Liberty owns a 487,000 square foot building in Birmingham, Alabama which currently serves as Liberty’s and United Investors’ home office. Approximately 134,000 square feet of this building is leased or available for lease to unrelated tenants by Liberty. Liberty also operates from 4 company-owned district offices used for agency sales personnel. Liberty is currently in the process of selling its remaining company-owned office buildings, opting instead to operate from leased facilities. A total of 5 buildings were sold in 2008, and 21 buildings were sold in each of the years 2007 and 2006.
Liberty and United American also lease district office space for their agency sales personnel.
Investment Segment. The investment segment involves the management of our capital resources, including investments and the management of corporate debt and liquidity. Our measure of profitability for the investment segment is excess investment income, which is:
segment has experienced increased competition in recent periods, especially in 2008, which has caused a decline in agent count resulting in a significant reduction in new sales.
Total revenues declined 5% in 2008 to $3.33 billion. In 2007, total revenues rose 2% to $3.49 billion from $3.42 billion in 2006. Life premium rose $47 million in 2008 and $46 million in 2007, while net investment income rose $23 million in 2008 and $20 million in 2007. Growth in these two revenue components accounted for the increase in 2007 revenues. However, 2008 revenues were negatively affected by the aforementioned pretax realized loss of $108 million and a decline in health premium of $110 million, described further under this caption.
Life insurance premium has grown steadily in each of the three years ending December 31, 2008, rising 3% in 2008 to $1.62 billion and also 3% in 2007. Margins as a percentage of premium have also increased slightly each year to 27% of premium in 2008 and 2007 from 26% in 2006. Life net sales rose 13% in 2008 to $298 million, after having declined slightly in the two preceding years. Net sales rose in each of the three major life distribution channels in 2008. Life insurance segment results are discussed further under the caption Life Insurance.
We market three primary health insurance products: under-age-65 limited-benefit health insurance, Medicare Supplement insurance, and the Medicare Part D prescription drug benefit. Health premium declined 9% in 2008 to $1.1 billion from $1.2 billion in 2007. Health premium was flat in 2007 with 2006. The primary factor in the 2008 decline was the decline in agent count in our United American Branch Office during the year, our largest health producer. This agency has experienced intense competition, which has resulted in a significant decrease in new health sales and has negatively impacted premium income. Efforts are underway to rebuild this agency. Prior to 2008, this agency had been instrumental in the growth in the sales of our limited-benefit health product, as demand for this product had increased. Accordingly, premium from the limited-benefit product has grown significantly in relation to Medicare Supplement premium in recent years. While Medicare Supplement remains our largest contributor to total health premium, increased competition has also dampened sales of this product resulting in premium declines in each successive year. Also, 2008 was our third year of offering Medicare Part D insurance. As most of the country’s Part D enrollees selected a plan provider in 2006, we do not expect growth in our Part D business going forward. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
Torchmark’s current investment policy limits new investment acquisitions to investment-grade fixed maturities generally with longer maturities (often exceeding twenty years) that meet our quality and yield objectives. Approximately 93% of our invested assets at fair value consists of fixed maturities of which 94% was investment grade at December 31, 2008. The average quality rating of the portfolio was BBB+. The portfolio contains no securities backed by sub prime or Alt-A mortgages, no residential mortgages, no counterparty risks, no credit default swaps, or derivative contracts. See the analysis of excess investment income and investment activities under the caption Investments in this report and Note 3-Investments in the Notes to Consolidated Statements of Operations for a more detailed discussion of this segment.
In each of the years 2006 through 2008, net income was affected by certain significant, unusual, and nonrecurring nonoperating items. We do not view these items as components of core operating results because they are not indicative of past performance or future prospects of the insurance operations. A discussion of these items follows.
Life Insurance. Life insurance is our largest insurance segment, with 2008 life premium representing 59% of total premium. Life underwriting income before other income and administrative expense represented 70% of the total in 2008. Additionally, investments supporting the reserves for life products result in the majority of excess investment income attributable to the investment segment.
We use three statistical measures as indicators of premium growth and sales over the near term: “annualized premium in force,” “net sales,” and “first-year collected premium.” Annualized premium in force is defined as the premium income that would be received over the following twelve months at any
given date on all active policies if those policies remain in force throughout the twelve-month period. Annualized premium in force is an indicator of potential growth in premium revenue. Net sales is annualized premium issued, net of cancellations in the first thirty days after issue, except in the case of Direct Response where net sales is annualized premium issued at the time the first full premium is paid after any introductory offer period has expired. We believe that net sales is a superior indicator of the rate of premium growth relative to annualized premium issued. First-year collected premium is defined as the premium collected during the reporting period for all policies in their first policy year. First-year collected premium takes lapses into account in the first year when lapses are more likely to occur, and thus is a useful indicator of how much new premium is expected to be added to premium income in the future.
Annualized life premium in force was $1.71 billion at December 31, 2008, an increase of 2% over $1.67 billion a year earlier. Annualized life premium in force was $1.62 billion at December 31, 2006.
Growth in the Liberty Agency’s sales and premium volume are highly dependent on building the size of its agency force. Liberty has implemented initiatives similar to those of American Income to recruit new agents, primarily through the use of the internet. The continued recruiting of new agents and the retention of productive agents are critical to growing the sales in controlled agency distribution systems. Liberty’s agent count rose 43% to 3,437 at December 31, 2008 from 2,410 a year earlier. This compared with an increase of 39% in 2007 but a decline of 20% in 2006. Most of the growth in the 2007 agent count occurred in the latter half of the year. As new agents become trained and more seasoned, they are expected to become more productive. The growth in 2008 net sales is attributable to the growth in the agent counts in 2008 and the latter part of 2007, while the 2007 decline in net sales was a result of the decline in agent counts in 2006 and early 2007. In 2006, the Liberty National Agency began the reorganization of its marketing leadership and restructured its agent compensation system to provide greater reward to productive agents and to establish production minimums for agents. These changes led to terminations and resignations during 2006 of agents not meeting these production minimums. However, management believes that these changes will result in a more productive agency over the long term. Management also believes these changes are responsible for recent margin improvements. A larger and more productive agency force should lead to increased sales, which in turn should result in increased premium growth.
We also offer life insurance through Other Agencies consisting of the United Investors Agency, the Military Agency, the United American Independent and Branch Office Agencies, and other small miscellaneous sales agencies. The United Investors Agency is comprised of several independent agencies that concentrate on annuity business. United Investors represented 4% of Torchmark’s 2008 life premium income. The Military Agency consists of a nationwide independent agency whose sales force is comprised primarily of former military officers who have historically sold primarily to commissioned and
We market supplemental health insurance products through a number of distribution channels with the two United American agencies being our market leaders. Over the past several years, we have placed greater emphasis on the sale of limited-benefit health insurance products to under-age-65 consumers rather than Medicare Supplement insurance as customer demand for the limited-benefit hospital/surgical
plans has increased and price competition and lesser demand for Medicare Supplements has dampened the sales of that product. While Medicare Supplement still remains our largest health product in terms of premium income, the proportion of premium from other limited-benefit health products has grown steadily over the past few years. As shown in the chart above, Medicare Supplement premium represented 51% of total health premium (excluding Part D) in 2008.
Health premium at this agency rose 4% in 2008 to $73 million, after having increased 5% to $71 million in 2007. Net health sales were $11.8 million in 2008, compared with $11.3 million in 2007 and $11.7 million in 2006. Net health sales comprised less than 10% of the American Income Agency’s total net sales in 2008.
Medicare Part D. Torchmark, through its subsidiary United American, began offering insurance coverage under the government’s Medicare Part D plan as of January 1, 2006. The Medicare Part D plan is a stand-alone prescription drug plan for Medicare beneficiaries. Part D is regulated and partially funded by the Centers for Medicare and Medicaid Services (CMS) for participating private insurers like United American, unlike the traditional Medicare program for hospital and doctor services, where CMS is the primary insurer and private Medicare Supplement insurers are secondary insurers. The program generally calls for CMS to pay approximately two thirds of the premium with the insured Medicare beneficiary paying one third of the premium. Total Medicare Part D premium was $176 million in 2008, compared with $215 million in 2007 and $212 million in 2006. The decline in Part D premium resulted from the decline in the number of enrollees. Enrollment for all Part D coverages ends on December 31 of the previous year, except for enrollees who reach age 65 in the current year. At December, 2007, United American had approximately 158 thousand enrollees for the 2008 Part D plan, compared with 189 thousand for the 2007 plan year. Although final enrollment has not been confirmed, we do not expect a significant increase in enrollees for the 2009 plan year. Our Medicare Part D product is sold primarily through the Direct Response operation, but is also sold by the two UA agencies. Part D net sales were $28 million in 2008 and $25 million in 2007, compared with $278 million in 2006. We count only sales to new first-time enrollees in net sales and 2006 was the first year the Medicare Part D program was in effect. The majority of 2008 and 2007 premium income was from previous enrollees.
We believe that the Medicare Part D program is an excellent addition to our health product offerings because of our experience with the senior-age market and with Medicare Supplements, the government assurances with regard to the risk-sharing agreements for participating insurers, the incremental income added to our health insurance margins, and the renewal of the business every year. Due to our experience with service to the senior-age market and the use of our existing Direct Response marketing system, entry to this business required little new investment. However, we do not expect growth in the Part D product in the near future, as most Medicare beneficiaries enrolled in a plan in 2006. Additionally, as with any government-sponsored program, the possibility of regulatory changes could change the outlook for this market.
Index to Financial Statements The following tables present underwriting margin data for health insurance for each of the last three years.
Index to Financial Statements Torchmark’s health insurance underwriting margin before other income and administrative expense declined 7% in 2008 to $195 million, but has improved as a percentage of premium in each of the periods presented. Health margin rose 1% to $208 million in 2007. These increases were primarily the result of the reduced loss ratios in the previously-mentioned closed block of cancer business at Liberty and improvements in American Income’s loss ratios in each successive year. Liberty’s health margins increased $2 million or 5% in 2008 and $6 million or 20% in 2007. As a percentage of premium, Liberty’s health margin was 26% in 2008, compared with 24% in 2007 and 20% in 2006. American Income’s margins rose $2 million in both 2008 and 2007. They were 37% of premium in 2008 and 36% of 2007 premium.
Annuities. Fixed annuity products are sold on a limited basis by our subsidiaries. Variable annuities were sold prior to 2008 but new sales were discontinued during the year. Annuities represented less than 1% of Torchmark’s 2008 premium revenue. We do not emphasize this segment, and annuities continue to diminish in relation to our other operations.
Index to Financial Statements Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2008.
Index to Financial Statements As mentioned in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements, we settled litigation in prior periods relating to issues occurring many years ago, but incurred $2.5 million in legal costs in 2008 and $933 thousand in 2007. As previously noted, we do not consider the costs of settling litigation applicable to prior periods to be related to current insurance operations. Stock compensation expense rose in 2008 because 2008 was the first year after adoption of the accounting rule requiring the expensing of stock options where we had three years of annual employee grants being expensed (2005, 2006 and 2008). The 2004 employee grant was fully vested in 2005 (before adoption) and there was no grant in 2007. New restricted stock grants in each of the three years 2006 through 2008, which generally vest over five years, have also contributed to the increases in 2008 and 2007 stock compensation expense. Management believes that it is highly unlikely that stock compensation expense will increase materially in 2009 or over the near term. As stated in Note 13-Business Segments in the Notes to Consolidated Financial Statements, management views stock compensation expense as a corporate expense, and therefore treats it as a Parent Company expense. As described in Note 3-Investments under the caption Other-than-temporary impairments, we wrote down certain Company-occupied real estate because it met our criteria as described in that note for other-than-temporary impairment. As a result, we incurred a pretax charge of $2.1 million which is included in Operating expenses in the 2008 Consolidated Statement of Operations.
The lower growth in income is reflective of new investments that have been made in recent years at long-term yields lower than the portfolio’s average yield, resulting from the lower rates available in financial markets in those periods. However, as noted under the caption Investment Acquisitions below, we did acquire $1.1 billion in fixed maturities in 2008 yielding 25 basis points higher than the average portfolio yield for the first time in several years. In each year 2006 through 2008, new acquisitions were made at lower yields than the yields on securities disposed of, contributing to the lower growth in income relative to the portfolio growth. Another factor limiting the growth in net investment income relative to average assets in 2007 was the purchase of $256 million of tax-exempt municipal securities. Yields available on municipal bonds are lower, but produce significant tax savings to the Company. Also contributing to the lower growth in yields in recent years were calls on fixed maturity securities in the portfolio, as the yield on the reinvestment of the proceeds was below that of the called securities. Given the sizeable annual cash flow from our operations, we expect mean invested assets to continue to grow, but if rates available for new investments do not exceed our portfolio yield, the rate of growth of investment income will lag the growth in assets. More detailed information about investment acquisitions follows under the caption Investment Acquisitions.
Financing costs declined $4 million or 6% in 2008. They declined $5 million or 7% in 2007. The 2008 decline resulted from a decrease in short-term interest rates during 2008, as well as a 4% decline in our average commercial paper balance for the year to $229 million. The primary factor in the 2007 decrease was the refinancing in 2006 of two of our funded debt issues. Our 6¼% Senior Notes ($180 million principal amount) matured and our 7¾% Trust Preferred Securities ($150 million redemption value) were called in the fourth quarter of 2006. These repayments were essentially funded by the issuance of two new instruments in the second quarter of 2006, our 6 3/8% Senior Notes ($250 million principal amount) and our 7.1% Trust Preferred Securities ($120 million principal amount). Because the new issues were offered several months before the other securities were repaid, interest on funded debt increased $11 million. It should be noted, however, that we invested the proceeds of the new offerings and the investment income from those proceeds offset the increased financing costs, having little impact on excess investment income. Partially offsetting the decline in interest on funded debt in 2007 was an increase in interest on short-term debt. While higher short-term rates were a factor, the primary cause of the increase was a higher average balance of our commercial paper outstanding in 2007, which rose 43% to $238 million.
Index to Financial Statements Prior to 2006, we entered into several interest-rate swap agreements, in which we exchanged our fixed-interest commitments for floating-rate commitments. In the low-interest environment experienced in the past several years, these swaps provided us with a considerable spread between our actual interest cost and what our fixed interest cost would have been. However, as rates began to rise in 2005 and 2006, we began to dispose of these instruments in 2005 and had disposed of all remaining swap instruments as of the second quarter of 2006. The benefit of the swaps in 2006 reduced our financing costs in that year by $491 thousand. More information concerning the debt offerings, repayments, and swaps is disclosed in Note 10-Debt in the Notes to the Consolidated Financial Statements.
We prefer to invest primarily in bonds that are not callable (on other than a make-whole basis) prior to maturity. We periodically invest some funds in callable bonds when the incremental yield available on such bonds warrants doing so. For investments in callable bonds, the actual life of the investment will depend on whether or not (and if so, when) the issuer calls the investment prior to the maturity date. Given our investments in callable bonds, the actual average life of our investments can not be known at the time of the investment. We do know that the average life will not be less than the average life to next call and will not exceed the average life to maturity. Data for both of these average life measures is provided in the above chart.
Prior to 2007, we generally did not invest in securities with maturity dates more than 30 years after the acquisition date. Because of the changing investment environment during 2007 and 2008, we invested some funds in fixed-maturity securities (bonds, trust preferred securities and redeemable preferred stocks) with longer scheduled maturity dates. In virtually all cases, such securities have a scheduled maturity date and are callable many years prior to the scheduled maturity date. Due primarily to this increase in these longer-term securities, the average life of funds invested during 2007 and 2008 (to both next call and maturity) is significantly higher than that of investments during 2006.
New cash flow available to us for investment has been affected by issuer calls as a result of the low-interest environment experienced during the past three years. Issuers are more likely to call bonds when rates are low because they often can refinance them at a lower cost. Calls increase funds available for investment, but they can have a negative impact on investment income if the proceeds from the calls are reinvested in bonds that have lower yields than that of the bonds that were called. Issuer calls were $238 million in 2008, $848 million in 2007, and $229 million in 2006. The 2007 level of calls was unusual, and contributed to the significant increase in funds invested in that year.
Index to Financial Statements Portfolio Analysis. Because Torchmark has recently invested almost exclusively in fixed-maturity securities, the relative percentage of our assets invested in various types of investments varies from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2008 with the latest industry data.
At December 31, 2008, approximately 94% of our investments at book value were in a diversified fixed-maturity portfolio. Policy loans, which are secured by policy cash values, made up an additional 4%. The remaining balance was comprised of other investments including equity securities, mortgage loans, and other long-term and short-term investments.
Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities. At December 31, 2008, fixed maturities had a fair value of $7.8 billion, compared with $9.2 billion at December 31, 2007. Net unrealized losses on fixed maturities increased from $103 million at December 31, 2007 to $1.8 billion at December 31, 2008. More than $1 billion of the increase in net unrealized loss during 2008 was attributable to securities for which there was no downgrade in the Bloomberg Composite Rating. Approximately $300 million of the increase was attributable to securities for which there was a one-step downgrade in the Bloomberg Composite Rating. More than $800 million of the increase was attributable to securities issued by banks and insurance companies. As discussed in Note 3-Investments under the caption Fair value measurements, we believe, based on what we have observed in the market, that much of the increase in unrealized losses was attributable to illiquidity in the markets. This illiquidity has contributed to a spread widening, and accordingly unrealized losses, on many securities that we expect to be fully recoverable. Torchmark has the ability and intent to hold these securities until recovery. An analysis of our fixed-maturity portfolio by component at December 31, 2008 is as follows:
Approximately 80% of our fixed maturity assets at December 31, 2008 were corporate bonds and 13% were redeemable preferred stocks. Less than 1% of the assets were residential and commercial mortgage-backed securities and collateralized debt obligations (CDOs). All of the mortgage-backed securities were rated AAA. The average rating of our CDOs was A-, with none rated less than BBB. Unless otherwise indicated, our security ratings are based on the Bloomberg Composite Rating, a blend of ratings of securities from four prominent rating agencies.
At December 31, 2008, approximately 37% of the fixed maturity assets at fair value were in the financial sector, including 16% in life and health or property casualty insurance companies and 17% in banks. Financial guarantors and mortgage insurers comprised approximately 1% of the portfolio. After financials, the next largest sector was utilities, which comprised 13% of the portfolio. The balance of the portfolio is spread among 246 issuers in a wide variety of sectors.
Gross unrealized losses were $1.9 billion. As previously noted, based upon what we have observed in the market, management believes that much of the unrealized loss at December 31, 2008 was attributable to illiquidity in the market, contributing to a spread widening, and accordingly unrealized losses, on many securities that we expect to be fully recoverable. Torchmark has the ability and intent to hold these securities until recovery. Approximately 54% of the gross unrealized losses were attributable to the financial sector, including 27% attributable to life and health or property casualty insurance companies and 17% attributable to banks. We are encouraged by the efforts of the Federal government to help banks and insurance companies to weather the current financial crisis, but the Company cannot predict at this time what impact these efforts will have on ultimate recovery.
Subsequent Data as of February 12, 2009. The gross unrealized loss on fixed maturity assets at February 12, 2009 was $2.0 billion, an increase of $95 million or 5% since December 31, 2008. The decline in fair value of fixed maturities in the Financial - Bank sector accounted for $109 million of the increase in gross unrealized loss.
Index to Financial Statements Market Risk Sensitivity. Torchmark’s financial securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 94% of the book value of our investments is attributable to fixed-maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio exceeding the book value of the portfolio and increases in interest rates cause the fair value to decline below the book value. Under normal market conditions, we do not expect to realize these unrealized gains and losses because it is generally our investment strategy to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offset the impact of rates on the investment portfolio. However, in accordance with GAAP, these liabilities are not marked to market.
Index to Financial Statements The following table summarizes our tax-effected realized gains (losses) by component for each of the years in the three-year period ended December 31, 2008.
Due to the current status of these entities, we expect our future net investment income to be reduced by approximately $7 million per year. Additionally in 2008, securities of certain non-financial institutions were determined to be other-than-temporarily impaired and were written down $12 million ($8 million after tax). We also wrote down a real estate investment to fair value in 2008, resulting in a loss of $1.1 million ($718 thousand after tax).
Cash inflows from insurance operations significantly exceed cash outflows primarily because life insurers, such as Torchmark, expect to pay the majority of their policyholder benefits in future periods, sometimes many years later. An actuarially computed reserve is carried in the financial statements for these future benefits. Earnings are charged for the increase in this reserve each period, but there is no corresponding cash outlay. Therefore, cash provided from operations is generally expected to exceed net income. Cash flows are also generated by the maturities and scheduled repayments of the investment portfolio. Cash flows in excess of immediate requirements are invested to fund future requirements. Available cash flows are also used to repay debt, to buy back Torchmark shares, to pay shareholder dividends, and for other corporate uses. As discussed below under the caption Parent Company Liquidity, the primary source of the cash flows for these purposes is dividends paid by the insurance subsidiaries to the parent company.
Cash flows provided from operations were $731 million in 2008, $850 million in 2007, and $865 million in 2006. In addition, we received $581 million in investment maturities, repayments, and calls in 2008, adding to available cash flows. Such repayments were $1.3 billion in 2007 and $606 million in 2006.
Our cash and short-term investments were $177 million at year-end 2008 and $131 million at year-end 2007. Additionally, we have a portfolio of marketable fixed and equity securities that are available for sale in the event of an unexpected need. These securities had a fair value of $7.8 billion at December 31, 2008. However, our strong cash flows from operations, investment maturities, and credit line availability make any need to sell securities for liquidity unlikely.
Capital in our insurance subsidiaries is sufficient to support current operations. As of December 31, 2008, the ratio of regulatory capital to Company Action Level required capital was 329%, in line with recent years.
(3) Pension obligations are primarily liabilities in trust funds that are calculated in accordance with the terms of the pension plans. They are offset by invested assets in the trusts, which are funded through periodic contributions by Torchmark in a manner which will provide for the settlement of the obligations as they become due. Therefore, our obligations are offset by those assets when reported on Torchmark’s Consolidated Balance Sheets. At December 31, 2008, these pension obligations were $230 million, but there were also assets of $175 million in the pension entities. The schedule of pension benefit payments covers ten years and is based on the same assumptions used to measure the pension obligations, except there is no interest assumption because the payments are undiscounted. Please refer to Note 9-Postretirement Benefits in the Notes to Consolidated Financial Statements for more information on pension obligations.
(4) Uncertain tax positions do not include $1.2 million of accrued interest. See Note 8-Income Taxes in the Notes to Consolidated Financial Statements for more information.
(5) Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force and separate account obligations at December 31, 2008. These estimated payments were computed using assumptions for future mortality, morbidity and persistency. The actual amount and timing of such payments may differ significantly from the estimated amounts shown. Management believes that the assets supporting the liability of $9 billion at December 31, 2008, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Index to Financial Statements Capital Resources. Torchmark’s capital structure consists of short-term debt (the commercial paper facility described in Note 10-Debt in the Notes to Consolidated Financial Statements), long-term funded debt, Junior Subordinated Debentures supporting its Trust Preferred Securities, and shareholders’ equity. The Junior Subordinated Debentures are payable to Torchmark’s Capital Trust III which is liable for its Trust Preferred Securities. In accordance with GAAP, these instruments are included in “Due to affiliates” on the Consolidated Balance Sheets. A complete analysis and description of long-term debt issues outstanding is presented in Note 10-Debt in the Notes to Consolidated Financial Statements.
During the second quarter of 2006, we registered and issued two new security offerings: our 7.1% Trust Preferred Securities, offered through Torchmark Capital Trust III at a redemption value of $120 million less issue expenses, and our 6 3/8% Senior Notes issued for the principal amount of $250 million less issue expenses. In the fourth quarter of 2006, we redeemed our 7 3/4% Trust Preferred Securities and we repaid our 6 1/4% Senior Notes which matured. The Trust Preferred Securities were redeemed for $150 million plus accrued dividends and our Senior Notes were repaid in the principal amount of $180 million plus accrued interest. Specific information about the new securities offered and the securities repaid in 2006, including the uses of proceeds and sources of funding, is disclosed and discussed in Note 10-Debt in the Notes to Consolidated Financial Statements.
We believe that the most beneficial use of our excess cash flow could be a strategic acquisition. However, an acquisition is unlikely until financial markets stabilize. Absent an acquisition, we believe that the best use of excess cash is to buy Company stock. However, we will exercise caution given current economic conditions. We will not jeopardize our liquidity or debt covenants through our share repurchase program. As previously mentioned, our Board reaffirmed its continued authorization of the stock repurchase program in October, 2008 in amounts and timing that management, in consultation with the Board, determined to be in the best interest of the Company. We have repurchased common stock every year since 1986, except for 1995, the year following the acquisition of American Income. Since the beginning of 1998, we have repurchased 60 million shares at a total cost of $2.7 billion, and have acquired no fewer than 3.4 million shares in any one year. We believe that Torchmark share purchases at favorable prices add incrementally to per share earnings and to return on equity, and are an excellent way to increase total shareholder value. As noted earlier in this report, we acquired over 7.6 million shares at a cost of $427 million in 2008 with excess cash flow. If the free cash flow used for the repurchase of our common stock had alternatively been invested in corporate bonds, an estimated $11 million of additional investment income, after tax, would have resulted and net income per diluted share would have declined 9% to $4.99. Because share purchases were made, actual net income per share was $5.11, a lesser decline of 7%. We intend to continue the repurchase of our common shares when conditions are favorable. The majority of purchased shares are retired each year.
As discussed earlier in this report, the fixed maturity portfolio incurred $1.8 million in net unrealized investment losses in 2008 ($1.1 million after tax and adjustments of deferred acquisition costs). These unrealized losses are believed by management to have been brought on by widening credit spreads in financial markets, and were the primary factor in the decline in our shareholders’ equity in 2008. Share purchases in each of the years 2006 through 2008 were generally offset by net income, having little impact on our total shareholders’ equity in those periods. Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 11.5 times in 2008, compared with 12.8 times in 2007 and 11.6 times in 2006. A discussion of our interest expense is included in the discussion of financing costs under the caption Investments in this report.
Index to Financial Statements Credit Ratings. The credit quality of Torchmark’s debt instruments and capital securities are rated by various rating agencies. In 2008, Standard & Poor’s affirmed all credit ratings on Torchmark and its subsidiaries. However, it revised its outlook to negative from stable for the Company. Standard & Poor’s cited our increased risk within our investment portfolio which has experienced significant unrealized losses concentrated in the financial sector. They also noted that our share repurchase program has reduced our capitalization, but that we were still well within a level adequate to support their rating. Fitch also revised its outlook to negative during 2008. During 2007, Standard & Poor’s lowered its credit rating on Torchmark’s outstanding debt from A+ to A, and lowered the rating of its preferred stock from A- to BBB+. The credit rating change was attributed to weaker agent productivity, recruiting, and retention, as well as changes in direct response strategy, all of which have contributed to lower new sales. During 2006, A.M. Best downgraded Torchmark’s funded debt one notch from a to a-, and its preferred stock from a- to bbb+. Moody’s downgraded our funded debt from A3 to Baa1, and our preferred stock from Baa1 to Baa2. Both downgrades were to reflect the “notching,” or widening of rating levels between the insurance companies and their parent company which has issued the debt. This notching is typical for these rating agencies as they rate other insurance companies. It does not reflect any change in the creditworthiness of the Company. The chart below presents Torchmark’s credit ratings as of December 31, 2008.
Information regarding related party transactions is found in Note 15-Related Party Transactions in the Notes to Consolidated Financial Statements.
Derivatives: Statement No. 161, Disclosures About Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133 (SFAS 161), was issued in March, 2008 expanding the disclosures about derivatives and hedging activities required under existing accounting guidance. SFAS 161 is effective for Torchmark as of January 1, 2009. As of December 31, 2008, Torchmark does not hold any of the derivative instruments subject to this Statement.
Postretirement Benefit Plan Assets: The FASB issued in December, 2008 FASB Staff Position 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets (FSP 132(R)-1). This document requires additional disclosures about plan assets, such as more detail information on asset categories, investment strategies, concentrations of credit risks, and valuation techniques. The valuation information is similar to the disclosures in SFAS 157 for Company investments. FSP 132(R)-1 also requires a discussion of the basis for the determination of the expected long-term-rate-of-return assumption. It is effective for annual periods for Torchmark beginning in 2009.
Approximately 95% of our recorded amounts for deferred acquisition costs at December 31, 2008 are accounted for under the provisions of SFAS 60 for which deferred acquisition costs are amortized over the premium-paying period in proportion to the present value of actual historic and estimated future gross premiums. The projection assumptions for SFAS 60 business are set at the time of contract issue. Under SFAS 60, these assumptions are “locked-in” at that time and, except where there is a loss recognition issue, are not revised for the lifetime of the contracts. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volume. We have not recorded a deferred acquisition cost loss recognition event for our SFAS 60 assets for any period in the three years ended December 31, 2008.
During 2008, the values of our fixed maturities have also been affected by illiquidity in the financial markets, which has contributed to a spread widening, and accordingly unrealized losses, on many securities that we expect to be fully recoverable. Even though our fixed maturity portfolio is available for sale, we have the ability and intent to hold the securities until maturity as a result of our strong and stable cash flows generated from our insurance products. Considerable information concerning the policies, procedures, classification levels, and other relevant data concerning the valuation of our fixed-maturity investments are presented in Note 3-Investments under the caption Fair Value Measurements.
Impairment of Investments. We continually monitor our investment portfolio for investments that have become impaired in value, where fair value has declined below carrying value. While the values of the investments in our portfolio constantly fluctuate due to market conditions, an other than temporary impairment charge is recorded only when a security has experienced a decline in fair market value which is deemed other than temporary. The policies and procedures that we use to evaluate and account for
Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31,
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2008
Gains and losses realized on the disposition of investments are determined on a specific identification basis. Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark’s net income. Investment income attributable to all other insurance policies and products is included in Torchmark’s net investment income. Net investment income for the years ended December 31, 2008, 2007, and 2006 included $480 million, $448 million, and $417 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocated to insurance policyholders’ liabilities.
Fair Value Measurements: Effective January 1, 2008, Torchmark adopted Financial Accounting Standards Board Statement No. 157, Fair Value Measurements (SFAS 157). This Statement clarifies the definition of fair value, establishes a hierarchy for measuring fair value, and expands disclosures about measurement methodology and its effects on fair value. It does not change which assets or liabilities are
Hybrid Financial Instruments: Statement No. 155, Accounting for Certain Hybrid Financial Instruments, (SFAS 155), was adopted by Torchmark effective January 1, 2007. It extended the scope of SFAS 133 to include certain securitized financial assets. Assets affected included primarily mortgage-backed securities, collateralized mortgage obligations, and asset-backed securities that contain an embedded derivative. The Company would have a one-time election to value the entire amount of any affected hybrid security at fair value, with fluctuations in value included in earnings. Because Torchmark has negligible investments in affected securities, the impact of adoption was immaterial.
information concerning the fair value of securities is found in Note 3-Investments under the caption Fair value measurements. The fair values of Torchmark’s long-term debt issues, along with the trust preferred securities, are based on quoted market prices. Interest-rate swaps are valued using discounted anticipated cash flows.
Future Policy Benefits: The liability for future policy benefits for universal life-type products according to SFAS 97 is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 73% of total future policy benefits, is provided on the net level premium method based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. Assumptions used are based on Torchmark’s previous experience with similar products. Once established, assumptions for these products are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions. These estimates are periodically reviewed and compared with actual experience. If it is determined that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover unamortized acquisition costs, then a premium deficiency exists. Such a deficiency would be recognized immediately by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future policy benefits. From that point forward, the liability for future policy benefits would be based on the revised assumptions.
Torchmark adopted and implemented Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48), on January 1, 2007. This interpretation was issued to clarify the accounting for income taxes by providing methodology for the financial statement recognition and measurement of uncertain income tax positions taken or expected to be taken in a tax return. The impact of the adoption of FIN 48 is described in Note 8-Income Taxes.
Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill. In accordance with SFAS 142, Goodwill and Other Intangible Assets, goodwill is subject to
In January, 2007, a subsidiary of Globe acquired the assets of Direct Marketing and Advertising Distributors, Inc. (DMAD) for $47 million in a cash transaction. For the preceding fifteen years, Globe was DMAD’s only insurance client. During this period of time, DMAD provided advertising and targeted marketing for the part of Globe’s direct response insurance business that is distributed through mailed coupon packets and publication inserts. The purchase added approximately $45 million of goodwill and $2 million of other assets to Torchmark as of the date of purchase. As a result of the transaction, Torchmark’s goodwill increased to $424 million.
The Company recorded a $10.8 million settlement benefit related to prior years during 2008 which primarily resulted from the favorable resolution of litigation concerning tax liabilities asserted by Canadian tax authorities covering several years. More information on this tax settlement is provided in Note 8-Income Taxes in the Notes to Consolidated Financial Statements. The Company also benefited from $1.1 million in U.S. Federal income tax issues settled in 2007 related to prior years.
Torchmark management views all stock-based compensation expense as a corporate or Parent Company expense and, therefore, presents it as such in its segment analysis (See Note 13-Business Segments). It is included in “Other operating expense” in the Consolidated Statements of Operations.
Proceeds from sales of fixed maturities available for sale were $123.7 million in 2008, $313.6 million in 2007, and $183.2 million in 2006. Gross gains realized on those sales were $2.9 million in 2008, $1.6 million
in 2007, and $3.8 million in 2006. Gross losses were $3.4 million in 2008, $4.7 million in 2007, and $7.5 million in 2006. There were no equities sold in 2008. Proceeds from sales of equity securities were $7.6 million in 2007 and $3.5 million in 2006. Gross gains realized on those sales were zero in both years. Gross losses realized on those sales were $2.2 million in both 2007 and 2006.
The following table represents assets measured at fair value on a recurring basis:
The following table represents changes in assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3).
Other-than-temporary impairments: Torchmark’s portfolio of fixed maturities fluctuates in value due to changes in interest rates in the financial markets as well as other factors. Fluctuations caused by market interest rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers these declines in value resulting from changes in market interest rates to be temporary. In certain circumstances, however, Torchmark determines that the decline in the value of a security is other-than-temporary and writes the book value of the security down to its fair value, realizing an investment loss. The determination that an impairment is other-than-temporary is highly subjective and involves the careful consideration of many factors. Among the factors considered are:
During 2008, the Company determined that certain of its holdings in fixed maturities and preferred stocks were other-than-temporarily impaired, resulting in writedowns in the amount of $106 million ($69 million after tax). The pretax writedown includes writedowns of $74 million for bonds issued by Lehman Brothers, $19 million for bonds issued by Washington Mutual, and $1.9 million for perpetual preferred stock issued by the Federal National Mortgage Association. All losses for other-than-temporary impairment were included in realized investment losses. Also during 2008, certain real estate holdings, measured on a nonrecurring special-event basis, were written down because the carrying values of these properties were not expected to be recoverable. The fair values were determined based on recent sales of similar properties (Level 2 observable inputs). The writedowns consisted of company-occupied property in the amount of $2.1 million ($1.4 million after tax) and investment real estate in the amount of $1.1 million ($.7 million after tax). The loss on company-occupied property was included in “Other operating expense” and the loss on invested real estate was included as a Realized investment loss.
Torchmark had $507 thousand in investment real estate at December 31, 2008 which was nonincome producing during the previous twelve months. Torchmark had no nonincome producing fixed maturities or other long-term investments during the twelve months ended December 31, 2008.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $3.2 million, $3.6 million, and $3.8 million for the years ended December 31, 2008, 2007, and 2006, respectively. The average interest rates used for the years ended December 31, 2008, 2007, and 2006 were 5.5%, 5.7%, and 5.7%, respectively. The estimated amortization, net of interest accrued, on the unamortized balance at December 31, 2008 during each of the next five years is: 2009, $5.5 million; 2010, $5.0 million; 2011, $4.5 million; 2012, $4.2 million; and 2013, $3.8 million.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 2008 is as follows:
The overall average interest assumption for determining the liability for future life and health insurance benefits in 2008 was 6.1%.
Torchmark’s Federal income tax returns are routinely audited by the Internal Revenue Service (IRS). In the fourth quarter of 2006, the Appeals Division of the IRS and Torchmark agreed to settle all issues with respect to the Company’s 1998, 2001, and 2002 tax years. As a result, Torchmark recorded $7.4 million tax benefit in 2006 to reflect the impact of these settlements on the tax years covered by the examinations as well as all other tax years to which the settled issues apply. The benefits relate primarily to Torchmark’s computation of the dividends received deduction on its separate account assets and the amount of life insurance reserves for income tax purposes. The IRS also completed its examination of Torchmark’s 2003 and 2004 tax years during 2008. As a result, Torchmark recorded a $.7 million tax benefit in 2008 to reflect the impact of the settlement. The statutes of limitation for the assessment of additional tax are closed for all tax years prior to 2005. The IRS has substantially completed its review of the Company’s 2005, 2006, and 2007 tax years. Final settlement of these reviews is expected in 2009 and is not expected to have any material impact on the Company’s effective tax rate. In addition, the statute of limitation for the assessment of additional tax is also expected to expire in 2009 for the 2005 tax year. Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from the completed examinations, future tax examinations, and other tax-related matters for all open tax years.
A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding effects of accrued interest, net of Federal tax benefits) for the years 2007 and 2008 is as follows:
If recognized in future periods, $518 thousand of the balance at December 31, 2008 would reduce the effective tax rate. The remaining $8 million relates to timing differences which, if recognized, would have no effect on the Company’s effective tax rate. As noted above, the IRS has substantially completed its review of Torchmark’s 2005, 2006, and 2007 Federal income tax returns. Final settlement of all issues relating to those tax years is expected to occur within the next twelve months. As a result, the Company estimates that approximately $3.9 million of its unrecognized tax benefits relating to positions taken in those tax years, each of which are individually insignificant, may be recognized by the end of 2009.
In January, 2007, Torchmark approved and implemented a new Supplemental Executive Retirement Plan (SERP), which provides to a limited number of executives an additional supplemental defined pension benefit. The supplemental benefit is based on the participant’s qualified plan benefit without consideration to the regulatory limits on compensation and benefit payments applicable to qualified plans, except that eligible compensation is capped at $1 million. The SERP is unfunded. The initial projected benefit obligation of this plan was $15 million. The liability at December 31, 2008 was $28 million and was $17 million a year earlier.
Plan assets in the funded plan consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair market value. The following table presents the assets of Torchmark’s defined benefit pension plans by component for the years ended December 31, 2008 and 2007.
All of the securities in the portfolio are highly marketable so that there will be adequate liquidity to meet projected payments. There are no specific policies calling for asset durations to match those of benefit obligations.
Allowed investments are limited to equities, fixed maturities, and short-term investments (invested cash). Equities include common and preferred stocks, securities convertible into equities, and mutual funds that invest in equities. Fixed maturities consist of marketable debt securities rated investment grade at purchase by a major rating agency. Short-term investments include fixed maturities with maturities less than one year and invested cash. Target asset allocations are as follows with a twenty percent allowable variance as noted.
Portfolio risk is managed through quality standards, diversification, and continuous monitoring. Equities must be listed on major exchanges and adequate market liquidity is required. Fixed maturities must be rated investment grade at purchase by a major rating agency. Short-term investments in commercial paper must be rated at least A-2 by Standard & Poor’s with the issuer rated investment grade. Invested cash is limited to banks rated A or higher. Investments outside of the aforementioned list are not permitted, except by prior approval of the Plan’s Trustees. At December 31, 2008, there were no restricted investments contained in the portfolio.
The portion of other comprehensive income that is expected to be reflected in pension expense in 2009 is as follows:
The accumulated benefit obligation (ABO) for Torchmark’s funded defined benefit pension plans was $184 million and $176 million at December 31, 2008 and 2007, respectively. In the unfunded plans, the ABO was $24 million at December 31, 2008 and $25 million at December 31, 2007.
Torchmark has estimated its expected pension benefits to be paid over the next ten years as of December 31, 2008. These estimates use the same assumptions that measure the benefit obligation at December 31, 2008, taking estimated future employee service into account. Those estimated benefits are as follows:
The table below presents the assumptions used to determine the liabilities and costs of Torchmark’s post-retirement benefit plans other than pensions.
(9) Classified as short-term debt. Senior debentures due 2009 were classified as long-term debt in 2007.
Trust III is a variable interest entity in which Torchmark is not the primary beneficiary under GAAP. Therefore, Torchmark is prohibited from consolidating Trust III even though it has 100% ownership, complete voting control, and has guaranteed the performance of Trust III. Accordingly, Torchmark carries its 7.1% Junior Subordinated Debentures due to Trust III as a liability under the caption “Due to Affiliates” on its Consolidated Balance Sheets. Expenses of $4.3 million related to the offering reduce long-term debt and are amortized over the forty-year redemption period.
Interest rate swaps: Torchmark previously entered into agreements with certain banks for which it received from the banks fixed-rate payments that matched the coupons that it paid to the holders of certain of its debt instruments, and made floating-rate payments based on LIBOR rates to the banks. As of January 1, 2006, two such swaps were outstanding. The swaps were carried at fair value and classified as “Other long-term investments” on the Consolidated Balance Sheets. These swaps exchanged the fixed-interest commitments for floating-rate commitments on Torchmark’s 6¼% Senior Notes ($180 million notional amount) and the 7¾% Trust Preferred Securities ($150 million notional amount). They were sold in June, 2006, as rising short-term rates continued to reduce future prospects for positive interest-rate spreads. Torchmark received $63 thousand in net proceeds from the sales of these swaps. No gain or loss was recognized on the sales. Swaps that qualify as hedges do not affect earnings on a periodic basis. Changes in the fair value of these swaps are offset by an adjustment of the carrying value of the related Notes in like amount each period. The swap related to the 6¼% Senior Notes qualified as a hedge under accounting rules. However, when sold, the cost basis of the underlying Note was decreased for the value of the swap, causing an increase in the amortization of that security until disposed of later in 2006. Swaps which do not qualify as hedges are revalued each period with such changes in value reflected in realized gains and losses as incurred. The other sold swap did not qualify as a hedge. Torchmark has held no interest-rate swaps since June, 2006.
Terms of the swaps held by Torchmark during 2006 were as follows:
Acquisition of Common Shares: Torchmark shares are acquired from time to time through open market purchases under the Torchmark stock repurchase program when it is believed to be the best use of Torchmark’s excess cash flows. Share repurchases under this program were 7.6 million shares at a cost of $427 million in 2008, 6.1 million shares at a cost of $402 million in 2007, and 5.6 million shares at a cost of $320 million in 2006. When stock options are exercised, proceeds from the exercises are generally used to repurchase approximately the number of shares available with those funds, in order to reduce dilution. Shares repurchased for dilution purposes were 487 thousand shares at a cost of $29 million in 2008, 767 thousand shares at a cost of $50 million in 2007, and 415 thousand shares costing $24 million in 2006.
Stock options to purchase 3.5 million shares, 432 thousand shares, and 21 thousand shares during the years 2008, 2007, and 2006, respectively, are considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
The following table summarizes information about stock options outstanding at December 31, 2008.
Torchmark’s reportable segments are based on the insurance product lines it markets and administers: life insurance, health insurance, and annuities. These major product lines are set out as segments because of the common characteristics of products within these categories, comparability of margins, and the similarity in regulatory environment and management techniques. There is also an investment segment which manages the investment portfolio, debt, and cash flow for the insurance segments and the corporate function. Torchmark’s chief operating decision maker evaluates the overall performance of the operations of the Company in accordance with these segments.
Life insurance products include traditional and interest-sensitive whole life insurance as well as term life insurance. Health products are generally guaranteed-renewable and include Medicare Supplement, Medicare Part D, cancer, accident, long-term care, and limited-benefit hospital and surgical coverages. Annuities include both fixed-benefit and variable contracts. Variable contracts allow policyholders to choose from a variety of mutual funds in which to direct their deposits.
The measure of profitability established by the chief operating decision maker for insurance segments is underwriting margin before other income and administrative expenses, in accordance with the manner the segments are managed. It essentially represents gross profit margin on insurance products before insurance administrative expenses and consists of premium, less net policy obligations, acquisition expenses, and commissions. Interest credited to net policy liabilities (reserves less deferred acquisition costs and value of insurance purchased) is reflected as a component of the Investment segment in order to match this cost to the investment earnings from the assets supporting the net policy liabilities.
The measure of profitability for the Investment segment is excess investment income, which represents the income earned on the investment portfolio in excess of net policy requirements and financing costs associated with Torchmark’s debt. Other than the above-mentioned interest allocations, there are no other intersegment revenues or expenses. Expenses directly attributable to corporate operations are included in the “Corporate” category. Stock-based compensation expense is considered a corporate expense by Torchmark management and is included in this category. All other unallocated revenues and expenses on a pretax basis, including insurance administrative expense, are included in the “Other” segment category. The following tables set forth a reconciliation of Torchmark’s revenues and operations by segment to its major income statement line items.
(1) Medicare Part D items adjusted to GAAP from the segment analysis, which matches expected benefits with policy premium.
Torchmark holds a sizeable investment portfolio to support its insurance liabilities, the yield from which is used to offset policy benefit, acquisition, administrative and tax expenses. This yield or investment income is taken into account when establishing premium rates and profitability expectations of its insurance products. In holding such a portfolio, investments are sold, called, or written down from time to time, resulting in a realized gain or loss. These gains or losses generally occur as a result of disposition due to issuer calls, a downgrade in credit quality, compliance with Company investment policies, or other reasons often beyond management’s control. Unlike investment income, realized gains and losses are incidental to insurance operations, and are not considered when setting premium rates or insurance product profitability expectations. While these gains and losses are not relevant to segment profitability or core operating results, they can have a material positive or negative result on net income. For these reasons, management removes realized investment gains and losses when it views its segment operations.
As described in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements, Torchmark accounts for its stock-based compensation under FASB Statement 123R, which requires the expensing of such compensation on a fair value basis. Torchmark management views stock-based compensation expense as a corporate expense. Therefore, stock-based compensation expense is included in the Corporate group in this segment analysis.
Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2.0 million per life. Life insurance ceded represented .9% of total life insurance in force at December 31, 2008. Insurance ceded on life and accident and health products represented .4% of premium income for 2008. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $5.1 million in 2008, $6.0 million in 2007, and $6.1 million in 2006. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2008 were as follows: 2009, $3.4 million; 2010, $2.1 million; 2011, $1.4 million; 2012, $1.2 million; 2013, $1.0 million and in the aggregate, $9.9 million.
Concentrations of Credit Risk: Torchmark maintains a diversified investment portfolio with limited concentration in any given issuer. At December 31, 2008, the investment portfolio, at fair value, consisted of the following:
Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Corporate debt and equity investments are made in a wide range of industries. At December 31, 2008, 2% or more of the corporate portfolio was invested in the following industries:
Otherwise, no individual industry represented 2% or more of Torchmark’s investments. At year-end 2008, 5% of invested assets was represented by fixed maturities rated below investment grade (BB or lower as rated by the Bloomberg Composite or the equivalent NAIC designation). Par value of these investments was $802 million, amortized cost was $712 million, and fair value was $461 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value of the securities.
Guarantees: At December 31, 2008, Torchmark had in place four guarantee agreements, all of which were either parent company guarantees of subsidiary obligations to a third party, or parent company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2008, Torchmark had no liability with respect to these guarantees.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks. The letters of credit were issued by TMK Re, Ltd., a wholly-owned subsidiary, to secure TMK Re, Ltd.’s obligation for claims on certain policies reinsured by TMK Re, Ltd. that were sold by other Torchmark insurance companies. These letters of credit facilitate TMK Re, Ltd.’s ability to reinsure the business of Torchmark’s insurance carriers. The agreement expires in 2011. The maximum amount of letters of credit available is $200 million. Torchmark (parent company) would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. At December 31, 2008, $200 million of letters of credit were outstanding.
Equipment leases: Torchmark has guaranteed performance of two subsidiaries as lessees under leasing arrangements for aviation equipment. The leases commenced in 2003 for lease terms of approximately 10 years. Lessees have certain renewal and early termination options, however. At December 31, 2008, total remaining undiscounted payments under the leases were approximately $3.3 million. Torchmark (parent company) would be responsible for any subsidiary obligation in the event the subsidiary did not make payments or otherwise perform under the terms of the lease.
Litigation: Torchmark and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims involving tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, management does not believe that such litigation will have a material adverse effect on Torchmark’s financial condition, future operating results or liquidity; however, assessing the eventual outcome of litigation necessarily involves forward-looking speculation as to judgments to be made by judges, juries and appellate courts in the future. This bespeaks caution, particularly in states with reputations for high punitive damage verdicts such as Alabama and Mississippi. Torchmark’s management recognizes that large punitive damage awards bearing little or no relation to actual damages continue to be awarded by juries in jurisdictions in which Torchmark and its subsidiaries have substantial business, particularly Alabama and Mississippi, creating the potential for unpredictable material adverse judgments in any given punitive damage suit.
Court for the Northern District of Alabama (In Re: Vesta Insurance Group, Inc. Securities Litigation, Master File No. 98-AR-1407-S). The amended consolidated complaint in this litigation alleged violations of Section 10 (b) of the Securities Exchange Act of 1934 by the defendants Vesta, certain present and former Vesta officers and directors, KPMG, LLP (Vesta’s former independent public accountants) and Torchmark and of Section 20 (a) of the Exchange Act by certain former Vesta officers and directors and Torchmark acting as “controlling persons” of Vesta in connection with certain accounting irregularities in Vesta’s reported financial results and filed financial statements. Unspecified damages and equitable relief were sought on behalf of a purported class of purchasers of Vesta equity securities between June 2, 1995 and June 29, 1998. A class was certified in this litigation on October 25, 1999. In September, 2001, Torchmark filed a motion for summary judgment, which was denied by the District Court on January 10, 2002. On April 9, 2003, the District Court issued an order denying the class plaintiffs’ motion to strike certain of Torchmark’s affirmative defenses, holding that Torchmark could not be held jointly and severally liable with Vesta under the securities law without an affirmative jury determination that Torchmark knowingly committed a violation of the securities laws.
received on certain issues, materials relating to objections to the proposed settlement submitted to the Court-appointed independent special master, objectors to the potential settlement heard and a report of the Court-appointed independent actuary received on certain issues thereafter.
On March 30, 2007, the Barbour County Circuit Court issued an order denying Liberty’s petition for clarification and/or modification of Robertson, holding that Liberty’s policies did not state that they will pay “actual charges” accepted by providers. On April 8, 2007, the Court issued an order granting a motion to intervene and establishing a subclass in Robertson comprised of Liberty cancer policyholders who were then or had within the past six years, undergone cancer treatment and filed benefit claims under the policies in question. Liberty filed a motion with the Barbour County Circuit Court to certify for an interlocutory appeal that Court’s order on Liberty’s petition for clarification in Robertson on April 17, 2007. An appellate mediation of these issues was conducted on August 9, 2007. On October 16, 2007, the Alabama Supreme Court entered orders, based upon the conclusion by the parties of the appellate mediation, staying the proceedings for a writ of mandamus, reinstating the cases on the appellate docket, and remanding the cases to the Barbour County Circuit Court to implement the parties’ settlement agreement. A fairness hearing on the proposed settlement agreement was held by the Barbour County Circuit Court on January 15, 2008. Subsequent to this hearing, an order approving the settlement agreement was approved by the Barbour County Circuit Court but was thereafter vacated by that Court due to technical errors in the printing of the original order. A corrected order finally approving the settlement was entered on or about May 6, 2008. Prior to the entry of the corrected order, notice of appeal was filed by one objector. On July 29, 2008, the Alabama Supreme Court dismissed the remaining appeal in Robertson, but reinstated that appeal on September 22, 2008. Appellate mediation was ordered with respect to this appeal, and on September 30, 2008, a settlement was reached in appellate mediation which resulted in a dismissal order in the objector’s litigation issued by the Barbour County Circuit Court on October 16, 2008. The Alabama Supreme Court dismissed the remaining appeal on December 18, 2008. The trial court’s May 6, 2008 order finally approving the second class settlement in Robertson is therefore in full force and effect.
On January 18, 2008, purported class action litigation was filed against Liberty in the U.S. District Court for the Southern District of Florida (Joseph v. Liberty National Life Insurance Company, Case No. 08-20117 CIV - Martinez) on behalf of all black Haitian-Americans who reside in Florida (including both naturalized and alien persons) and who have or have had an ownership interest in life insurance policies sold by Liberty where it is alleged that Liberty issued and administered such policies on a discriminatory basis because of their race and Haitian ancestry, ethnicity or national origin. The plaintiffs alleged an intentional plan on behalf of Liberty to discriminate against the black Haitian-American community in the formation, performance and termination of life insurance contracts in violation of 42 U.S.C. §1981 and §1982 by target marketing and underwriting inquiries regarding whether the applicant for insurance was Haitian, had traveled to Haiti in the past or planned to do so at any time in the future and, based upon such information, either denying the application or issuing a substandard policy or in some instances it was alleged, refusing to pay death benefits on issued policies. The plaintiffs sought unspecified compensatory damages in excess of $75,000, punitive damages, injunctive relief, attorneys’ fees and other relief. After the death of one of the named class plaintiffs and the Court’s dismissal of that plaintiff’s claims without prejudice, the remaining two class plaintiffs elected to proceed with this litigation on an individual basis. On January 22, 2009, the Court issued an Order granting Liberty’s Motion for Summary Judgment and closing the case. A settlement has also been reached in substantially identical class litigation filed on September 17, 2008 in the United States District Court for the Southern District of Florida (Joseph v. Liberty National Life Insurance Company, Case No. 08-1:08-cv-22580).
First Command. Lamar C. Smith, a director of Torchmark, served as Chief Executive Officer of First Command Financial Services, Inc. (First Command), a corporation 100% owned by the First Command Employee Stock Ownership Plan (First Command ESOP) until May 1, 2007 and thereafter as Chairman of First Command Bank, a subsidiary of First Command, until his retirement from First Command September 30, 2007. Mr. Smith was a beneficiary of the First Command ESOP although he had no ability to vote the stock of First Command that is held by the First Command ESOP, which is independently trusteed. First Command receives commissions as the Military Agency distribution system for selling certain life insurance products offered by Torchmark’s insurance subsidiaries. These commissions were $45.3 million in 2007 and $50.8 million in 2006. Torchmark held balances due from this agency of $5.0 million at year-end 2007.
Torchmark currently has two loan agreements with First Command, a mortgage loan agreement and a collateral loan agreement. The mortgage loan bears interest at a rate of 7.0%. The initial balance of $22.3 million is being repaid in equal monthly payments over fifteen years, which began May 1, 2003. At year end 2007, the outstanding balance was $17.8 million. The loan is collateralized by a four-story office building in Fort Worth, Texas, which was appraised by an independent firm in 2001 at $22.8 million. In addition to the office building as collateral, Torchmark has the right of offset to any commissions due First Command, in the event of default.
The collateral loan bears interest at the rate of 7.0%. First Command is making fixed monthly payments which are scheduled to repay the loan by May, 2010. First Command has the right to make additional, unscheduled payments. At year end 2007, the outstanding balance was $5.4 million. The loan is collateralized by real estate and a parking garage in Fort Worth, Texas. The property was appraised by an independent firm in 2002 at $17.6 million.
Baxley. William J. Baxley is a partner in the law firm of Baxley, Dillard, Dauphin, McKnight & Barclift which performs legal services for Torchmark and certain of its subsidiaries. In 1997, Mr. Baxley was loaned $668 thousand on an unsecured basis at a rate of 6.02%. Repayments are made in the form of legal services at customary rates and are applied against the outstanding balance, amortizing the loan with interest over its remaining term. In October, 2001, the terms of the loan were revised and an additional amount of $395 thousand was loaned to Baxley. The interest rate was revised to 5.6% and the term of the loan was extended until July, 2013. The loan is being repaid in accordance with its amortization schedule and all payments are current. At December 31, 2008 and 2007, the outstanding balance of this loan was $371 thousand and $442 thousand, respectively.
Additionally, Torchmark has loaned Mr. Baxley’s wife $883 thousand secured by a mortgage on a building sold to her in 1997. Prior to 2006, interest was charged at a rate of 7.7%. This loan was originally due to be repaid in 2007 with a balloon payment, but in January, 2006, the outstanding balance of $734 thousand was refinanced and extended until January of 2023. The interest rate was revised to 5.5%. Scheduled cash payments are made to amortize the loan. At December 31, 2008 and 2007, the outstanding balance of this loan was $651 thousand and $681 thousand, respectively.
Torchmark customarily grants options to certain consultants for their services in addition to their fees. Mr. Baxley received Torchmark options in 2008, 2007, and 2006.