Numerous risks and uncertainties may impact the matters addressed by our forward-looking statements, any of which could negatively and materially affect our future financial results and performance.
While the available-for-sale securities are generally expected to be held to maturity, they are classified as available-for-sale and are sold periodically to manage risk. Although a majority of the investment portfolio is classified as available-for-sale, the Company has the ability and intent to hold the securities until maturity. See Note 2 - Investments in the Notes to the Consolidated Financial Statements for detailed disclosures regarding the Company's investment portfolio.
Net investment income represented approximately 41% and 47% of the Company's total revenues as of December 31, 2017 and 2016, respectively. When comparing current and prior year results, net investment income was lower in the current year in most of the major investment categories. The largest declines were in the fixed maturities and mortgage loan investment portfolios.
Income from the fixed maturities investment portfolio is down approximately 6% when comparing 2017 and 2016 results. The decrease is attributable to the Company holding fewer bonds combined with upgrading credit quality. During 2017, the Company sold some lower rated, higher yielding securities and replaced them with higher rated, lower yielding securities.
Income from the mortgage loan investment portfolio is down approximately 34% when comparing 2017 and 2016 results. The decline is the result of the continued pay off of loans within the portfolio, particularly the discounted mortgage loans, which have, in recent periods, provided significant earnings. During the first quarter of 2016, two of the discounted mortgage loans paid off, which produced income of approximately $842,000. Similar such payoffs did not occur during 2017. Management does not anticipate any significant future earnings from its discounted mortgage loans as the remaining balance has become immaterial.
Net realized investment gains were up approximately 23% in 2017 as compared to 2016. As seen in the table above, the 2017 gains were the result of the sale of certain fixed maturities, equity securities and real estate, which were offset by the recognition of other-than-temporary impairments on certain assets. Realized investment gains are the result of one-time events and are expected to vary from year to year.
The 2017 realized gains from real estate are mainly attributable to the sale of two real estate parcels, which produced realized gains of approximately $3.5 million. During 2016, the realized gains from real estate were mainly attributable to the sale of two real estate parcels, which produced net gains of approximately $4.4 million. Gains from the sale of real estate are the result of one-time events and are expected to vary from year to year.
In summary, the Company's basis for future revenue is expected to come from the following primary sources: Conservation of business currently in-force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.
Changes in policyholder reserves, or future policy benefits, also impact this line item. Reserves are calculated on an individual policy basis and generally increase over the life of the policy as a result of additional premium payments and acknowledgment of increased risk as the insured continues to age.
Operating expenses increased approximately 8% in 2017 as compared to 2016. When analyzing 2017 and 2016 results, the operating expenses in two of the major expense categories, salaries and charitable contributions, were higher in 2017 and driving the variance from the prior year to the current year . The increase in salary expense is the result of increased bonuses paid to employees and officers of the Company. Bonuses are not contractual or dependent upon meeting certain financial goals. They are not necessarily paid each year, and when they are paid, the amounts will vary depending on the decision of Management, the Compensation Committee, and the Board of Directors. Charitable contributions are a function of the Company's earnings. Expenses in all of the other categories were comparable for the current and prior year.
Liquidity provides the Company with the ability to meet on demand the cash commitments required by its business operations and financial obligations. The Company's liquidity is primarily derived from a portfolio of marketable securities and line of credit facilities. The Company has two principal needs for cash - the insurance company's contractual obligations to policyholders and the payment of operating expenses.
Cash used in operating activities was approximately $13.2 million and $11.4 million in 2017 and 2016, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years. As such, premium revenues continue to decline. Management anticipates future cash flows from operations to remain similar to historic trends.
Net cash used in financing activities was approximately $3.5 million and $2 million during 2017 and 2016, respectively. On July 22, 2016, the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company's outstanding common stock. The acquisition was made under the Company's stock buy-back program. As part of this transaction, two promissory notes totaling $2.9 million were issued. The notes require principal payments of one half of the note value to be paid one year from the date of purchase and the other one half to be paid two years from the date of purchase. The notes had an interest rate of 0%. The notes were fully repaid during 2017.
As of December 31, 2017, the Company had no debt outstanding with third parties.
The Company had $0 debt outstanding as of December 31, 2017 and $2.9 million as of December 31, 2016. On July 22, 2016, the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company's outstanding common stock. The acquisition was made under the Company's stock buy-back program. As part of this transaction, two promissory notes totaling $2.9 million were issued. The notes require principal payments of one half of the note value to be paid one year from the date of purchase and the other one half to be paid two years from the date of purchase. The notes had an interest rate of 0%. The notes were fully repaid during 2017. See Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements for detailed disclosures regarding the Company's notes payable.
At December 31, 2017, UG has a ratio of approximately 5.76, which is 576% of the authorized control level. Accordingly, the Company meets the RBC requirements.
As mentioned in Note 7 above, on July 22, 2016 the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company's outstanding common stock. The purchase price per share was $14.50 was derived through private negotiation. The purchase was paid with cash and the issuance of promissory notes.
Shareholders' equity was approximately $110 million and $94 million as of December 31, 2017 and 2016, respectively. Total shareholders' equity increased approximately 17% in 2017 compared to 2016. The increase is primarily attributable to the change in accumulated other comprehensive income and retained earnings. As of December 31, 2017 and 2016, the Company reported accumulated other comprehensive income of approximately $32.9 million and $20.4 million, respectively. The change in accumulated other comprehensive income is mainly attributable to the net unrealized holding gains of approximately $17 million and $22.4 million in 2017 and 2016. As previously discussed in the above in the Financial Condition - Investment Information section of the MD&A, the variance in the net unrealized gains and losses is the result of normal market fluctuations mainly related to changes in interest rates in the market place.
Business - UTG, Inc. is an insurance holding company. The Company's dominant business is individual life insurance, which includes the servicing of existing insurance in-force and the acquisition of other companies in the life insurance business. UTG and its subsidiaries are collectively referred to as the "Company".
Principles of Consolidation - The accompanying consolidated financial statements include the accounts of the Registrant and its wholly and majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated during consolidation.
Gains and Losses - Realized gains and losses include sales of investments and investment impairments. If any, other-than-temporary impairments in fair value are recognized in net income on the specific identification basis.
Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax impact attributable to differences between the financial statement book values and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Tax Cuts & Jobs Act ("TCJA"), signed into law on December 22, 2017, reduces the corporate Federal income tax rate from 35% to 21%, effective for years beginning after December 31, 2017. More information concerning income taxes is provided in Note 6 - Income Taxes.
Accounting Standards Update (ASU) 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash - The amendments included in ASU 2016-18 require that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. As a result, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendments do not provide a definition of restricted cash or restricted cash equivalents. ASU 2016-18 is effective for public companies for fiscal years beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company's consolidated financial statements.
Accounting Standards Update (ASU) 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities - The amendments included in ASU 2016-01 requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. ASU 2016-01 also requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). The guidance eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for fiscal years beginning after December 15, 2017. The Company adopted this guidance on January 1, 2018 and it is expected to have a material impact on the Consolidated Statements of Operations. However, the change does not impact total shareholders' equity.
The following table provides a summary of fixed maturities by contractual maturity as of December 31, 2017. Actual maturities could differ from contractual maturities due to call or prepayment provisions:
The Company held below investment grade investments with an estimated market value of $21,108,077 and $33,064,563 as of December 31, 2017 and December 31, 2016, respectively. The investments are all classified as "All other corporate bonds".
The fair value of investments with sustained gross unrealized losses at December 31, 2017 and 2016 are as follows:
Securities designated as trading securities are reported at fair value, with gains or losses resulting from changes in fair value recognized in net investment income on the Consolidated Statements of Operations. Trading securities include exchange-traded equities and exchange-traded options. Trading securities carried as liabilities are securities sold short. A gain, limited to the price at which the security was sold short, or a loss, potentially unlimited in size, will be recognized upon the termination of the short sale. The fair value of derivatives included in trading security assets and trading security liabilities as of December 31, 2017 was $0 and $0, respectively. The fair value of derivatives included in trading security assets and trading security liabilities as of December 31, 2016 was $2,500 and $(1,439), respectively. Earnings from trading securities are classified in cash flows from operating activities. The derivatives held by the Company are for income generation purposes only.
During 2017 and 2016, the maximum and minimum lending rates for mortgage loans were:
A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The Company acquired the discounted mortgage loans at below contract value, and believes that it will fully recover its carrying value upon disposal, therefore no reserve for delinquent loans is deemed necessary. Those not currently paying are being vigorously worked by Management. The current discounted commercial mortgage loan portfolio has an average price of 36% and 32% of face value as of December 31, 2017 and 2016, respectively. Management has determined that this deep discount provides a financial cushion or built in allowance for any of the loans that are not currently performing within the portfolio of loans purchased. The mortgage loan reserve was $0 at December 31, 2017 and 2016.
Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the Consolidated Statements of Operations. Based upon Management's evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the Consolidated Statements of Operations.
Notes receivable represent collateral loans and promissory notes issued by the Company and are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. The valuation allowance as of December 31, 2017 and 2016 was $0. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status.
The Company regularly reviews its investment securities for factors that may indicate that a decline in fair value of an investment is other than temporary. The factors considered by Management in its regular review to identify and recognize other-than-temporary impairment losses on fixed maturities include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the Company's intent to sell, or be required to sell, the debt security before the anticipated recovery of its remaining amortized cost basis; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; subordinated credit support, whether the issuer of a debt security has remained current on principal and interest payments; current expected cash flows; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions, including the effect of changes in market interest rates. If the Company intends to sell a debt security, or it is more likely than not that it would be required to sell a debt security before the recovery of its amortized cost basis, the entire difference between the security's amortized cost basis and its fair value at the balance sheet date would be recognized by a charge to other-than-temporary losses in the Consolidated Statements of Operations.
The Company measures its assets and liabilities recorded at fair value in the Condensed Consolidated Balance Sheets based on the framework set forth in the GAAP fair value accounting guidance. The framework establishes a fair value hierarchy of three levels based upon the transparency of information used in measuring the fair value of assets or liabilities as of the measurement date. The fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three categories.
As is customary in the insurance industry, the insurance subsidiary cedes insurance to, and assumes insurance from, other insurance companies under reinsurance agreements. Reinsurance agreements are intended to limit a life insurer's maximum loss on a large or unusually hazardous risk or to obtain a greater diversification of risk. The ceding insurance company remains primarily liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. However, it is the practice of insurers to reduce their exposure to loss to the extent that they have been reinsured with other insurance companies. The Company sets a limit on the amount of insurance retained on the life of any one person. The Company will not retain more than $125,000, including accidental death benefits, on any one life. At December 31, 2017, the Company had gross insurance in-force of $1.2 billion of which approximately $242 million was ceded to reinsurers. At December 31, 2016, the Company had gross insurance in-force of $1.3 billion of which approximately $266 million was ceded to reinsurers.
Most recently, UG utilized reinsurance agreements with Optimum Re Insurance Company ("Optimum"), and Swiss Re Life and Health America Incorporated ("SWISS RE"). Optimum and SWISS RE currently hold an "A-" (Excellent) and "A+" (Superior) rating, respectively, from A.M. Best, an industry rating company. The reinsurance agreements were effective December 1, 1993, and covered most new business of UG. Under the terms of the agreements, UG cedes risk amounts above its retention limit of $100,000 with a minimum cession of $25,000. Ceded amounts are shared equally between the two reinsurers on a yearly renewable term ("YRT") basis, a common industry method. The treaty is self-administered; meaning the Company records the reinsurance results and reports them to the reinsurers.
UG entered into a coinsurance agreement with Park Avenue Life Insurance Company ("PALIC") effective September 30, 1996. Under the terms of the agreement, UG ceded to PALIC substantially all of its then in-force paid-up life insurance policies. Paid-up life insurance generally refers to non-premium paying life insurance policies. Under the terms of the agreement, UG sold 100% of the future results of this block of business to PALIC through a coinsurance agreement. UG continues to administer the business for PALIC and receives a servicing fee through a commission allowance based on the remaining in-force policies each month. PALIC has the right to assumption reinsure the business, at its option, and transfer the administration. The Company is not aware of any such plans. PALIC's ultimate parent, The Guardian Life Insurance Company of America ("Guardian"), currently holds an "A++" (Superior) rating from A.M. Best. The PALIC agreement accounts for approximately 63% of UG's reinsurance reserve credit, as of December 31, 2017 and 2016.
At December 31, 2017 and 2016, the Company had gross deferred tax assets of $1,027,203 and $1,727,307, respectively, and gross deferred tax liabilities of $12,023,607 and $17,186,356, respectively, resulting from temporary differences primarily related to the life insurance subsidiary. A valuation allowance is to be provided when it is more likely than not that deferred tax assets will not be realized by the Company. No valuation allowance has been recorded (except as noted below) relating to the Company's deferred tax assets since, in Management's judgment, the Company will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
The Company's Federal income tax returns are periodically audited by the Internal Revenue Service ("IRS"). There are currently no examinations in process, nor is Management aware of any pending examination by the IRS. The Company follows the accounting guidance for uncertainty in income taxes using the provisions of Financial Accounting Standards Board ("FASB") ASC 740, Income Taxes. Using that guidance, tax positions initially need to be recognized in the financial statements when it is more-likely-than-not the position will be sustained upon examination by the tax authorities. Such tax positions initially and subsequently need to be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and relevant facts. The Company has evaluated its tax positions, expiring statutes of limitations, changes in tax law and new authoritative rulings and believes that no disclosure relative to a provision of income taxes is necessary, at this time, to cover any uncertain tax positions. Tax years that remain subject to examination are the years ended December 31, 2014, 2015, 2016 and 2017.
At December 31, 2017 and 2016, the Company had the following outstanding debt:
Under the insurance guaranty fund laws in most states, insurance companies doing business in a participating state can be assessed up to prescribed limits for policyholder losses incurred by insolvent or failed insurance companies. Although the Company cannot predict the amount of any future assessments, most insurance guaranty fund laws currently provide that an assessment may be excused or deferred if it would threaten an insurer's financial strength. Mandatory assessments may be partially recovered through a reduction in future premium tax in some states. The Company does not believe such assessments will be materially different from amounts already provided for in the condensed consolidated financial statements, though the Company has no control over such assessments.
During 2006, the Company committed to invest in RLF III, LLC ("RLF"), which makes land-based investments in undervalued assets. RLF makes capital calls as funds are needed for continued land purchases.
As mentioned in Note 7 above, on July 22, 2016 the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company's outstanding common stock. The purchase price per share was $14.50 was derived through private negotiation. The purchase was paid with cash and the issuance of promissory notes. The promissory notes were fully repaid during 2017.
Director Compensation - Effective September 18, 2013, each outside Director will annually receive $8,000 as a retainer and $1,000 per meeting attended. The compensation, however, shall be paid in UTG common stock. The value will be determined annually on the close of business December 20th or the next business day should December 20th be a weekend or holiday, based on the activity of the year just ending. UTG's director compensation policy also provides that Directors who are employees of UTG or its affiliates do not receive any compensation for their services as Directors except for reimbursement for reasonable travel expenses for attending each meeting. In December of 2017, the Company issued 2,560 shares of its common stock as compensation to the Directors. The shares were valued at $25.00 per share, the market value at the date of issue. During 2017, the Company recorded $64,000 in operating expense related to the stock issuance. In December of 2016, the Company issued 3,575 shares of its common stock as compensation to the Directors. The shares were valued at $17.05 per share, the market value at the date of issue. During 2016, the Company recorded $60,954 in operating expense related to the stock issuance.
The computation of diluted earnings per share is the same as basic earnings per share for the years ending December 31, 2017 and 2016, as there were no outstanding securities, options or other offers that give the right to receive or acquire common shares of UTG.
Statutory Restrictions - Restrictions exist on the flow of funds to UTG from its insurance subsidiary. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. UG is required to maintain minimum statutory surplus of $2,500,000. At December 31, 2017, substantially all of the consolidated shareholders' equity represents net assets of UTG's subsidiaries.
UTG has a 30.10% ownership interest in an aircraft that is jointly owned with First Southern National Bank and Bandyco, LLC. Bandyco, LLC is affiliated with the Estate of Ward F. Correll. Mr. Correll is the father of Jesse Correll and a former director of the Company. The aircraft is used for business related travel by various officers and employees of the Company. For years 2017 and 2016, UTG paid $328,933 and $418,104 for costs associated with the aircraft, respectively.
Effective January 1, 2007, UTG entered into administrative services and cost sharing agreements with its subsidiary. Under this arrangement, the subsidiary pays its proportionate share of expenses, based on an allocation formula. During 2017 and 2016, UG paid $7,213,590 and $7,561,326, respectively, in expenses. The Ohio Department of Insurance has approved the cost sharing agreement and it is Management's opinion that where applicable, costs have been allocated fairly and such allocations are based upon accounting principles generally accepted in the United States of America.
During 2016, the Company began renting approximately 8,000 square feet of office space, located in Stanford, Kentucky, from FSNB and pays $2,000 per month in rent. The Company paid rent of $24,000 and $8,000 to FSNB during 2017 and 2016, respectively .
As previously disclosed in the Notes Receivable section of Note 2 - Investments, several of the Company's notes have participation agreements in place with third parties. Certain participation agreements are with FSF, a related party. The participation agreements are sold without recourse and assigned to the participant based on their pro-rata share of the principal, interest and collateral as specified in the participation agreements. The undivided participations in the notes receivable range from 20% - 50%. The total amount of loans participated to FSF was $250,000 as of December 31, 2017 and 2016.
During 2016, UG and FSF established a partnership agreement and formed a limited liability company to purchase real estate. FSF contributed $140,000 to the partnership, which gave them a 10% ownership in the LLC.
Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of December 31, 2017 and 2016, approximately 55% of the Company's total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies.
The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 20% and 21% of total life insurance in force at December 31, 2017 and 2016, respectively. Insurance ceded represented 36% and 28% of premium income for 2017 and 2016, respectively. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.