We lease our principal office in Austin, Texas to service all business entities and operations. We lease space for our office in Bermuda related to CICA Ltd. and in Louisiana, Arkansas and Mississippi related to our Home Service Insurance operations. We also own properties in Louisiana related to our Home Service Insurance operations and in Buchanan Dam, Texas used for our general business operations. On February 15, 2019, we sold an owned building located at 400 East Anderson Lane and a nearby property in Austin, Texas to a third-party. Following the sales, we no longer own any property in Austin. We have listed our property in Buchanan Dam for sale.
This section of this Annual Report on Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018.
The Company derives its revenues principally from: (1) premiums earned for insurance coverages provided to insureds; (2) net investment income; and (3) net realized capital gains and losses.
Pricing adequacy depends on a number of factors, including the ability to obtain regulatory approval for rate changes if applicable, proper evaluation of underwriting risks, the ability to project future losses based on historical loss experience adjusted for known trends, the Company’s response to competitors, and expectations about regulatory and legal developments and expense levels. The Company seeks to price our insurance policies such that insurance premiums and future net investment income earned on premiums received will cover underwriting expenses and the ultimate cost of paying claims reported on the policies and provide for a profit margin. The Company has the ability to adjust dividend scales and interest crediting rates at its discretion based on economic and other factors. The profitability
The primary investment objective for the Company is to maximize economic value, consistent with acceptable risk parameters, including the management of credit risk and interest rate sensitivity of invested assets, while generating sufficient after-tax income to meet policyholder and corporate obligations. The Company maintains a prudent investment strategy that may vary based on a variety of factors including business needs, regulatory requirements and tax considerations.
Net investment income increased 9.8% in 2019 compared to 2018, totaling $59.5 million and $54.2 million, respectively. The increase was driven by a growing asset base derived from cash flows from our insurance operations, improvements in cash management, and a strategic focus on achieving greater yields while maintaining a prudent risk profile for our investment portfolio. The average yield on the consolidated investment portfolio was an annualized rate of 4.36% for 2019 compared to 4.17% for 2018.
The change in future policy benefit reserves decreased 13.0% in 2019 compared to 2018 and 36.9% in 2018 compared to 2017. The conversion to a new actuarial valuation system impacted the change in reserves in both years. The conversion resulted in a decrease in future policy benefit reserves of $11.9 million in 2018 and $2.4 million in 2019. Changes in surrender and maturity activity also impacted this line item in both periods.
Endowment product sales have been the primary driver of sales in this segment. The Company has noted that the twenty year endowment is our top selling product, followed by an endowment product that matures at age sixty-five. The Company repriced its top six selling international products as of the beginning of 2017 and introduced minimum guaranteed rates and current crediting rates in these products to allow for adjustments relative to market interest rates as needed.
Through the domestic market of our Life Insurance segment, we collect renewal premiums on ordinary whole life, credit life insurance, and final expense policies issued to middle and lower income families and individuals in certain markets in the mountain west, midwest and southern U.S. We stopped issuing new domestic ordinary whole life and endowment life insurance policies in 2017. The majority of our domestic revenues are generated by the policies of domestic life insurance companies we have acquired since 1987.
The low interest rate environment continues to limit increases in profit margins for insurers. We have been impacted by the historically low interest rate environment over the past several years as our fixed maturity investment portfolio, primarily invested in callable securities, has generally been reinvested at lower yields. Although the Company’s prudent investment strategy has not changed, the Company has made new investments in securities of state, municipalities, essential services and corporate issuers as well as focused on identifying investment opportunities in other asset classes such as private equity to increase our yields while maintaining a prudent risk profile for our overall portfolio. Our investment earnings also impact the reserve and deferred policy acquisition costs ("DAC") balances, as assumptions are used in the development of the balances.
Innovation and digital development strategies will be implemented in various industries including the insurance industry in the coming years which could significantly impact our business. It will be critical that we embrace these changes for the benefit of our policyholders, agents and stockholders.
While our management has extensive experience in writing life insurance policies for foreign residents, changes to foreign laws and regulations and their related application and enforcement, along with currency controls affecting our foreign resident insureds, could adversely impact our revenues, results of operations and financial condition.
A discussion of consolidated results is presented below, followed by a discussion of segment operations and financial results by segment.
Endowment sales represent a significant portion of new business sales internationally with the 20-year endowment and endowment to age 65 representing our top products. In addition, most of our life insurance policies contain a policy loan provision, which allows the policyholder to use cash value within a policy to pay premiums. The policy loan asset balance increased 1.5% in 2019 and 9.6% in 2018 and remains in line with historical levels when compared to policy benefit liabilities.
Investment income from fixed maturity securities accounted for approximately 87.8% of total investment income for the year ended December 31, 2019 as compared to 87.0% for 2018.
Investment income from fixed maturity securities increased 9.6% in 2019 and 2.0% in 2018. We continue to adjust our investment management strategy to increase our investment yields while maintaining a prudent risk profile. In addition, the increase in the policy loans asset balance, which represents policyholders utilizing their accumulated policy cash value to pay for premiums, contributed to the increase in investment income for 2019.
Claims and Surrenders. As noted in the table below, claims and surrenders increased 17.3% from $91.1 million in 2018 to $106.8 million in 2019.
Death claims increased 11.1% in 2019 and declined 0.8% in 2018. The increase in 2019 was driven primarily by higher average paid death benefit amounts. The Company monitors death claims based upon expectations, and we reinsure for losses in excess of a threshold level. These values may routinely fluctuate from year to year.
Policy surrenders increased 19.7% in 2019 and 10.7% in 2018. Surrenders represented less than 1.0% of total direct ordinary whole life insurance in force of $4.7 billion as of December 31, 2019. The increase in surrender expense is primarily related to our international business. A significant portion of surrenders relates to policies that have been in force over fifteen years and no longer have associated surrender charges.
Matured endowments increased 66.7% in 2019 after tripling in 2018. These increases were anticipated based upon the dates of when our policy endowment contracts were sold and their expected maturities as set forth in their contracts.
to our consolidated financial statements for a discussion of the conversion to our new actuarial system and the impact on our reserves.
Other General Expenses. Total general expenses increased 1.7% in 2019 compared to 2018 due primarily to higher long-term incentive compensation expenses in 2019, partially offset by reduced audit fees. General expenses increased 2.7% in 2018, due primarily to additional audit fees related to the 2017 audit, higher legal and consulting fees and higher salaries, partially offset by a decrease in our tax compliance best estimate liability.
Federal Income Tax. Federal income tax expense was $7.1 million, $13.1 million and $35.1 million in 2019, 2018 and 2017, respectively, resulting in effective tax rates of 126.0%, 652.6% and (1,176.9)%, respectively. Subsequent to the novation, the operations of CICA Ltd. are subject to Subpart F of the IRC and, therefore, is included in Citizens taxable income. The Subpart F income inclusion generated $18.4 million of federal income tax expense in 2018 which was largely driven by the impact of the novation transaction, as compared to $5.9 million in 2019. The increase in tax from Subpart F income was partially offset in 2018 and 2019 by foreign income tax rate differential of $8.1 million and $1.6 million, respectively. The significant change in effective tax rate noted in 2017 is the result of the Tax Cuts and Jobs Act of 2017 (the "Tax Act") enacted at the end of 2017 which resulted in $35.7 million of income tax due to the remeasurement of deferred tax assets. Differences between our effective tax rate and the statutory tax rate result from income and expense items that are treated differently for financial reporting and tax purposes. Refer to Note 9. Income Taxes in the notes to our consolidated financial statements for further discussion.
Our insurance operations are the primary focus of the Company, as those operations generate most of our income. The amount of insurance, number of policies issued, and average face amounts of policies issued during the periods indicated are shown below.
The Company has taken actions over the past few years to pursue long-term stability that may have negatively impacted sales levels, including reducing discretionary dividends on existing international policies in response to the sustained low interest environment. In addition, in 2017, the Company introduced a set of repriced products in response to the continued low interest rate environment. These measures resulted in more expensive policies for our customers and
likely negatively impacted our new sales. Also, in April 2018, in connection with the review of our international business model, we discontinued accepting new life insurance applications from Brazilian citizens or residents. Brazil had been one of our top premium-producing countries in our international life insurance business for the past several years. Finally, Venezuela, which has historically been one of our more critical markets, has experienced prolonged economic and social turmoil, which has negatively impacted our sales in the country, decreasing approximately 10% in both 2019 and 2018.
Most of our life insurance policies contain a policy loan provision, which allows the policyholder to use the accumulated cash value of a policy to pay premiums. These accumulated cash values can also be taken as a cash loan from the policy at the request of the policyholder and are secured by the policy values. The policy loan asset balance increased 1.3% from 2018 to 2019 and remains at the same approximate ratio to life reserves as noted in prior years.
The following table sets forth, by country, our direct premiums from our international life insurance business for the periods indicated.
financial performance. Our international business may also be affected by our ongoing strategic review of our business model and by economic or other events in foreign countries in which our policies are marketed.
Death claims expense increased 14.1% in 2019 compared to 2018 and 6.3% in 2018 compared to 2017. The increase in 2019 was driven primarily by higher average paid death benefit amounts. While death claim amounts are subject to variation from period to period, they are monitored closely by the Company.
We noted increases in surrender expense over the last several years, which is primarily related to activity in Colombia and Venezuela and is expected to increase over time due to the aging of this block of business and the larger distribution of in force business in these two top countries. Most of our policy surrender benefits paid are attributable to our international business and are related to policies that have been in force over fifteen years, when surrender charges are no longer assessed.
Endowment benefit expense primarily results from the election by policyholders of a product feature providing an annual guaranteed benefit. This is a fixed benefit over the life of the contract, and thus this expense will vary with new sales and the persistency of the business.
Matured endowments increased 70.8% in 2019 compared to 2018 after increasing 261.6% in 2018 compared to 2017. We anticipate this trend will continue as previous endowments products sold reach their stated maturity.
Other policy benefits relate primarily to interest paid on premium deposits and policy benefit accumulations.
Policyholder Dividends. Policyholders' dividends decreased 4.9% and increased 1.4% in 2019 and 2018, respectively. Policyholders’ dividends are impacted by changes in persistency and production. The Company issues long duration participating policies to foreign residents that are expected to pay dividends to policyholders based upon actual experience. The boards of our life insurance companies approve any dividends on an annual basis and may change the dividend rates as needed for business purposes.
Our Home Service Insurance segment provides pre-need and final expense ordinary life insurance and annuities to middle and lower income individuals primarily in Louisiana, Mississippi and Arkansas. Our policies in this segment are sold and serviced through a home service marketing distribution system and through funeral homes utilizing over 444 employees and independent agents.
Premiums. The premiums in this segment remained relatively flat in 2019 compared to 2018 and 2017.
Net investment income yield for our Home Service Insurance segment is summarized as follows:
Death claims expense increased 10.0% in 2019 compared to 2018 after declining in 2018. Death claims can fluctuate from year to year. In 2019, we experienced higher average paid death benefit amounts. Mortality experience is closely monitored by the Company as a key performance indicator and these amounts were within expected levels.
Property claims decreased in 2019 compared to 2018, and in 2018 compared to 2017, as we experienced relatively favorable weather in 2019 and 2018.
Other General Expenses. Expenses decreased 4.5% in 2019 and 12.7% in 2018 compared to prior periods. Expenses for 2019 were lower as a decline in audit fees which offset higher salaries, bonuses and other compensation. Expenses are allocated by segment, based upon an annual expense study performed by the Company. Expenses in 2017 were higher due to the impairment of our Home Service Insurance goodwill, which resulted in an increase in expenses of $4.6 million.
Yields on investment assets vary between segment operations due to different portfolio mixes and durations in the segments. Our annualized yield on average invested assets on the consolidated level increased 19 basis points in 2019 compared to 2018, primarily driven by the Life Insurance segment and maintaining sufficient cash balances in 2018 to fund our Bermuda novation.
The annualized yield decreased in 2018 compared to 2017 due to the decrease in investment income as make-whole calls declined compared to prior years. These calls resulted in $0.7 million of additional net income in 2017, all of which related to the Life Insurance segment, providing additional net income in 2017. A make-whole call provision in the bond instruments allows the borrower to pay off the debt early and, in doing so, incur make-whole premiums. This option was elected by borrowers on some of our bond issues as noted.
The table below shows the categories in which the Company held investments in special revenue bonds that were greater than 10% of fair value based upon the Company's portfolio of fixed maturity securities at December 31, 2019.
We evaluate the carrying value of our fixed maturity securities at least quarterly. We measure our equity securities at fair value through the income statement so there is no need to assess these securities for impairment. The Company monitors all debt securities on an on-going basis relative to changes in credit ratings, market prices, earnings trends and financial performance, in addition to specific region or industry reviews. The assessment of whether impairments have occurred is based on a case-by-case evaluation of underlying reasons for the decline in fair value. The Company determines OTTI by reviewing all relevant evidence related to the specific security issuer as well as the Company's intent to sell the security, or if it is more likely than not that the Company would be required to sell a security before recovery of its amortized cost.
The Company recorded no OTTI losses on securities in 2019 and recorded losses of $0.8 million in 2018 related to fixed maturity bond and equity securities holdings. Based upon our analysis of whether declines in fair value below cost are temporary or other-than-temporary, management believes that our investments in fixed maturity investments at December 31, 2019 were not impaired, and no additional other-than-temporary losses were recorded.
Gross unrealized losses on fixed maturities available-for-sale amounted to $1.6 million as of December 31, 2019 and $11.3 million as of December 31, 2018. This decrease in gross unrealized losses during 2019 was a result of a decrease in the interest rate environment.
Information on both unrealized and realized gains and losses by category, including OTTI, is set forth in Note 2. Investments of the notes to our consolidated financial statements.
Virtually all of the Company's non-credit accident and health insurance has been reinsured and is administered by Unified Life Insurance Company, an unaffiliated party.
SPFIC has first and second event catastrophe reinsurance coverage of $10.0 million per event and a retention level of $0.5 million per event. Thus, the first $0.5 million of incurred claims and any claims in excess of $10.0 million are
SPFIC's responsibility. The reinsurance premium for first event catastrophe reinsurance was $0.8 million in 2019, 2018 and 2017, respectively.
Liquidity refers to a company's ability to generate sufficient cash flows to meet the needs of its operations. Liquidity is managed through insurance operations to ensure stable and reliable sources of cash flows are available to meet obligations and is provided by a variety of sources.
Our liquidity requirements are met primarily by funds provided from operations. Premium deposits and revenues, investment income and investment maturities are the primary sources of funds, while investment purchases, policy benefits, and operating expenses are the primary uses of funds. Historically, we have not had to liquidate investments to provide cash flow, and there were no liquidity issues in 2019 or 2018. At December 31, 2019, our investments consist of 93.1% marketable debt securities classified as available-for-sale and 1.1% of equity securities that could be readily converted to cash for liquidity needs.
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, have been largely consistent with our assumptions in asset liability management, our associated cash outflows historically have 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 may need to 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.
At December 31, 2019, all our insurance subsidiaries were above the required minimum RBC or TCL levels.
We have committed to the following contractual obligations as of December 31, 2019, with the payments due by the period indicated below:
The payments related to the future policy benefits and policy claims payable reflected in the table above have been projected utilizing assumptions based upon our historical experience and anticipated future experience. Payments of amounts related to annuity, dividend and other policyholder funds left on deposit are projected based on assumptions of policyholder withdrawal activity. Because the exact timing and amount of the ultimate policyholder fund obligation is subject to significant uncertainty, we have reflected the obligation at the amount of the liability presented on the consolidated balance sheet in the more than five year category.
The Company does not have off-balance sheet arrangements at December 31, 2019 and does not expect any future effects on the Company's financial condition related to any such arrangements. We do not utilize special purpose entities as investment vehicles, nor are there any such entities in which we have an investment that engages in speculative activities of any nature, and we do not use such investments to hedge our investment positions.
Citizens is a holding company and has minimal operations of its own. Our assets consist of the capital stock of our subsidiaries, cash, fixed maturity securities, mutual funds and investment real estate. Our cash flows depend primarily upon the availability of statutorily permissible payments, primarily payments under management agreements from our life insurance subsidiaries. The ability to make payments is limited by applicable laws and regulations of Bermuda and U.S. states of domicile, which subject insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that these insurance subsidiaries maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay to the holding company. We historically have not relied upon dividends from subsidiaries for our cash flow needs. However, our subsidiaries have made dividend payments of available funds from time to time in relation to business strategies.
Management has discussed the development and selection of its critical accounting estimates with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the disclosure presented below relating to them. See Note 1. Summary of Significant Accounting Policies in the notes to our consolidated financial statements for further information on our critical accounting policies.
The evaluation of securities for impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer's
financial condition or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period.
If management determines that an investment experienced an OTTI, management must then determine the amount of OTTI to be recognized in earnings. If management does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment. If management intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the consolidated financial statement date. Any recoveries related to the value of these securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders' equity) and not recognized in income until the security is ultimately sold.
The ending DAC asset balance is calculated at a seriatim level for policies in force at the end of each reporting period based on the remaining unamortized asset. The assumptions used to calculate DAC are set when a policy is issued and do not change with changes in actual experience, unless a loss recognition event occurs. The seriatim method ensures that policies lapsed or surrendered during the reporting period are no longer included in the DAC calculation. This method limits the amount of deferred costs to its estimated realizable value, provided actual experience is comparable to that contemplated in the locked-in assumptions.
Goodwill is tested for impairment on an annual basis or more frequently if indicators of potential impairment exist. The goodwill testing requires us to compare the estimated fair value of a reporting unit to its carrying value. If the carrying value of the reporting unit is lower than its estimated fair value, no further evaluation is required. If the carrying value of the reporting unit exceeds its estimated fair value, an impairment charge is recorded for that excess, limited to the total amount of goodwill allocated to that reporting unit. We have the option of performing an assessment of certain qualitative factors to determine if it is more likely than not that the fair value of a reporting unit is less than its carrying value or proceeding directly to a quantitative impairment test. Management’s determination of the fair value of each reporting unit under the accounting guidance incorporates multiple inputs including discounted cash flow calculations based on assumptions that market participants would make in valuing the reporting unit. Other assumptions can include levels of economic capital, future business growth, and earnings projections.
We elected to early adopt the FASB's issued Accounting Standards Update ("ASU") No. 2017-04, Simplifying the Test for Goodwill Impairment as of December 31, 2017.
We continue to use the original assumptions (including a provision for the risk of adverse deviation) in subsequent periods to determine the changes in the liability for future policy benefits (the "lock-in concept”) unless a premium deficiency exists. Management monitors these assumptions and has determined that a premium deficiency did not exist as of December 31, 2019. Management believes that our policy liabilities and increase in future policy benefit reserves as of the years ended December 31, 2019, 2018 and 2017 are based upon assumptions, including a provision for the risk of adverse deviation, that do not warrant revision. Annually, the Company completes experience studies with respect to mortality, lapse, interest and expenses. The results of these studies are used for current year reserve adequacy testing, which includes loss recognition, goodwill, and establishing benefit liabilities and DAC for the following year's new issues.
Premiums on life and accident and health policies are reported as earned when due or, for short duration contracts, over the contract period on a pro rata basis. Benefits and expenses are associated with earned premiums and occur throughout the estimated life of the contracts. This matching is accomplished by means of provisions for future benefits and the capitalization and amortization of DAC.