company.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in financial statements. SFAS No. 131 establishes new guidelines for public business enterprises to report financial and descriptive information about their operating segments. These statements are effective for financial statement periods beginning after December 15, 1997.
Many existing computer programs were designed and developed without regard to the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. The Company is dependent on computer systems and applications to conduct its business. The Company's significant processing applications are maintained by an outsider vendor. Management and vendor representatives have developed a conversion plan to prepare the Company's systems for year 2000 compliance. The cost of testing and conversion of system applications is not expected to be material to the Company, because much of the conversion programming will be the responsibility of the outside vendor. Management believes that planned modifications to existing systems and conversions to new systems will be complete before year 2000 and that year 2000 issues will not pose a significant problem to the Company. The Company is initiating formal communications with its outside business partners to determine the extent to which they will be year 2000 compliant. Where practicable, the Company will assess and attempt to mitigate its risks with respect to such third parties. The Company is not able to estimate the effect, if any, on its results of operations from the failure of such parties to be year 2000 compliant.
The Company's audited consolidated financial statements for the three years ended December 31, 1997 and the related report of independent accountants thereon are set forth at pages to hereof and are incorporated herein by reference. Reference is made to the Index to Financial Statements on page herein.