This report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based our forward-looking statements on our current expectations and projections about future events. Our forward-looking statements include information about possible or assumed future results of operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as the growth of our business and operations, our business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "probably," or similar expressions, we are making forward-looking statements.
Mortgage loans on real estate are carried at their unpaid principal balances, adjusted for amortization of premium or discount and valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected.
Deferred Income Taxes - The provision for deferred income taxes is based on the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized by applying enacted statutory tax rates to temporary differences between amounts reported in the Consolidated Financial Statements and the tax basis of existing assets and liabilities. A valuation allowance is recognized for the portion of deferred tax assets that, in Management's judgment, is not likely to be realized. The effect on deferred income taxes of a change in tax rates or laws is recognized in income tax expense in the period that includes the enactment date. Refer to Note 1 - Summary of Significant Accounting Policies in the Notes to the Consolidated Financial Statements for detailed information regarding the Company's significant accounting policies.
On a consolidated basis, the Company had net income attributable to common shareholders of $3.3 million and $9.3 million in 2013 and 2012, respectively. In 2013, income before income taxes was $4.7 million compared to $15.4 million in 2012. Total revenue was $34.4 million in 2013 and $44.8 million in 2012.
One-time events, primarily reflected in realized gains, comprise a substantial portion of the net income and revenue reported by the Company during 2013 and 2012. The magnitude of realized investment gains and losses in a given year is a function of the timing of trades of investments relative to the markets themselves as well as the recognition of any impairments on investments. Future earnings will be significantly negatively impacted should earnings from these one-time items not be realizable in a future period. While Management believes there remain additional investments with such one-time earnings, when or if realized remains uncertain.
Total benefits and other expenses paid in 2013 were $29.7 million compared to $29.4 million in 2012.
Premiums and policy fee revenues, net of reinsurance premiums and policy fees, decreased approximately 7% when comparing 2013 to 2012. The Company writes very little new business. Unless the Company acquires a new company or a block of in-force business, Management expects premium revenue to continue to decline on the existing block of business at a rate consistent with prior experience. The Company's average persistency rate for all policies in-force for 2013 and 2012 was approximately 96.5% and 96.2%, respectively. Persistency is a measure of insurance in-force retained in relation to the previous year.
Net investment income increased approximately 20% in 2013 compared to 2012. The increase in the current year net investment income, in comparison to the prior year results, is attributable to favorable results in the equity securities and discounted mortgage loan investment portfolios.
The Company's net realized investment gains decreased 94% when comparing 2013 to 2012.
During 2013 and 2012, realized gains were offset by other-than-temporary impairments of $1.2 million and $187,000, respectively. The other-than-temporary impairments were taken as a result of Management's assessment and consideration of the length of time the securities have remained in an unrealized loss position and as a result of appraisal valuations. The investments were written down to better reflect their current expected market value.
Management made this determination due to the thin profit margin associated with this contract coupled with its labor intensity. The non-renewal of this contract is not expected to have a material financial impact to net income as Management anticipates operating expense reductions close to the lost revenues. The Company has no current plans to terminate any other TPA arrangements and intends to continue to pursue new clients.
In summary, the Company's basis for future revenue growth is expected to come from the following primary sources: expansion of TPA revenues, conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.
In early 2013, the Company began a proactive analysis of its in-force business to try to reconnect with lost customers and verify its customers are not deceased. In some instances, the Company found that the customer was indeed deceased, but no notification or claim was presented to the Company. During 2013, the Company paid approximately $2.9 million in death claim benefits as a result of this action. This process remains ongoing with a target completion date of May of 2014.
Management continues to view the Company's investment portfolio with utmost priority. Significant time has been spent internally researching the Company's risk and communicating with outside investment advisors about the current investment environment and ways to ensure preservation of capital and mitigate losses. Management has put extensive efforts into evaluating the investment holdings. Additionally, members of the Company's Board of Directors and investment committee have been solicited for advice and provided with information. Management reviews the Company's entire portfolio on a security level basis to be sure all understand our holdings, potential risks and underlying credit supporting the investments. Management intends to continue its close monitoring of its bond holdings and other investments for additional deterioration or market condition changes. Future events may result in Management's determination that certain current investment holdings may need to be sold which could result in gains or losses in future periods. Such future events could also result in other than temporary declines in value that could result in future period impairment losses.
There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if impairment is other-than-temporary. These risks and uncertainties related to Management's assessment of other-than-temporary declines in value include but are not limited to: the risk that Company's assessment of an issuer's ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer; the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated; the risk that fraudulent information could be provided to the Company's investment professionals who determine the fair value estimates.
UTG is a holding company that has no day-to-day operations of its own. Cash flows from UTG's insurance subsidiary, UG, are used to pay costs associated with maintaining the Company in good standing with states in which it does business and the servicing of its debt. UTG's cash flow is dependent on management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. As of December 31, 2013 and 2012, substantially all of the consolidated shareholders equity represents net assets of its subsidiaries. In 2013, the Parent received $2.7 million in dividends from its insurance subsidiary and $3.3 million in 2012. The dividends were mainly used to pay debt obligations of the Parent company. Certain restrictions exist on the payment of dividends from the insurance subsidiary to the Parent company. For further information regarding the restrictions on the payment of dividends by the insurance subsidiary, see Note 9 - Shareholders' Equity in the Notes to the Consolidated Financial Statements. Although these restrictions exist, dividend availability from the insurance subsidiary has historically been sufficient to meet the cash flow needs of the Parent company.
Cash used in operating activities was $10.9 million and $10.6 million in 2013 and 2012, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years. As such, premium revenues continue to decline. Management anticipates future cash flows from operations to remain similar to historic trends.
The Company had cash and cash equivalents of $19.8 million and $23.3 million as of December 31, 2013 and 2012, respectively. The Company has a portfolio of marketable fixed and equity securities that are available for sale, if an unexpected event were to occur. These securities had a fair value of approximately $215 million and $218 million at December 31, 2013 and 2012, respectively. However, the strong cash flows from investing activities, investment maturities and the availability of the line of credit facilities make it unlikely that the Company would need to sell securities for liquidity purposes. See Note 2 - Investments in the Notes to the Consolidated Financial Statements for detailed disclosures regarding the Company's investment portfolio.
The Company's capital structure consists of short-term debt, long-term debt and shareholders' equity. A complete analysis and description of the short-term and long-term debt issues outstanding as of December 31, 2013 and 2012 are presented in Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements.
At December 31, 2013, UG has a ratio of approximately 3.87, which is 387% of the authorized control level. Accordingly, the Company meets the RBC requirements.
The Board of Directors of UTG authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. The Board of Directors approved resolutions for a total repurchase of $6 million. Repurchased shares are available for future issuance for general corporate purposes. This program can be terminated at any time. Open market purchases are made based on the last available market price and are generally limited to a maximum per share price of the most recent reported per share GAAP equity book value of the Company. Through December 31, 2013, UTG has spent $4.9 million in the acquisition of 588,526 shares under this program.
We have audited the accompanying consolidated balance sheets of UTG, Inc. (a Delaware corporation, the "Company") and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
This document at times will refer to the Registrant's largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC ("FSF"), a Kentucky corporation, and First Southern Bancorp, Inc. ("FSBI"), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank ("FSNB"). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG's largest shareholder through his ownership control of FSF, FSBI and affiliates. At December 31, 2013, Mr. Correll owns or controls directly and indirectly approximately 56.23% of UTG's outstanding stock.
UTG's life insurance subsidiary has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate investments. The real estate investments were placed into the limited liability companies and partnerships to provided additional protection to the policyholders and to UG.
Fixed Maturity Investments - The Company classifies its fixed maturity investments, which include bonds, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Premiums and discounts on debt securities purchased at other than par value are amortized and accreted, respectively, to interest income in the Consolidated Statements of Operations, using the constant yield method over the period to maturity. Net realized gains and losses on sales of available for sale securities, and unrealized losses considered to be other-than-temporary, are recorded to net realized investment gains (losses) in the Consolidated Statements of Operations.
Mortgage Loans on Real Estate - Mortgage loans on real estate are reported at their unpaid principal balances, adjusted for amortization of premium or discount and valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected.
Property and Equipment - Company-occupied property, data processing equipment and furniture and office equipment are stated at cost less accumulated depreciation of $3,559,052 and $3,399,309 at December 31, 2013 and 2012, respectively. Depreciation is computed on a straight-line basis for financial reporting purposes using estimated useful lives of three to thirty years. Depreciation expense was $159,743 and $168,442 for the years ended December 31, 2013 and 2012, respectively.
Policy Claims and Benefits Payable - Policy and contract claims include provisions for reported claims in process of settlement, valued in accordance with the terms of the policies and contracts, as well as provisions for claims incurred and unreported. The estimate of incurred and unreported claims is based on prior experience. The Company makes an estimate after careful evaluation of all information available to the Company. There is no certainty the stated liability for policy claims and benefits payable, including the estimate for incurred but unreported claims, will be the Company's ultimate obligation.
Comprehensive Income - In February 2013, the FASB issued an accounting standard which requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. This guidance is effective for periods beginning after December 15, 2012. The adoption of this new guidance did not have a material impact on the Company's consolidated financial statements.
Substantially all of the unrealized losses on fixed maturities available for sale at December 31, 2013 and 2012 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The unrealized losses on equity investments were primarily attributable to normal market fluctuations. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company's expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company's evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of December 31, 2013 and 2012.
During 2013 and 2012, the maximum and minimum lending rates for mortgage loans were:
Management has conservatively decided to place the loans in the discounted mortgage loan portfolio on a non-accrual status, due to the instability of the borrowers.
The following table summarizes the number loans held in the discounted mortgage loan portfolio and the carrying value of the loans as of December 31, 2013:
Securities designated as trading securities consist of exchange traded equities and exchange traded options. These securities are primarily valued at quoted active market prices, and are therefore categorized as Level 1 in the fair value hierarchy.
There were no transfers in or out of Level 3 as of December 31, 2013. Transfers occur when there is a lack of observable market information.
The Company has been purchasing non-performing discounted mortgage loans at a deep discount through an auction process led by the Federal Government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price, which Management believes approximates fair value. The inputs used to measure the fair value of our discounted mortgage loans are classified as Level 3 within the fair value hierarchy.
Policy loans are carried at the aggregate unpaid principal balances in the consolidated balance sheets which approximate fair value, and earn interest at rates ranging from 4% to 8%. Individual policy liabilities in all cases equal or exceed outstanding policy loan balances. The inputs used to measure the fair value of our policy loans are classified as Level 3 within the fair value hierarchy.
The carrying amount of cash and cash equivalents in the financial statements approximates fair value given the highly liquid nature of the instruments. The inputs used to measure the fair value of our cash and cash equivalents are classified as Level 1 within the fair value hierarchy.
As is customary in the insurance industry, the insurance subsidiary cedes insurance to, and assumes insurance from, other insurance companies under reinsurance agreements. Reinsurance agreements are intended to limit a life insurer's maximum loss on a large or unusually hazardous risk or to obtain a greater diversification of risk. The ceding insurance company remains primarily liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. However, it is the practice of insurers to reduce their exposure to loss to the extent that they have been reinsured with other insurance companies. The Company sets a limit on the amount of insurance retained on the life of any one person. The Company will not retain more than $125,000, including accidental death benefits, on any one life. At December 31, 2013, the Company had gross insurance in-force of $1.5 billion of which approximately $313 million was ceded to reinsurers. At December 31, 2012, the Company had gross insurance in-force of $1.6 billion of which approximately $335 million was ceded to reinsurers.
The Company's reinsured business is ceded to numerous reinsurers. The Company monitors the solvency of its reinsurers in seeking to minimize the risk of loss in the event of a failure by one of the parties. The Company is primarily liable to the insureds even if the reinsurers are unable to meet their obligations. The primary reinsurers of the Company are large, well-capitalized entities.
At December 31, 1992, UG (formerly American Capitol) entered into a reinsurance agreement with Canada Life Assurance Company ("the Canada Life agreement") that fully reinsured virtually all of its traditional life insurance policies. The reinsurer's obligations under the Canada Life agreement were secured by assets withheld by UG representing policy loans and deferred and uncollected premiums related to the reinsured policies. UG continues to administer the reinsured policies. At December 31, 2013, the Canada Life agreement has insurance in-force of approximately $6,815,000, with no reserve credit being taken on that amount. At December 31, 2012, the Canada Life agreement had insurance in-force of approximately $7,433,000, with no reserve credit being taken on that amount.
The Company does not have any short-duration reinsurance contracts. The effect of the Company's long-duration reinsurance contracts on premiums earned in 2013 and 2012 were as follows:
At December 31, 2013 and 2012, respectively, the Company had gross deferred tax assets of $2,562,650 and $2,793,932, respectively, and gross deferred tax liabilities of $12,196,291 and $15,095,509, respectively, resulting from temporary differences primarily related to the life insurance subsidiary. A valuation allowance is to be provided when it is more likely than not that deferred tax assets will not be realized by the Company. No valuation allowance has been recorded relating to the Company's deferred tax assets since, in Management's judgment, the Company will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
At December 31, 2013 and 2012, the Company had the following outstanding debt:
The HPG Acquisitions promissory note issued on February 7, 2007 carried interest at a fixed rate of 5%. This promissory note was fully repaid during 2013.
The UTG line of credit carries interest at a fixed rate of 3.75% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company ("UG"). The UTG line of credit was fully repaid on July 5, 2013. On October 28, 2013, the Company borrowed $3,000,000 on its line of credit. The funds were used to pay the ACAP dissenting shareholders. See Note 8 for further information regarding this matter.
On November 9, 2011, ACAP shareholders approved a proposed merger with UTG whereby ACAP shareholders received 233 shares of UTG for each share previously held of ACAP. On November 14, 2011, the merger was completed. Certain of the ACAP shareholders dissented to the merger requesting the courts determine the value of the ACAP shares. Following the merger, the Company established a contingent liability of $2,550,822 to cover the anticipated proceeds due to the dissenting shareholders and associated legal and other costs.
Executive Compensation - In December 2012, the Company issued 16,225 shares of its common stock to certain members of management as part of year-end bonuses based on 2012 operating results. The shares were valued at $13.25 per share, the market value at the date of issue. During 2012, the Company recorded $214,981 in operating expenses related to this stock issuance.
UG is domiciled in the state of Ohio. Ohio requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. UG paid ordinary dividends of $2,700,000 and $3,316,722 to UTG in 2013 and 2012, respectively. No extraordinary dividends were paid during the two year period.
On November 14, 2011, UTG, Inc. merged with ACAP. Shareholders of ACAP received shares of UTG in exchange for their ACAP shares. ACAP was a 73.0% owned subsidiary of UG. The merger reduced the corporate structure and provided certain efficiencies and economies to the Companies. All ACAP shareholders, other than UTG or UG, have the right to receive 233 shares of UTG common stock for each share of ACAP common stock they owned at closing. Under the terms of the exchange ratio, UTG issued 50,328 shares to former ACAP shareholders. An additional 129,548 UTG shares were not issued due to dissenting ACAP shareholders. The shareholder dispute was settled during 2013. See Note 8 - Commitments and Contingencies for additional information regarding the ACAP dissenting shareholders.
Effective January 1, 2007, UTG entered into administrative services and cost sharing agreements with its subsidiary. Under this arrangement, the subsidiary pays its proportionate share of expenses, based on an allocation formula. During 2013 and 2012, UG paid $7,442,588 and $8,843,596, respectively, in expenses. The Ohio Department of Insurance has approved the cost sharing agreement and it is Management's opinion that where applicable, costs have been allocated fairly and such allocations are based upon accounting principles generally accepted in the United States of America.
At the end of August 2012, the reinsurance agreement with Canada Life Assurance Company was fully repaid. At that time, the reserves were recaptured through elimination of reinsurance recoverable in exchange for assets received equal to the recaptured reserves. The following table reflects the breakdown of the assets received.
During the second quarter of 2013, UG and one of its subsidiaries, Cumberland Woodlands, LLC, entered into noncash transactions whereby short-term investments in the amount of $6.3 million were exchanged for real estate in the amount of $6.3 million.
The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 21% of total life insurance in force at December 31, 2013 and 2012. Insurance ceded represented 27% and 28% of premium income for 2013 and 2012, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.