Following is a discussion and analysis of the consolidated financial statements and other statistical data that management believes will enhance the understanding of FIC’s financial condition and results of operations. This discussion should be read in conjunction with the consolidated financial statements beginning on page. See also “Item 1 - Description of Business”.
Financial Industries Corporation (“FIC” or the “Company”) is a holding company engaged through its subsidiaries in the business of marketing, underwriting and servicing life insurance and annuity products in 49 states, the District of Columbia and the U.S. Virgin Islands. Like other financial intermediaries, FIC earns income principally based on the “spread” between what it pays its customers (death benefits, interest on funds on deposit) and what it earns on the money (premiums, policy and annuity deposits) its customers place in its care.
FIC reported net income of $3.6 million in 2007 compared to net losses of $24.8 million and $165,000 in 2006 and 2005, respectively. The net loss incurred during 2006 primarily includes losses from the discontinued operations of the Company’s wholly-owned subsidiary, Family Life, totaling $25.5 million. This is offset by income from continuing operations of $0.7 million. The relatively small net loss for 2005 is largely attributable to lower policyholder benefits and operating expenses, along with increases in net realized gains on investments.
At the end of 2007, the equity of FIC’s shareholders totaled $67.5 million, up from $60.7 million at the end of 2006. This $6.8 million increase in shareholders’ equity primarily reflects the Company’s net income for the year and other comprehensive income of $3.8 million.
FIC’s mutual commitments with its life insurance policyholders and annuitants - policyholders to pay premiums and make future deposits, FIC to pay annuities and death benefits - stretch far into the future. This means that FIC’s consolidated statement of operations and balance sheet must necessarily embody several significant estimates about future events. The rates at which its customers will actually become ill and die, or will withdraw their funds in response to interest rate changes or other factors, and the returns that FIC will be able to earn on its investments, must all be estimated far into the future in order to judge whether the Company is truly operating currently at a profit and whether its consolidated balance sheet is properly reflecting the current value of its assets and liabilities. Most of these estimates are embodied in balance sheet accounts such as deferred policy acquisition costs, the present value of future profits of acquired businesses, and policy liability reserves.
As part of the strategic initiative previously described, on January 14, 2008, following the unanimous approval of its Board of Directors, FIC entered into a definitive agreement providing for the merger of the Company with an indirect, wholly-owned subsidiary of Americo Life, Inc., (“Americo”). In the merger, each outstanding share of FIC’s common stock, par value $0.20 per share (other than those shares held by Americo, FIC, any of their respective subsidiaries or any shareholders who perfect appraisal rights under Texas law) will be converted into the right to receive cash in the amount of $7.25, subject to downward adjustment in the event there is an increase in the number of fully-diluted shares of common stock in excess of a specified threshold. The Company estimates that the total value of the transaction is $74.7 million. Following the merger, FIC will become an indirect, wholly-owned subsidiary of Americo. The merger is subject to customary regulatory approvals, including clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (which was obtained on February 25, 2008) and the approval of the Texas Department of Insurance, as well as other customary conditions for similar transactions, including the approval of the shareholders of FIC pursuant to Texas law. The merger is expected to close in the second quarter of 2008.
On January 31, 2008, the Company determined that it would immediately cease underwriting new policies. In doing so, FIC terminated its agreements with certain independent insurance agents. FIC will continue to manage its existing block of insurance policies and will continue to earn commissions on policies sold by agents appointed with its subsidiary, ILG Sales Corporation, under marketing agreements with unrelated insurance companies.
On December 29, 2006, Financial Industries Corporation completed the sale of its wholly owned subsidiary, Family Life Insurance Company, to The Manhattan Life Insurance Company for $28.0 million in cash. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), the consolidated financial statements for all periods presented reflect the assets, liabilities and operating results of Family Life Insurance Company as discontinued operations, adjusted for certain activities as described below.
In connection with the sale of Family Life, Investors Life entered into a coinsurance agreement with Family Life pursuant to which Investors Life will cede to Family Life (now a wholly-owned subsidiary of Manhattan Life) 35% of the face amount of mortgage protection term policies written during the five-year period beginning April 1, 2007 and ending March 31, 2012. Such business will be administered by Investors Life, and Investors Life will receive allowances for its expenses on the portion of the business that is ceded. Accordingly, the Company accrued a deferred revenue liability of $1.4 million in conjunction with recording the sale of Family Life, equal to the estimated net present value of future business expected to be ceded to Manhattan Life. Costs associated with the Family Life agents while affiliated with Family Life, much of which were capitalized and amortized as deferred policy acquisition costs, are included in discontinued operations.
Loss on discontinued operations for 2006, net of taxes, totaled $25.5 million which consists of a $1.1 million loss on operations during the year and a $24.4 million loss on the sale of Family Life.
Reduction to beginning retained earnings of $1.2 million for the implementation of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”) related to uncertain income tax positions as described under “Recent Adoption of Accounting Pronouncements”
$354,000 for common shares issued to Mr. Boisture as described in Note 11 to the accompanying consolidated financial statements,
$349,000 for the purchase of the Company’s common shares into treasury.
Total managed assets decreased during 2007 by $38.6 million, or 5.6%. This overall decrease was largely related to the reduction in cash and short-term investments and fixed maturity securities, utilized for the run-off of the Company’s annuity and life insurance business in force.
Since the engagement of Conning as the Company’s investment manager in October 2003, the Company has realigned its portfolio, decreasing its investment in mortgage-backed securities (including asset-backed securities) significantly, from 35.8% in 2004 to 21.8% at December 31, 2007 as a percentage of its total investment in fixed maturities. With the reduction of this exposure to mortgage and asset-backed securities, the Company increased its holdings in corporate securities from 48.3% in 2004 to 67.4% at December 31, 2007, substantially all of which are in investment grade securities.
Mortgage-backed securities are sensitive to changes in prevailing interest rates, since interest rate levels affect the rate at which the underlying mortgage obligations are repaid. Mortgage-backed pass-through securities, sequential CMOs and support bonds, which comprised approximately 66.0% of the market value of FIC’s mortgage-backed securities at December 31, 2007, are sensitive to prepayment and extension risks. FIC’s insurance subsidiary has reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class (“PAC”), target amortization class (“TAC”) instruments and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches (“support classes”) of the CMO. At December 31, 2007, PAC and TAC instruments and scheduled bonds represented approximately 23.7% of the market value of FIC’s mortgage-backed securities. Sequential and support classes represented approximately 22.4% of the market value of FIC’s mortgage-backed securities at December 31, 2007.
An allocation by security type of the Company’s investments in fixed maturities as of December 31, 2007 and 2006 is detailed below.
FIC’s equity securities consist primarily of its investment in the investment funds underlying the separate accounts business of Investors Life. As of December 31, 2007, FIC’s equity securities totaled $9.6 million, compared to $9.8 million at December 31, 2006. The decrease is due to the declining performance of the equity markets at the end of 2007 resulting in the depreciation of the investment funds.
Other liabilities, which totaled $19.2 million at December 31, 2007, compared to $34.0 million at December 31, 2006, consist primarily of accrued expenses, policyholder suspense liabilities, pension plan liabilities, income taxes payable, amounts due on unsettled security transactions, and amounts held as agent or trustee. This decrease in other liabilities is partially due to amounts due for unsettled transactions for purchased securities. There were no amounts due for unsettled transactions at December 31, 2007 as compared to a balance of $15.2 million at December 31, 2006. This decrease from unsettled transactions was partially offset by the reporting of a liability for unrecognized tax benefits totaling $5.5 million resulting from the implementation of FIN 48 as disclosed further in this section.
The ILCO pension plan has a projected benefit obligation at year-end 2007 totaling $18.1 million in comparison to the fair value of plan assets of $19.4 million. The difference in these amounts reflects a funded status of approximately $1.3 million, which is reflected as a pension asset in other assets in the accompanying consolidated financial statements. The Family Life pension plan has a projected benefit obligation at year-end 2007 totaling $7.2 million in comparison to the fair value of plan assets of $6.1 million. The difference in these amounts reflects an unfunded status of approximately $1.1 million, which is reflected as a pension liability in other liabilities in the accompanying consolidated financial statements. Amounts included as components of the projected benefit obligation which have not been recognized as an expense are included in accumulated other comprehensive income.
On December 31, 2006, the Company adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158 (“SFAS 158”), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”. SFAS 158 required the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligation) of its defined benefit pension plans in its December 31, 2006 consolidated financial statements, with a corresponding adjustment to accumulated other comprehensive income, net of tax, eliminating the minimum pension liability provision of SFAS No. 87. For the ILCO pension plan, this new accounting requirement effectively resulted in an implementation adjustment of $3,250,000, before taxes, as a reduction to accumulated other comprehensive income as the Company would have been able to recognize a larger pension asset under the previous rules. There was no SFAS 158 implementation adjustment for the Family Life pension plan due primarily to its unfunded status and frozen benefit status in the current and prior year.
The entire principal amount of the 2003 Notes and any accrued but unpaid interest may become immediately due and payable upon an event of default, which includes: (1) failure to pay interest within 30 days of any due date; (2) failure to pay principal when due; (3) the bankruptcy or insolvency of FIC; or (4) the merger of FIC or sale of all or substantially all of its assets unless the successor entity to a merger is a United States corporation (or a foreign corporation that agrees to be bound by certain tax provisions). The terms of the 2003 Notes also place certain limitations on the offer or sale of securities of FIC if it would render invalid the exemption of the notes issued in connection with the loan from the registration requirements of the Securities Act of 1933. Other terms and conditions of the $15 million borrowing are described in Note 7 in the accompanying consolidated financial statements. As of December 31, 2007, the Company is in compliance with all provisions of this agreement.
Investors Life is subject to regulation under state law. Among other requirements, these state laws and regulations impose capital adequacy requirements on insurance companies. Using a calculation that takes into account the quality, liquidity, maturities, and amounts of its assets and liabilities, Investors Life is required to calculate its “risk-based capital” (or “RBC”). Investors Life’s total adjusted capital must exceed 200% of the authorized control level RBC to avoid supervisory activity by the insurance regulators. The RBC solvency margins for Investors Life at December 31, 2007 and 2006 were in excess of NAIC minimum standards. At December 31, 2007 and 2006, the RBC ratios for Investors Life were 536% and 584%, respectively.
State regulators also use NAIC IRIS ratios to monitor capital adequacy requirements. The NAIC ratios cover 12 categories of financial data with defined “usual” ranges for each such category. The ratios are intended to provide insurance regulators with “early warnings” as to when a given company might warrant special attention. An insurance company may fall outside of the usual range for one or more ratios, and such variances may result from specific transactions that are, by themselves, immaterial or eliminated at the consolidation level. In certain states, insurers with more than three IRIS ratios outside of the NAIC usual ranges may be subject to increased regulatory oversight. For 2007 and 2006, Investors Life had four ratios which were outside the usual ranges, which were primarily related to changes in investment income and changes in premium, product mix, and reserving. The ratios were outside the usual ranges primarily due to a recapture of ceded reinsurance by Family Life from Investors Life during 2006. This recapture occurred prior to the sale of Family Life. For statutory accounting purposes, the recapture affected premium income and change in policy reserves which caused ratios to fall outside the usual ranges in both 2006 and 2007. Excluding the effects of the reinsurance recapture, Investors Life would have had one ratio outside the usual ranges, which related to investment income. Investors Life continues to maintain capital and surplus positions which significantly exceed risk-based capital (“RBC”) and other regulatory requirements.
In 2007, income from continuing operations was affected by the following items:
Premium revenues increased $2.4 million in 2007 compared to 2006 primarily due to increased sales of mortgage protection term ($1.0 million) and final expense whole life ($1.2 million) insurance products.
Increases in net investment income of $1.7 million are due to dividend income received on investments in equity securities, along with some improvement in investment yields for the year ended December 31, 2007.
Other revenues increased $2.1 million in 2007 primarily due to the recognition of deferred revenue related to the Company’s coinsurance agreement with Family Life of $1.3 million and fees earned for services performed under an administrative services agreement with Family Life of $807,000.
Earned insurance charges decreased $1.4 million partially offset by a decrease in interest expense on contractholder deposit funds of $751,000, both due primarily to the general runoff of the Company’s universal life insurance and annuity business.
Operating expenses declined $239,000 in 2007. The Company is now experiencing lower audit and actuarial fees compared to prior years. However, the Company also recognized compensation expense in 2007 of $363,000 related to the requisite service period as discussed in Note 11 to the accompanying consolidated financial statements.
Premium revenues reported for traditional life insurance products are recognized when due. Improvements were shown in both renewal and first-year premiums during 2006 and 2007, as shown in the following table. The increases in premiums are primarily from sales of mortgage protection term and final expense whole life insurance products, which increased by $1.0 million and $1.2 million respectively, along with decreases in reinsurance premium expenses, during the year ended December 31, 2007.
In accordance with GAAP, deposits received in connection with annuity contracts and premiums received for universal life (“UL”) insurance policies are reflected in the consolidated financial statements as increases in liabilities for contractholder deposit funds and not as revenues. Annual charges made against these deposits are reported as revenue. For the years 2005 through 2007, the table below reflects the amounts of such annuity deposits and UL premiums.
For the year ended December 31, 2006, FIC had $517,000 net realized gains on real estate sales, compared to $9.2 million net realized gains in 2005. The realized gains on real estate for 2005 includes $8.5 million in gains recognized on the sale of the River Place Corporate Park property and $761,000 of gains recognized on the sale of three properties included in real estate held for sale. The Company’s remaining three properties were sold in January 2006.
For the year ended December 31, 2007, FIC had $78,000 net realized gains on fixed maturities and other investments, compared to net realized losses of $11,000 in 2006 and $631,000 in 2005. In the third quarter of 2005, a bond was classified as temporarily impaired, resulting in a writedown of $1 million. This bond was called in the fourth quarter of 2005. Various other bonds were called or sold by the Company throughout 2005 for net gains that largely offset the previously described write-down.
Other revenues totaled $7.1 million, $4.9 million and $2.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. The significant increases during 2007 are partially due to the recognition of deferred revenue related to the Company’s coinsurance agreement with Family Life of $1.3 million and fees earned for services performed under an administrative services agreement with Family Life. The significant increase in other revenues in 2006 is primarily related to fees earned related to the Company’s separate accounts. As previously described, effective June 1, 2006, Investors Life recaptured the previously reinsured investment annuity business with Symetra Life resulting in the retention of 100% of this business. The recapture of this previously reinsured separate accounts business increased other revenues in 2006 by approximately $1.3 million as compared with 2005. Additionally, other revenues in 2006 included approximately $0.6 million in interest income received from the IRS on tax refunds related to prior years’ amended returns.
Other revenues for 2007 were also impacted by the recognition of $1.3 million of deferred revenue related to the Company’s coinsurance agreement with Family Life. As described in more detail in Note 2 of the accompanying consolidated financial statements, in connection with the sale of Family Life, Investors Life entered into a coinsurance agreement with Family Life pursuant to which it will cede to Family Life (a wholly-owned subsidiary of Manhattan Life) 35% of the face amount of mortgage protection term policies written by the Family Sales Division during the five-year period beginning April 1, 2007 and ending March 31, 2012. Such business will be administered by Investors Life, and Investors Life will receive allowances for its expenses on the portion of the business that is ceded. Accordingly, the Company accrued a deferred revenue liability of $1.4 million in conjunction with recording the sale of Family Life, equal to the estimated net present value of future profits expected to be ceded to Manhattan Life. The $1.4 million liability reflected the estimated portion of the $28 million sales price of Family Life that was paid by Manhattan Life for the value of the coinsurance agreement.
Amortization of deferred policy acquisition costs (“DAC”) totaled $2.1 million, $1.2 million, and $1.6 million for the years ended December 31, 2007, 2006, and 2005, respectively. These expenses represent the amortization of the costs of producing new business, which consist primarily of agents’ commissions and certain policy issuance and underwriting costs. DAC is amortized over the premium-paying period of the policies in proportion to estimated annual premium revenue for traditional life insurance business. For interest sensitive products, these costs are amortized in relation to the estimated annual gross profits of the policies. The level of policy lapses and surrenders can also have a significant impact on the amount of amortization. Lower policy lapses and surrenders for certain blocks of traditional life business resulted in the reduced amortization for 2006. The increase in amortization in 2007 is primarily due to the increased sales of traditional business by Investors Life since the third quarter of 2006 and the amortization relating to the DAC capitalized on these sales.
As the Company is now current with its SEC filing requirements, significant reductions are anticipated going forward in these audit, actuarial, accounting and consulting expenses. The Company has, in fact, already experienced significant reductions in these fees in the second half of 2007. Additionally, as described in Note 11 of the accompanying consolidated financial statements, the Company recognized compensation expense of $363,000 for the year ended December 31, 2007 related to the requisite service period necessary for its stock options. This compensation expense is new in 2007 as stock option plans for employees and directors were approved by the shareholders in June 2007.
As of December 31, 2005, Investors Life held $15.4 million of notes receivable from FIC that represented the remaining indebtedness related to the Family Life acquisition. Although this intercompany indebtedness was eliminated on FIC’s consolidated balance sheets, it created a debt service requirement at the holding company level. These notes were paid off by FIC on December 29, 2006 using proceeds from the sale of Family Life.
A primary liquidity consideration with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawals. Deposit fund liabilities for universal life and annuity products as of December 31, 2007, were $424.9 million, compared to $453.7 million at December 31, 2006. Individual life insurance policies are less susceptible to withdrawal than are annuity contracts because life insurance policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. At December 31, 2007, the bulk of the liabilities for contractholder deposit funds on FIC’s balance sheet, $321.8 million, represented insurance products, as compared to only $103.1 million of annuity product liabilities.
The following table summarizes information regarding FIC’s contractual obligations, including principal and interest where applicable, as of December 31, 2007. The amounts in the table are different than those reported in our consolidated balance sheet as of December 31, 2007 due to the consideration of interest on debt obligations. Some of the amounts included in this table are based on management’s estimates and assumptions about these obligations, including those related to duration, future mortality, and persistency. Because these estimates and assumptions are necessarily subjective, the amounts actually paid by the Company in the future may vary significantly due to the uncertainty of the timing of cash flows based on insurable events or policyholder surrenders.
The increase of $18.7 million in cash and cash equivalents during 2006 was primarily due to cash provided by operating activities and by investing activities from the proceeds due to the sale of Family Life. The increase of $12.0 million in cash and cash equivalents during 2005 was primarily due to proceeds from the sales and maturities of invested assets, net of reinvestment of a portion of these proceeds.
The significant decrease in contractholder fund deposits in 2007, 2006 and 2005 from prior years was largely due to the Company’s decision in 2004 to temporarily discontinue the sale of fixed annuity products, as previously described. Certain design features of the Company’s annuity products, coupled with competition in the annuity market and a low interest rate market environment led to this decision. Additionally, most of the Company’s marketing efforts shifted to the sale of traditional insurance products, such as mortgage protection term and final expense products, as opposed to universal life insurance products. Total contractholder fund deposits, which include UL premiums and annuity deposits, for 2007, 2006, and 2005 were $23.1 million, $27.7 million, and $29.9 million, respectively.
The accounting policies below have been identified as critical to the understanding of the results of operations and financial position. The application of these critical accounting policies in preparing the financial statements requires management to use significant judgments and estimates concerning future results or other developments, including the likelihood, timing or amount of one or more future transactions. Actual results may differ from these estimates under different assumptions or conditions. On an ongoing basis, estimates, assumptions and judgments are evaluated based on historical experience and various other information believed to be reasonable under the circumstances. For a detailed discussion of other significant accounting policies, see Note 1 - Organization and Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.
The Company’s principal investments are in fixed maturity securities which are exposed to three primary sources of investment risk: credit, interest rate and liquidity. Fixed maturity securities, which are all classified as available for sale, are carried at their fair value in the Company’s balance sheet, with unrealized gains or losses recorded in accumulated other comprehensive income. The investment portfolio is monitored regularly to ensure that investments which may be other than temporarily impaired are identified in a timely fashion and properly valued, and that impairments are charged against earnings as realized investment losses. The valuation of the investment portfolio involves a variety of assumptions and estimates, especially for investments that are not actively traded. Fair values are obtained from a variety of external sources. The Company has a policy and process in place to identify securities that could potentially have an impairment that is other−than−temporary. This process involves monitoring market events that could impact issuers’ credit ratings, business climate, management changes, litigation and government actions, and other similar factors. This process also involves monitoring late payments, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts and cash flow projections as indicators of credit issues. At the end of each quarter, all securities are reviewed where fair value is less than ninety percent of amortized cost for six months or more to determine whether impairments should be recorded. The analysis focuses on each issuer’s ability to service its debts and the length of time the security has been trading below cost. This quarterly process includes an assessment of the credit quality of each investment in the entire securities portfolio. The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other−than−temporary. Relevant facts and circumstances considered include (1) the length of time the fair value has been below cost, (2) the financial position of the issuer, including the current and future impact of any specific events, and (3) the Company’s ability and intent to hold the security to maturity or until it recovers in value. To the extent the Company determines that a security is deemed to be other than temporarily impaired, the difference between amortized cost and fair value is charged to income as a realized investment loss. There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other−than−temporary. These risks and uncertainties include (1) the risk that the Company’s assessment of an issuer’s ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer, (2) the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated, (3) the risk that fraudulent information could be provided to the Company’s investment professionals who determine the fair value estimates and other−than−temporary impairments, and (4) the risk that new information obtained by the Company or changes in other facts and circumstances lead the Company to change its intent to hold the security to maturity or until it recovers in value. Any of these situations could result in a charge to income in a future period.
The costs of acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are included in deferred policy acquisition costs (“DAC”). DAC is then amortized to reflect an appropriate expense in relation to the projected stream of profits (for universal life and annuity products) or to the premium revenue stream (for traditional life products). When existing blocks of business are acquired, an intangible asset (termed “present value of future profits of acquired business” or “PVFP”) reflecting the costs of acquiring the business is created and then amortized over an appropriate term relative to the expected revenues and profitability of the block.
The Company has not recorded a premium deficiency adjustment for its SFAS 60 DAC and PVFP asset for any period in the last three years. Additionally, the Company currently does not foresee any premium deficiencies or changes to the “locked in” assumptions.
DAC and PVFP for universal life and annuity products is reported under Statement of Financial Accounting Standards No. 97 (“SFAS 97”), pursuant to which DAC and PVFP is amortized over the estimated lives of the contracts in proportion to actual and estimated future gross profits. Estimated future gross profit assumptions are not subject to lock-in as with SFAS 60 policies. The amount of future gross profits is dependent principally upon returns in excess of the amounts credited to policyholders, mortality, persistency, interest crediting rates, and expenses to administer the business. Each reporting period, the Company updates the estimated gross profits with the actual gross profits for that period. When the actual gross profits exceed the previously estimated gross profits, DAC and PVFP amortization will increase, resulting in a current period charge to earnings. The opposite result occurs when the actual gross profits are below the previously estimated gross profits. Each reporting period, the Company also updates the actual amount of business remaining in-force, which impacts expected future gross profits.
The Company also periodically reviews long-term assumptions underlying the projections of estimated gross margins and profits. These include investment returns, interest crediting rates, mortality, persistency, and expenses to administer the business. Management annually updates assumptions used in the calculation of estimated gross margins and profits which may have significantly changed. If the update of assumptions causes expected future gross margins and profits to increase, DAC and PVFP amortization will decrease, resulting in a current period increase to earnings. The opposite result occurs when the assumption update causes expected future gross margins and profits to decrease.
Over the past three years, the Company’s primary assumption changes have been due to revisions for investment returns. Due to the rather mature nature of the Company’s existing SFAS 97 blocks of business, the Company expects the investment return assumption to be the one that is most like to cause significant changes in the future. The Company is almost exclusively selling SFAS 60 type products with very little sales of SFAS 97 products. The SFAS 97 products sold in the past, which are universal life insurance and annuities, represent virtually closed, mature blocks of business. Historically, the Company has not had assumption changes of the magnitude that results in significant DAC and PVFP amortization adjustments for SFAS 97 related contracts.
Policy liabilities include contractholder deposit funds and liabilities for future policy benefits. Contractholder deposit funds represent liabilities for universal life and annuity products that totaled $424.9 million, or 78.7% of total policy liabilities, at December 31, 2007. These liabilities consist of deposits received from customers and are accumulated at actual credited interest rates on their fund balances less charges for expenses and mortality. These liabilities are not based on assumptions or judgment but are based on a calculated fund balance.
Liabilities for future policy benefits relate to traditional life insurance products that totaled $114.9 million, or 21.3% of total policy liabilities, at December 31, 2007. Future policy benefit liabilities are computed using the net level premium method, or an equivalent actuarial method. Assumptions used in these computations include those for investment yields, expenses, withdrawals, and mortality. The investment yield assumption varies by product duration and is based on Company experience and expectations. Expense assumptions and assumptions for withdrawals vary by product, issue age, and policy duration, and are also based on Company experience and expectations. Assumptions for mortality are based upon industry experience as modified to reflect Company experience. Additional provisions are also made to allow for possible adverse deviation from assumptions used.
A premium deficiency is recognized when existing policy liabilities, together with the present value of future gross premiums, will not be sufficient (a) to cover the present value of future benefits to be paid to or on behalf of policyholders and settlement and maintenance costs relating to a block of long-duration contracts and (b) to recover unamortized deferred policy acquisition costs. A premium deficiency is recognized by a charge to income and (a) a reduction of unamortized deferred policy acquisition costs and/or (b) an increase in the liability for future policy benefits.
Actual experience is compared to assumptions periodically. For policies issued under a set of assumptions, those assumptions are “locked in” and are not revised for the lifetime of the policies, except where there is a significant deviation of actual experience from original assumptions (i.e., a premium deficiency exists). Over the past three years, the Company has not had any premium deficiency issues nor does it anticipate such an issue in the foreseeable future.
The Company computes deferred income taxes utilizing the asset and liability method. Under this method, balance sheet amounts for deferred income taxes are computed based on the tax effect of the differences between the financial reporting and federal income tax bases of assets and liabilities using the tax rates which are expected to be in effect when these differences are anticipated to reverse. Deferred income tax assets are subject to ongoing evaluation of whether such assets will be realized. Realization of deferred tax assets is dependent upon the Company’s generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in prior periods. If future taxable income is not expected, the Company establishes a valuation allowance, when based on the weight of the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized.
Effective January 1, 2007, the Company adopted FIN 48 which clarifies the accounting for uncertainty in tax positions. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheets; and provides transition and interim period guidance, among other provisions. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. As a result of the implementation of FIN 48, the Company recognized a $1,441,000 increase in the liability for unrecognized tax benefits and a $255,000 increase in deferred tax assets, net of valuation allowance, resulting in a $1,186,000 reduction to the January 1, 2007 balance of retained earnings. The Company also reclassified, at adoption, $3,522,000 of current tax liabilities (previously recorded as a reduction to current tax receivables) and $503,000 of deferred tax liabilities to the liability for unrecognized tax benefits included within other liabilities.
Effective January 1, 2007, the Company adopted American Institute of Certified Public Accountants (“AICPA”) Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred policy acquisition costs (“DAC”) on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. It is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of SOP 05-1 did not have a material impact on the Company’s consolidated financial statements.
The following pronouncements have been identified as those which could be applicable to the Company’s consolidated financial statements.
In December, 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”). Under SFAS 141R, as under SFAS No. 141, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. Statement 141R will also change the accounting treatment for certain specific items, including acquisition costs, noncontrolling interests, acquired contingent liabilities, in-process research and development, restructuring costs associated with a business combination, and changes in deferred tax asset valuation allowances and income tax uncertainties. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS 141R amends SFAS 109 such that adjustments made to valuation allowances on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date of SFAS 141R would also apply the provisions of SFAS 141R. SFAS 141R is not expected to have a material impact on the Company’s consolidated financial statements as the Company is currently not anticipating any future acquisitions.
Reports of BDO Seidman, LLP, Independent Registered Public Accounting Firm, dated March 17, 2008.
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2007, 2006, and 2005.