We own our principal office in Austin, Texas, consisting of an 80,000 square foot office building and approximately one acre of land nearby that contains housing storage facilities. Approximately 50,000 square feet is occupied or reserved for our operations with the remainder of the building being leased to a single tenant under a lease expiring in late 2006.
elsewhere herein. The net income (loss) per share amounts have been adjusted retroactively for all periods presented to reflect the 7% common stock dividends paid on December 31, 2005 and December 31, 2004.
We conduct operations as an insurance holding company emphasizing ordinary life insurance products in niche markets where we believe we can achieve competitive advantages. Our core operations include:
the issuance of ordinary life insurance in U.S. dollar denominated amounts to foreign nationals with significant net worth; and
growing source of new business, and in 2005 was the leading source of new premium income.
In 2005, our International Life segment generated revenue of approximately $79.7 million which accounted for 55.2% of our total revenue. For the year ended December 31, 2004, this segment produced revenue of $72.9 million which accounted for 70.9% of our total revenue, compared to 2003, when it produced approximately $63.3 million, or 67.0% of total revenue. The decrease in percentage of total revenue in 2005 relates to the inclusion of Security Plan’s results for all of 2005, as the revenues from Security Plan were only included in the fourth quarter of 2004 because it was acquired by us on October 1, 2004. Our strategy in operating our International Life segment is to increase new business written through our existing marketers as well as expand the number of countries from which we receive policy applications. Our international business grew at a double-digit pace during 2003, 2004 and 2005. New annualized issued and paid premiums from the international market increased by more than 25.7% during 2004 compared to 2003, and increased an additional 17.9% during 2005 compared to 2004. The development of new markets in the Pacific Rim, particularly Taiwan, and the expansion of existing markets in Latin America were the primary contributors to the growth in this segment.
Home Service Life. Through a subsidiary we acquired in October 2004, Security Plan, we provide final expense ordinary life insurance to middle to lower income individuals in Louisiana. Our policies in this segment are sold and serviced through the home service marketing distribution system utilizing employee-agents who work on a route system to collect premiums and service policyholders.
occurred by year end 2005. For 2006, SPFIC has increased its catastrophe reinsurance to cover up to $10 million in claims per event.
We also realize earnings from our investment portfolio. Life insurance companies earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid out under policies. Changes in interest rates, changes in economic conditions and volatility in the capital markets can all impact the amount of earnings that we will realize from our investment portfolio.
As an increasing percentage of the world population reaches retirement age, we believe we will benefit from increased demand for living products rather than death products, as aging baby boomers will require cash accumulation to provide expenses to meet their lifetime needs. Our ordinary life products are designed for our policyowners to accumulate cash values to provide for living expenses in the insured’s later years while continuously providing a death benefit.
The volatility in the equity markets over the past few years has posed a number of problems for some companies in the life insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We historically have had minimal equity exposure, including less than 1% of total invested assets as of December 31, 2005 and December 31, 2004, and we plan to continue to have minimal assets in equity investments in the future.
Corporate bond defaults and credit downgrades, which have resulted in other-than- temporary impairment in the value of many securities, have had a material
impact on life insurers in the past few years. We have not incurred significant losses from bond defaults for many years. The majority of our investment portfolio is held in debt instruments carrying the full faith and credit of the U.S. Government, or U.S. government-sponsored enterprises. We intend to manage our investment portfolio conservatively in the future in these type of debt instruments.
Many of the events and trends affecting the life insurance industry have had an impact on the life reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, we may find it difficult to obtain reinsurance in the future, forcing us to seek reinsurers who are more expensive to us. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we would have to reduce our underwriting commitments.
We entered into coinsurance agreements, effective January 1, 2004, and ceded approximately $14 million of our annual accident and health premium and corresponding benefits and claims. In consideration for these cessions, we made a closing settlement payment of $10,440,000 to the reinsurer in June 2004. Due to this cession, we also reduced our January 1, 2004 deferred policy acquisition costs, cost of customer relationships acquired and policy benefit reserves by $2,197,000, $2,886,000 and $14,960,000, respectively. We recorded an initial amount payable to the reinsurer of $10,440,000, resulting in a first quarter 2004 charge of $634,000 and a deferred gain of $72,000, which was amortized during 2004. The coinsurance agreements provide that this ceded business will revert to the reinsurer when parallel assumption reinsurance agreements are approved by the various state insurance departments holding jurisdiction. We also participate in future profits on the accident and health business subject to the coinsurance agreements over a 10-year period. During 2004, we recognized approximately $809,000 as profit under the agreements. No amounts were recognized in 2005. Negotiations were underway, as of December 31, 2005, with the assuming party to sell our primary accident and health insurance subsidiary, CNLIC, which represents approximately 70% of the ceded business.
As further discussed below, increases in revenues offset by increased amortization expenses, contributed to a 45.8% increase in earnings before Federal income tax in 2005. A significant increase in Federal income tax expense, as described below, resulted in 2005 net income approximating that of 2004. Earnings per share declined in 2005 by 23.5% compared to 2004 as the result of significantly increased taxes and higher expenses relating to our outstanding preferred stock. (See Note 1(i) of the Notes to Consolidated Financial Statements.)
Net Investment Income. Net investment income increased 38.6% during 2005 to $23,568,000 compared to $17,005,000 during 2004 and $14,322,000 in 2003. Our Home Service Life segment’s inclusion added $11,573,000 to the 2005 results and $2,875,000 to 2004 results. Available returns were slightly higher during 2005 compared to 2004 and 2003, however, the remaining companies’ investment income declined slightly during 2005 due to the sale of a significant amount of bonds to fund the acquisition of Security Plan and the transfer of the accident and health business in 2004 and the sale/maturity of $30 million of bonds to retire the outstanding bank debt. We continue to invest in bonds U.S. government-sponsored enterprises, such as FNMA and FHLMC. Also, during 2005, approximately $20 million of AAA-rated, tax-exempt municipal bonds were purchased, which generated tax-equivalent yields of 30-40 basis points higher than on agency instruments.
Reserves. The change in future policy benefit reserves increased from $18,627,000 in 2004 to $24,223,000 in 2005, predominantly due to an improvement in persistency on our international business, as well as a change in product mix which resulted in larger first year reserves. During 2004 and 2005, a shift in products sold occurred with the addition of sales in the Pacific Rim, which resulted in a more rapid rise in reserves. Our Home Service segment decreased net reserves by $244,000 in 2005, due to minimal loss of business as the result of hurricanes. The change in future policy benefit reserves increased from $7,904,000 in 2003 to $18,627,000 in 2004, due predominantly to increased persistency on our business and an increase and change in product mix in new business. New issuances of policies to several large producing areas shifted to endowment products, which build reserves at a much higher rate.
Casualty claims and other policy benefits amounted to $4,477,000 in 2005, compared to $1,328,000 in 2004 and $780,000 in 2003. These other benefits are comprised of supplemental contract benefits, interest on policy funds and assorted other miscellaneous policy benefits. In 2005, Home Service casualty claims totaled $3,685,000, compared to $562,000 in 2004. Of these 2005 casualty claims, $1,250,000 were due to Hurricanes Katrina and Rita, as discussed earlier.
Underwriting, Acquisition and Insurance Expense. Underwriting, acquisition and insurance expenses increased 46.2% to $25,429,000 in 2005 compared to $17,391,000 during 2004. The increase was largely attributable to our Home Service segment’s inclusion for the entire year, whose expenses were approximately $9,571,000 in 2005, as the segment was only included in the fourth quarter of 2004. Underwriting, acquisition and insurance expenses decreased 8.3% to $17,391,000 in 2004, compared to $18,966,000 in 2003, due primarily to economies of scale being achieved in administration of the business of our domestic insurance subsidiaries.
Deferred Policy Acquisition Costs. Capitalized deferred policy acquisition costs increased 41.5% from $17,241,000 in 2004 to $24,388,000 in 2005. These costs were $16,558,000 in 2003. This increase was primarily related to the increase in new life production discussed above. Capitalized expenses for the Home Service segment, which were not included in 2005 results, were $3,076,000. Amortization of these costs was $10,313,000 and $8,438,000, respectively, in 2005 and 2004.
Cost of Customer Relationships Acquired. Amortization of cost of customer relationships acquired and other intangibles increased from $4,136,000 in 2004 to $5,881,000 in 2005. Amortization of these items related to the Security Plan acquisition was $3,811,000 in 2005 and $848,572 for the fourth quarter of 2004. These costs decreased in 2004 to $4,136,000 from $7,110,000 in 2003. With most of the accident and health business ceded effective January 1, 2004, amortization of these costs was minimal in 2004.
A primary liquidity concern is the risk of an extraordinary level of early policyholder withdrawals. We include provisions within our insurance policies, such as surrender charges, that help limit and discourage early withdrawals. Since these contractual withdrawals, as well as the level of surrenders experienced, were largely consistent with our assumptions in asset liability management, our associated cash outflows have to date not had an adverse impact on our overall liquidity. Individual life insurance policies are less susceptible to withdrawal than annuity reserves and deposit liabilities because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. Cash flow projections and cash flow tests under various market interest rate scenarios are also performed annually to assist in evaluating liquidity needs and adequacy. We currently anticipate that available liquidity sources and future cash flows will be adequate to meet our needs for funds.
U.S. government agency securities. Management has the intent and believes we have the ability to hold the securities to maturity.
We have committed to the following contractual obligations as of December 31, 2005 with the payments due by the period indicated below:
Lapses and surrenders increased in 2005 compared to 2004 due to Security Plan’s inclusion for the entire year. Reinsurance declined because of a decrease in the average face amount of international policies issued. The significant increase in 2004 ceded premium compared to 2003 related to the 100% cession of the in-force accident and health premiums to another carrier.
Acquisition costs, consisting of commissions and policy issuance, underwriting and agency expenses that relate to and vary with the production of new business, are deferred. These deferred policy acquisition costs are amortized primarily over the estimated premium paying period of the related policies in proportion to the ratio of the annual premium recognized to the total premium revenue anticipated, using the same assumptions as were used in computing liabilities for future policy benefits.
method limits the amount of deferred costs to its estimated realizable value, provided actual experience is comparable to that contemplated in the factors.
At December 31, 2005, investments in fixed maturity and equity securities were 94.4% and 0.1%, respectively, of total investments. Approximately 98.3% of our fixed maturities were classified as available-for-sale securities at December 31, 2005, with the remaining 1.7% classified as held-to-maturity securities based upon our intent and ability to hold these securities to maturity. All equity securities at December 31, 2005 are classified as available-for-sale securities. We have no fixed maturity or equity securities that are classified as trading securities at December 31, 2005.
Additionally, at December 31, 2005, 63.3% of our fixed maturity securities were invested in securities backed by the full faith and credit of the U.S. government or U.S. government-sponsored entities. We evaluate the carrying value of our fixed maturity and equity securities at least quarterly. A decline in the fair value of any fixed maturity or equity security below cost that is deemed other than temporary is charged to earnings resulting in the establishment of a new cost basis for the security. The new cost basis is not changed for subsequent recoveries in the fair value of the fixed maturity or equity security. With the exception of Security Plan, virtually all investments of our subsidiaries are in bonds that carry the full faith and credit of the U.S. government or U.S. government-sponsored enterprises. Security Plan has significant investments in corporate and municipal bonds.
Gross unrealized losses on fixed maturities available-for-sale amounted to $10,460,000 as of December 31, 2005. Of the 2005 total gross unrealized loss, $6,754,000 were in a continuous loss situation for 12 months or more and $3,706,000 were in a continuous loss situation for less than 12 months. Gross unrealized losses on fixed maturities available-for-sale as of December 31, 2004 were $3,857,000, of which $2,018,000 were in a continuous loss situation for 12 months or more and $1,839,000 were in a continuous loss situation for less than 12 months. The majority of the fixed maturities available-for-sale that have been in a continuous loss situation for less than 12 months are from investments owned by Security Plan. The losses are due to the coupon interest rate being less than the prevailing market interest rates at December 31, 2005. We have determined that there is no need to establish a new cost basis for these securities.
The fixed maturities available-for-sale in a gross unrealized loss situation for more than 12 months are primarily investments in callable instruments issued by U.S. government sponsored enterprises and U.S. government agencies. It is remote that unrealized losses on these instruments will result in realized losses, since we have the intent and believe we have the ability to hold these securities to the call date or maturity date.
These securities are being monitored by us to determine if the unrealized loss as of December 31, 2005 indicates that there is a loss which is other-than-temporary. As of December 31, 2005, we had determined that there is no need to establish a new cost basis for these securities.
In September 2005, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and For Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. Under SOP 05-1, modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. A replacement contract that is substantially changed will be accounted for as an extinguishment of the replaced contract resulting in a release of unamortized deferred acquisition costs and unearned inducements associated with the replaced contract. The guidance in SOP 05-1 will be applied prospectively and is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company is
In September 2005, the EITF reached consensus on Issue No. 05-8, “Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature” (“EITF 05-8”). EITF 05-8 concludes that (i)the issuance of convertible debt with a beneficial conversion feature results in a basis difference that should be accounted for as a temporary difference and (ii) the establishment of the deferred tax liability for the basis difference should result in an adjustment to additional paid in capital. EITF 05-8 will be applied retrospectively for all instruments with a beneficial conversion feature accounted for in accordance with EITF Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF Issue No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments,” and is effective for periods beginning after December 15, 2005. The Company’s Series A-1 Convertible Preferred Stock has a beneficial conversion feature, and we will implement EITF 05-8 in the first quarter of 2006. The implementation is not expected to have a material impact on the financial position, results of operations or liquidity of the Company.
Effective July 1, 2005, the Company adopted EITF Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements” (“EITF 05-6”). EITF 05-6 provides guidance on determining the amortization period for leasehold improvements acquired in a business combination or acquired subsequent to lease inception. As required by EITF 05-6, the Company adopted this guidance on a prospective basis which had no material impact on the Company’s consolidated financial statements.
In June 2005, the Financial Accounting Standards Board (“FASB”) completed its review of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its
In June 2005, the FASB cleared SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), Implementation Issue No. B38, “Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option” (“Issue B38”) and Implementation Issue No. B39, “Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor” (“Issue B39”). Issue B38 clarifies that the potential settlement of a debtor’s obligation to a creditor that would occur upon exercise of a put or call option meets the net settlement criteria of SFAS No. 133. Issue B39 clarifies that an embedded call option, in which the underlying is an interest rate or interest rate index, that can accelerate the settlement of a debt host financial instrument should not be bifurcated and fair valued if the right to accelerate the settlement can be exercised only by the debtor (issuer/borrower) and the investor will recover substantially all of its initial net investment. Issue Nos. B38 and B39, which must be adopted as of the first day of the first fiscal quarter beginning after December 15, 2005, are not expected to have a material impact on the Company’s consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20 and FASB Statement No. 3 (“SFAS 154”). The statement requires retrospective application to prior periods’ financial statements for a voluntary change in accounting principle unless it is deemed impracticable.
In December 2004, the FASB issued FSP 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP 109-2”). The American Jobs Creation Act of 2004 (“AJCA”) introduced a one-time dividend received deduction on the repatriation of certain earnings to a U.S. taxpayer. FSP 109-2 provides companies additional time beyond the financial reporting period of enactment to evaluate the effects of the AJCA on their plans to repatriate foreign earnings for purposes of applying SFAS No. 109, “Accounting for Income Taxes.” The Company does not have any foreign subsidiaries.
Consolidated statements of financial position at December 31, 2005 and 2004
Schedules for each of the years in the three-year period ended December 31, 2005: