The Company does not own any real estate. The Company's principal operations are conducted from leased office space pursuant to a leasing arrangement with ALLIED Mutual. See "Certain Transactions and Relationships" in the 1998 Proxy Statement for additional information. Management considers the leased space to be adequate for its needs.
The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information so long as it is identified as forward-looking and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements relate to the plans and objectives of management for future operations, future economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. In the following discussion and elsewhere in this report, statements containing words such as expect, anticipate, believe, goal, objective, or similar words are intended to identify forward-looking statements. ALLIED Life Financial Corporation (ALFC or the Company) undertakes no obligation to update such forward-looking statements, and it wishes to identify important factors that could cause actual results to differ materially from those projected in the forward-looking statements contained in the following discussion and elsewhere in this report.
The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include, but are not limited to, the following: (1) heightened competition, particularly intensified price competition, the entry of new competitors from the financial services sector, and the creation of new products by competitors; (2) adverse state and federal legislation and regulations, including federal tax laws affecting individuals, changes in the taxation of insurance companies, federal legislation allowing the entry of new competitors from the financial services sector, and the regulation of product design and the marketing of those products; (3) changes in interest rates causing a reduction of investment income; (4) general economic and business conditions that are less favorable than expected; (5) unanticipated changes in industry trends; (6) inaccuracies in assumptions regarding future morbidity, persistency, mortality, and interest rates; and (7) other risks detailed herein and from time to time in the Company's other reports.
ALLIED Life Financial Corporation is an insurance holding company with 56% of its outstanding voting stock owned by ALLIED Mutual Insurance Company (ALLIED Mutual). The financial statements include the accounts of ALLIED Life Insurance Company (ALLIED Life), ALLIED Life Brokerage Agency, Inc. (ALBA), and ALLIED Group Merchant Banking Corporation (AGMB). ALLIED Life accounts for substantially all of the Company's operations and sells primarily life insurance and annuity products.
Term life insurance policies provide life insurance protection over a specified number of years. Policyholders remit premiums for the insurance protection but accumulate no cash value.
Annuity contracts are products that provide for fixed or variable periodic benefit payments that commence according to contract terms and permit interest income to accumulate on a tax-deferred basis. Considerations paid by policyholders are credited to their accounts and earn interest at rates determined by ALLIED Life. To encourage policy persistency, surrender charges are imposed against account balances for early termination of annuity contracts.
In accordance with Generally Accepted Accounting Principles (GAAP), universal life insurance premiums received are shown as increases in liabilities for policyholder account balances and not as revenues. Revenues reported for universal life products consist of fee income from mortality charges, administration expenses, and surrender charges assessed against the account balances. Surrender benefits paid are reflected as decreases in liabilities for these account balances and not as expenses. Interest credited to account balances is reported as benefit expenses in the financial statements.
The costs related to acquiring new business (principally commissions), certain costs of issuing policies, and certain other variable selling expenses (defined as deferred policy acquisition costs) are capitalized and amortized into expense primarily in proportion to the present value of expected gross profits. This amortization is adjusted when ALLIED Life revises its current or estimated future gross profits. For example, deferred policy acquisition costs are amortized earlier than originally estimated when policy terminations are higher than expected and when investments are sold at a gain prior to their anticipated maturity.
Estimated future profits and amortization of costs are reviewed annually for universal life insurance and annuity products and may be reviewed more frequently if circumstances dictate. GAAP requires that the estimated future profits and future amortization be recomputed based on actual experience and updated expectations of future experience (unlocking). This unlocking may result in adjustments related to prior amortization as well as changes to ongoing amortizations rates.
Death and other policyholder benefits reflect ALLIED Life's exposure to mortality risk. They fluctuate from period to period according to the level of claims incurred under ALLIED Life's insurance retention limit.
The following table reflects ALLIED Life's production information and pretax operating results excluding realized investment gains (losses) and related amortization of deferred policy acquisition costs for the years indicated.
Consolidated revenues for the year ended December 31, 1997 were $90.3 million, an 11.8% increase over the $80.7 million reported for 1996. Life insurance premiums and other insurance income net of reinsurance premiums ceded rose 12.6% to $9.5 million from $8.4 million. Investment income grew 8.3% to $52.2 million from $48.2 million. In 1997 the Company had realized gains on investments of $2.4 million as compared with realized gains of $122,000 in 1996.
Operating income before taxes (which excludes realized investment gains and losses net of related amortization of deferred policy acquisition costs) was $14.9 million for 1997 compared with $11.8 million in 1996. Operating earnings per share were $1.82 compared with $1.35. Net income totaled $10.5 million ($1.94 per share) compared with $8.1 million ($1.39 per share). Operating income before taxes for 1996 included an adjustment to deferred policy acquisition costs of $2.8 million reflecting changes in assumptions used to estimate future gross profits on certain blocks of annuity business. The effect of the adjustment was to decrease operating earnings per share by $0.40.
The face amount of new term life insurance sold directly by agents decreased 12.9% to $1.3 billion from $1.5 billion. ALLIED Life continues to sell mainly 10- and 20-year guaranteed rate term life policies within this product line.
Death benefits net of reinsurance increased 18% to $8.2 million from $6.9 million. Other policyholder benefits decreased 3.4% to $6.1 million from $6.4 million. Other insurance operating expenses increased 9% to $4.4 million from $4 million.
While the Company continues to re-evaluate the DPAC assumptions, it does not anticipate making additional material adjustments to DPAC amortization schedules in the foreseeable future. Further adjustments would be necessary only if actual experience should differ significantly from the assumptions used in the DPAC study models.
Primarily due to the DPAC adjustment taken in 1996, ALLIED Life's operating income in 1997 grew 26.2% to $14.8 million from $11.7 million.
Consolidated revenues for the year ended December 31, 1996 were $80.7 million, a 7.2% increase over the $75.3 million reported in 1995. The increase was attributable to life insurance premiums and other insurance income net of reinsurance premiums ceded that rose 9.9% due to increased sales of term life insurance. Investment income increased 6.1% to $48.2 million from $45.4 million. In 1996 the Company had realized investment gains of $122,000 compared with realized losses of $722,000 in 1995.
The face amount of new life insurance sold directly by agents in 1996 increased 2.9% to $1.9 billion from $1.8 billion in 1995. The face amount of new universal life insurance sold decreased 32.6% to $410.6 million from $609.7 million. Universal life account balances increased 8.3% at year-end 1996 from year-end 1995. Fee income increased 3% to $22.9 million from $22.2 million in 1995.
First-year annuity premiums decreased 10.4% to $68.1 million from $75.9 million in 1995. The lower sales were caused by a flat interest yield curve, which allowed banks and other financial institutions to offer short-term certificates of deposit at more competitive interest rates. The total annuity account balance increased 13.4% to $467.5 million at year-end 1996 from $412.2 million at year-end 1995.
Adjusted insurance revenues increased 5.3% to $44.9 million in 1996 from $42.7 million in 1995. The increase was primarily attributable to increased investment spread and other insurance income (due to term life insurance sales). The growth in life insurance in force and policyholder account balances permitted invested assets at cost to increase 12.2% to $714.1 million at December 31, 1996 from $636.7 million at December 31, 1995. Investment income increased by 6.5%. ALLIED Life's return on invested assets decreased to 7.4% in 1996 from 7.8% in 1995.
Investment spread grew to $13.6 million from $12.7 million. Annual average interest-credited rates on universal life contracts decreased to 5.4% from 5.9% and on annuities decreased to 5.6% from 5.9%. The ratio of investment spread to investment income remained even at 28.2%.
Death benefits net of reinsurance remained at $6.9 million. Other policyholder benefits decreased 5.1% to $6.4 million from $6.7 million as decreases in reserves for supplemental contracts and single premium immediate annuities with life contingencies more than offset the increase in reserves on new term life sales and policyholder bonus reserves on universal life products. Other insurance operating expenses increased 9.1% to $4 million from $3.7 million.
Amortization of DPAC was $10.7 million in 1996. Included in that amount was an adjustment taken by the Company of $2.8 million as the result of its annual DPAC study. DPAC amortization was $6 million in 1995.
Primarily due to the increase in DPAC amortization, operating income before taxes decreased to $11.7 million in 1996 from $14.8 million in 1995.
(i) 10% of statutory policyholders' surplus as of December 31 of the preceding year
Company operations provided cash inflows of $9.4 million in 1997, $16.6 million in 1996, and $11.7 million in 1995. Cash inflows from financing activities amounted to $32.5 million, $62.4 million, and $73.3 million during 1997, 1996, and 1995, respectively. These funds and the excess operating inflows were used primarily to increase the Company's fixed maturity investment portfolio.
As of December 31, 1997, 97.2% of the Company's investments were in fixed maturities. The investment policy for the Company requires that the fixed maturity portfolio be invested primarily in debt obligations rated "BBB" or higher when they are acquired. Of the Company's fixed maturity investments held at year-end 1997, 84.2% were rated "A" or better; less than 1% were rated below investment grade (below "BBB").
At year-end 1997, all of the Company's CMOs were investment-grade securities. They were carried at a fair value of $55.4 million; 88.3% of these investments were in PAC and sequential-pay bonds. All of the Company's CMO investments have an active secondary market; therefore, their effect on liquidity is not expected to differ from the effect of other fixed maturity investments.
Management anticipates that funds to meet the Company's short-term and long-term capital expenditures, cash dividends, and operating cash needs will come from existing capital and internally generated funds. As of December 31, 1997, the Company had no material commitments for capital expenditures. As additional capital needs arise, the Company will consider taking on additional debt or issuing equity. Specific methods for meeting such needs will depend upon financial market conditions at the time.
Management does not believe inflation has had a material effect on consolidated results of operations. To reduce exposure to interest rate fluctuations, management attempts to invest new funds in securities with expected durations that match related policyholder obligations.
Interest rate changes and the slope of the yield curve may have temporary effects on the sale and profitability of the universal life and annuity products offered by ALLIED Life. For example, if interest rates rise, competing investments may become more attractive to potential purchasers until the interest rates credited to policyholder account balances are increased. If interest rates fall, profitability will be affected negatively until credited rates are adjusted to compensate for the decline in investment income. ALLIED Life sells universal life and annuity contracts that generally permit flexible responses to interest rates, which are monitored frequently.
Floors are being purchased to reduce the negative effect that may result from extreme decreases in interest rates to a level below the guaranteed interest rates provided for in the universal life insurance contracts. They entitle the Company to receive payments from the instruments' counterparties on future reset dates if the interest rate (which is tied directly to the 10-year constant maturity treasury curve) on the expiration date is below a specified fixed rate (5.0% for instruments entered into as of December 31, 1997).
Premiums paid to purchase call options are capitalized and included in other assets. For the years ended December 31, 1997 and 1996, the Company paid $6.4 million and $2.3 million, respectively, in premiums. Premiums are amortized as an expense over the term of the instruments on a straight-line basis. Gains and losses on these instruments and related liabilities are not recorded in income until realized. For more information on call options see Note 3 of Notes to Consolidated Financial Statements.
The costs of the interest rate hedging programs are not expected to have a material impact on the interest rate margin. The Company does not anticipate making any further purchases of interest rate hedges in the near future. For swaptions, floors, call, and puts the Company pays only the original premium and is not at risk of further payments regardless of market conditions.
On January 20, 1998, a complaint was filed by Sharlotte G. Harbott, a policyholder of ALLIED Life, in Superior Court of the State of California for the County of Los Angeles, against the Company, ALLIED Life, ALLIED Mutual, and unnamed persons. The complaint, an alleged class action suit, asserts that ALLIED Life fraudulently increased the cost of insurance rates charged to policyholders in breach of the terms of its universal life policies, its fiduciary obligations, and its obligations of good faith and fair dealing toward its policyholders and without adequate notice. The plaintiff, an insured under a universal life policy issued by ALLIED Life, seeks actual, consequential, and punitive damages in unspecified amounts as well as interest, attorney's fees, an accounting for moneys allegedly improperly charged to policyholders, and injunctive relief on behalf of herself and all policyholders of ALLIED Life with similar universal life policies.
The Company's insurance subsidiary is subject to regulation and supervision by the states in which it is admitted to transact business. State insurance laws generally establish supervisory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus, and regulating the type and amount of investments permitted.
Recently, the insurance regulatory framework has received increased scrutiny from various states, the federal government, and the National Association of Insurance Commissioners (NAIC). The NAIC has recommended to the states for adoption and implementation several regulatory initiatives, none of which are expected to have a material impact on ALLIED Life.
The audit committee of the Board of Directors, comprised solely of outside directors, meets regularly with the independent auditors, management, and internal auditors to review the scope and results of the audit work performed. The internal auditors and independent auditors have access to the audit committee to discuss the results of the audit, the adequacy of internal accounting controls, and the quality of financial reporting.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALLIED Life Financial Corporation and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements include the accounts of ALLIED Life Financial Corporation (the Company), an insurance holding company, and its wholly owned subsidiaries, which as of December 31, 1997 consisted of ALLIED Life Insurance Company (ALLIED Life), ALLIED Life Brokerage Agency, Inc. (ALBA), and ALLIED Group Merchant Banking Corporation (AGMB). At December 31, 1997, ALLIED Mutual Insurance Company (ALLIED Mutual) owned 56% of the outstanding voting stock of the Company and The ALLIED Life Employee Stock Ownership Trust (ESOP Trust) owned 2%. The remainder was owned by public stockholders.
The carrying values of all the Company's investments are reviewed on an ongoing basis for credit deterioration; if this review indicates a decline in fair value below cost that is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a specific write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. Realized gains and losses on investments sold are recognized on a specific identification basis.
Deferred policy acquisition costs are reviewed at least annually to determine that the unamortized portion of such costs does not exceed recoverable amounts after anticipated investment income is taken into account. Expected gross profits used in determining the recoverability and amortization pattern of deferred policy acquisition costs are based on historical gross profits and management's estimates and assumptions regarding future investment spreads, maintenance expenses, and persistency of blocks of business. The accuracy of the estimates and assumptions is affected by several factors, including factors outside the control of management such as movements in interest rates and competition from other investment alternatives. It is reasonably possible that conditions affecting the estimates and assumptions will change and that such changes will result in future adjustments to deferred policy acquisition costs.
Costs deferred were $17.3 million, $17.7 million, and $17.2 million for the years ended December 31, 1997, 1996, and 1995, respectively. Amortization of deferred policy acquisition costs net of interest accretion included in the consolidated statements of income were $11.1 million, $10.6 million, and $5.9 million for the years ended December 31, 1997, 1996, and 1995, respectively. In 1996 the amortization included an adjustment of approximately $2.8 million the Company recorded as a result of its annual deferred policy acquisition costs study. The study suggested refinements in certain assumptions used to estimate future gross profits to be realized from blocks of annuity business. The Company will continue to re-evaluate all applicable assumptions but does not anticipate making further material adjustments in the foreseeable future. At December 31, 1997, unamortized deferred policy acquisition costs were decreased by approximately $18.4 million (by $4 million in 1996 and $9.6 million in 1995) to recognize the impact of unrealized appreciation of investments on such deferred costs. The decreases net of deferred income taxes were charged to stockholders' equity.
Policyholder account balances for universal life and annuity contracts consist of deposits received plus accumulated credited interest less withdrawals and accumulated policy-holder assessments. Interest credited to policyholder account balances for universal life contracts averaged 5.3%, 5.4%, and 5.9% in 1997, 1996, and 1995, respectively. Interest credited to policyholder account balances for annuity contracts averaged 5.4%, 5.6%, and 5.9% in 1997, 1996, and 1995, respectively. Rates used to credit interest to policyholder account balances are subject to periodic adjustment. Certain universal life and annuity contracts offer persistency bonuses, which are accrued in the accompanying financial statements based on assumptions of investment yields, withdrawals, mortality, and other factors. For term life insurance policies, liabilities for future policy benefits are provided according to the net level premium method based on estimated investment yields, withdrawals, mortality, and other assumptions that were appropriate at the time the policies were issued.
Revenues from universal life contracts include policy fees for administration expenses, mortality charges, and surrender charges assessed against policyholder account balances during the period; revenues from annuity contracts include only surrender charges. Benefits and expenses relating to these contracts include interest credited as well as benefits incurred in excess of policyholder account balances during the period. Premiums and considerations received and surrender benefits paid on these contracts are reported as deposits to and withdrawals from policyholder account balances.
The table below presents the amortized cost and estimated fair value of investments in fixed maturities at December 31, 1997 by contractual maturity. Expected maturities at December 31, 1997 will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
A summary of net realized investment gains (losses) and net changes in unrealized appreciation (depreciation) of invest-ments is as follows:
Investments in any one entity or its affiliates (other than U.S. Treasury securities and obligations of U.S. government corporations and agencies) exceeding 10% of the Company's consolidated stockholders' equity as of December 31, 1997 consisted of fixed maturity securities issued by Hydro Quebec at a carrying value of $11.5 million.
The Company offers equity indexed annuity products that guarantee the return of principal to the customer and credits interest based on a percentage of the gain in the S&P 500 Index(R). A portion of the premium from each customer is invested in investment grade fixed income securities to cover the minimum guaranteed value due the customer at the end of the term. A portion of the premium is used to purchase S&P 500 call options (call options) to hedge the growth in interest credited to the customer as a direct result of increases in the S&P 500 Index(R). The call options provide the Company the opportunity to participate in the increases of the S&P 500 Index(R) if the market advances. As of December 31, 1997, the Company had purchased 113 call options with notional amounts ranging from $70,000 to $1.1 million (total of $36.3 million) and the call options were carried at an amortized cost of $7.9 million. At December 31, 1996, the Company had 40 call options with notional amounts totaling $11.2 million and amortized cost of $2.2 million.
The Company is exposed to the risk of extreme declines in the market value of its call options if there is a sharp and prolonged decrease in the stock market. The Company currently is purchasing puts to reduce the negative effect of such a decline. The put agreements allow the Company to receive payments on future exercise dates if the S&P 500 Index(R) is below specified index levels.
The costs of the interest rate hedging programs are not expected to have a material impact on the interest rate margin. For swaptions, floors, calls, and puts the Company pays only the original premium and is not at risk of further payments regardless of market conditions.
The Company is exposed to the risk of losses in the event of nonperformance of the counterparties of the previously described swaptions, floors, and call options. Losses recorded in the Company's financial statements in the event of nonperformance are limited to the unamortized premium paid to purchase the instruments. Any economic loss will be measured by the net replacement cost of such instruments or by their fair value if net fair value is in the Company's favor. The Company limits its exposure to economic loss by diversifying purchases among reputable counterparties with appropriate credit ratings.
The Company and its subsidiaries are parties to the Intercompany Operating Agreement (the Agreement) with ALLIED Group, Inc., ALLIED Mutual, and each of their respective subsidiaries. ALLIED Mutual controls 18.2% of the voting stock of ALLIED Group, Inc. The Agreement provides for the continued availability of office space, marketing services, agency forces, and computer and other facilities. The Agreement extends through December 31, 2004, after which it may be terminated on two years' notice given after December 31, 2002 by any party. Expenses are charged to the Company based on specific identification, or, if undeterminable, the expenses are allocated on the basis of cost and time studies that are updated annually. Rental expense incurred for office space allocated to the Company by ALLIED Mutual amounted to approximately $226,000, $253,000, and $234,000 for the years ended December 31, 1997, 1996, and 1995, respectively. ALLIED Life receives certain services from the Human Resources Department of ALLIED Group, Inc. that include, but are not limited to, maintaining employment documents, administering payroll and employee benefits, keeping related records, placing employees, and providing termination counseling and processing. For such services, ALLIED Life pays a fee to ALLIED Group, Inc. based on a percentage of the Company's gross payroll. Also included in this fee is an amount that represents the Company's share of the current net periodic postretirement benefit cost for the ALLIED Group, Inc. medical plan. Amounts incurred were approximately $162,000, $156,000, and $132,000 for the years ended December 31, 1997, 1996, and 1995, respectively.
The following table presents the carrying value and estimated fair value of the Company's significant financial instruments at December 31, 1997, and 1996:
In the normal course of business, the Company seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance contracts. In 1997, the Company followed the policy of reinsuring that portion of the risk in excess of $150,000 on each life ($250,000 for insureds aged 59 and under). The Company's long-term care and medicare supplement insurance coverage is 100% ceded.
Reinsurance contracts do not relieve the Company of its obligations to policyholders. The Company is contingently liable for these amounts and would become actually liable in the event such reinsurers were unable to pay their portion of the claims. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
The Company is authorized to issue 7.5 million shares of preferred stock without par value. The preferred stock may be issued from time to time by the Board of Directors in one or more series with such dividend rights, conversion rights, voting rights, redemption provisions, liquidation preferences, and other rights and restrictions as the Board of Directors may determine.
The Company paid dividends to ALLIED Mutual on its outstanding 6.75% Series through the issuance of 148,402, 138,793, and 129,808 shares of such stock in 1997, 1996, and 1995, respectively.
As holder of the outstanding ESOP Series, the ESOP Trust is entitled to vote the ESOP Series on all matters submitted to a vote of the holders of the common stock of the Company, voting together with the holders of common stock and 6.75% Series as one class. The ESOP generally provides that each ESOP participant is entitled to direct the trustee how to vote (or whether to tender or exchange) the shares of the ESOP Series allocated to the participant's account. Each share of the ESOP Series is convertible into one share of common stock and has one vote, subject to antidilution adjustments. During 1997, 1996, and 1995, respectively, 12,393, 2,834, and 5,263 shares of the ESOP Series were converted to common stock.
The ESOP Series has no preemptive rights and is not registered or traded. Upon any transfer by the trustee, the ESOP Series is automatically converted into shares of the Company's common stock.
The Company and ALLIED Mutual have entered into a Stock Rights Agreement (Agreement) that expires in 2008. Under the Agreement, ALLIED Mutual is entitled to nominate and the Company is required to use its best efforts to cause the election or retention of a number of members of the Company's Board of Directors in proportion to ALLIED Mutual's percentage ownership of the total number of shares of the Company's voting stock outstanding at the time of nomination. In addition, the Company is required to elect to its Executive Committee at least one Company director who has been nominated by ALLIED Mutual. The Agreement restricts the ability of ALLIED Mutual to grant proxies to other than affiliated individuals and to solicit other shareholders of the Company. ALLIED Mutual also is prohibited from initiating or accepting a tender offer for shares of the common stock except under certain conditions. The Company has a right of first refusal with respect to any sale by ALLIED Mutual of the common stock, subject to certain exceptions. ALLIED Mutual has incidental registration rights and three-demand registration rights with respect to all stock of the Company owned by ALLIED Mutual.
The Company has reserved 350,000 shares of common stock for issuance under the ALLIED Life Financial Corporation Employee Stock Purchase Plan (ESPP). The Company receives 85% of the fair market value of the shares issued under the ESPP. During 1997, 1,571 shares were issued at prices ranging from $13.82 to $20.40. During 1996 and 1995, 1,934 and 6,963 shares, respectively, were issued at prices ranging from $13.18 to $17.37 for 1996 and $12.33 to $19.13 for 1995. At December 31, 1997, 326,959 shares were available for issuance.
The Company has reserved 350,000 shares of common stock for issuance under the ALLIED Life Financial Corporation Outside Director Stock Purchase Plan (DSPP). Under the DSPP, participants pay 85% of the fair value of the shares issued. The 15% discount is recognized as expense on the date of issue. During 1997, 2,958 shares were issued at prices ranging from $19.13 to $21.50. During 1996 and 1995, 2,677 and 4,737 shares were issued at prices ranging from $17.37 to $17.38 and $17.06 to $17.13, respectively. At December 31, 1997, 335,213 shares were available for issuance.
During 1995 the Company reserved 350,000 shares of common stock for issuance under the ALLIED Life Financial Corporation Dividend Reinvestment and Stock Purchase Plan. Any stockholder of record may participate in the plan and have cash dividends reinvested in additional shares of Company common stock. The plan also allows for optional cash payments. Shares of common stock purchased under the plan may be either original issue shares or open market shares. The Company has determined the purchased shares will be original shares until it determines otherwise. The number of shares purchased by the plan participants is based upon fair market value on a predetermined date. During 1997, 535 shares were issued at prices ranging from $16 to $23.88. During 1996, 628 shares were issued at prices ranging from $15.88 to $21; during 1995, 312 shares were issued at prices ranging from $16.81 to $19.13. At December 31, 1997, 348,525 shares were available for issuance.
During 1997, pursuant to rule 10b-18 under the Securities Exchange Act of 1934, the Company repurchased and canceled 150,000 shares of Company common stock on the open market at an average cost of $16.52 per share. During 1996, the Company repurchased and canceled 150,000 shares of Company common stock on the open market at an average cost of $16.94 per share.
At December 31, 1997, the Company had four stock-based compensation plans, two described in note 8 (the ESPP and DSPP) and two described here: the ALLIED Life Financial Corporation Long-Term Management Incentive Plan (Incentive Plan) and the ALLIED Life Financial Corporation Executive Stock Option Plan (Option Plan). The Company applies APB Opinion 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for the following stock option plans or for the ESPP. Had compensation cost for these items been determined consistent with SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated in the table:
The Company reserved 186,800 shares of common stock for issuance to key employees of the Company and its affiliates under the Incentive Plan. Under the Incentive Plan, shares of common stock are available for grant until December 31, 2003 as incentive and nonqualified stock options (collectively, Options), stock appreciation rights (SARs), and restricted stock. The Options, SARs, and restricted stock were issued to vest beginning two or three years after the grant date at a rate of 25% or 33.3% per year and expire ten years after the date of grant. Options, SARs, and restricted stock prices are based on the fair market value as of the date of grant. As of December 31, 1997, the 64,467 outstanding Options and SARs had exercise prices ranging from $12.88 to $23.13 and had a weighted-average remaining contractual life of 8.6 years. At December 31, 1997, 108,282 shares were available for award under the Incentive Plan.
The Company has reserved 213,000 shares of common stock for issuance to key employees of the Company and its affiliates under the Option Plan until September 1, 2003. The Option Plan is a nonqualified stock option plan. Options are granted subject to a vesting schedule whereby 33.3% vest three years from the date of grant, 66.7% vest four years from the date of grant, and 100% vest five years from the date of grant. The option price is equal to the fair market value of the common stock at the time the option is granted. Options granted under the Option Plan expire ten years from the date of grant. As of December 31, 1997, the 124,293 outstanding options had exercise prices ranging from $12.00 to $17.63 and had a weighted average remaining contractual life of 6.2 years. At December 31, 1997, 31,167 shares were available for award under the Option Plan.
Retained earnings of ALLIED Life available for distribution as dividends to ALLIED Life Financial Corporation are limited by law. Under the Iowa Insurance Code, dividends may be paid by ALLIED Life only from statutory earned surplus, which as of December 31, 1997 was $21.3 million. In addition, ALLIED Life may not pay an extraordinary dividend without prior notice to and approval of the Iowa Insurance Commissioner. An extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value together with that of other dividends or distributions made within the preceding twelve months exceeds the greater of (i) 10% of statutory policyholders' surplus (total capital stock plus surplus) as of December 31 of the preceding year or (ii) the statutory net gain from operations of the insurer for the twelve-month period ending December 31 of the preceding year. During 1997, 1996, and 1995, the Company paid cash dividends on common stock of $1.1 million, $959,000, and $785,000, respectively. During 1997, 1996, and 1995, the Company paid cash dividends of $107,000, $95,000, and $85,000, respectively, on preferred stock. ALLIED Life paid to the Company dividends of $1.8 million, $1.4 million, and $800,000 during 1997, 1996, and 1995, respectively, primarily to fund the Company's cash dividend requirements and its note payments on indebtedness to affiliates. During 1998, the maximum amount available for distribution to the Company from ALLIED Life without regulatory approval of the Iowa Insurance Commissioner is $9 million.
The ESOP established by the Company is a nonleveraged defined contribution plan. The ESOP covers all employees who meet eligibility requirements. Shares of the ESOP Series are allocated annually to each employee's account pursuant to a formula based on employee compensation and years of service and are held in trust until the employee's termination, retirement, or death. The Company recognized compensation expense for the amount contributed to the ESOP.
The Company's ESOP expense was $183,000, $238,000, and $176,000 in 1997, 1996, and 1995, respectively. During 1997, 1996, and 1995, the ESOP Trust received $106,609, $95,163, and $84,826, respectively, from dividends on the ESOP Series, which were used to purchase stock for participants.
The Company has a line of credit agreement with the Federal Home Loan Bank to make available borrowings of up to $25 million. The line expires March 13, 1998. Interest is payable at either an adjustable interest rate with the interest rate set daily on the outstanding advance amount or at a fixed rate with the interest rate set at issuance. As of December 31, 1997 and 1996, borrowings on this line of credit agreement were $6.4 million and $20.5 million at an interest rate of 6.3% and 5.7% per annum, respectively. The Company incurred interest expense to nonaffiliates of $919,000, $690,000, and $656,000 in 1997, 1996, and 1995, respectively.
The income tax effects of temporary differences that gave rise to significant portions of the deferred income tax assets and deferred income tax liabilities at December 31, 1997 and 1996 follow:
For the years ended December 31, 1997, 1996, and 1995, the actual income tax expense differed from the expected income tax expense based on the statutory federal income tax rate of 35%, primarily as a result of a reduction of income taxes related to prior years. The Company paid federal and state income taxes of $7 million, $3.9 million, and $4.1 million in 1997, 1996, and 1995, respectively.
Prior to 1984, life insurance companies were permitted to defer from taxation a portion of statutory income. At December 31, 1983, the Company had accumulated approximately $3.3 million of this deferred income in what is referred to as its policyholders' surplus account. This amount was frozen under the Deficit Reduction Act of 1984 and could become taxable in the future only under certain conditions that management considers remote. The accumulated amount of income subject to current taxation less certain adjustments is set aside in another special memorandum tax account called a shareholders' surplus account. Dividends paid by the Company in excess of the balance in the shareholders' surplus account cannot be paid without a portion of policyholders' surplus becoming taxable. The balance of the shareholders' surplus account was approximately $57.5 million as of December 31, 1997.
On January 20, 1998, a complaint was filed by a policyholder of ALLIED Life, in Superior Court of the State of California for the County of Los Angeles, against the Company, ALLIED Life, ALLIED Mutual, and unnamed persons. The complaint, an alleged class action suit, asserts that ALLIED Life fraudulently increased the cost of insurance rates charged to policyholders in breach of the terms of its universal life policies, its fiduciary obligations, and its obligations of good faith and fair dealing toward its policyholders and without adequate notice. The plaintiff, an insured under a universal life policy issued by ALLIED Life seeks actual, consequential, and punitive damages in unspecified amounts as well as interest, attorney's fees, an accounting for moneys allegedly improperly charged to policyholders, and injunctive relief, on behalf of herself and all policyholders of ALLIED Life with similar universal life policies.
The Company is a party to other lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial position.