The Company, through its three operating divisions, provides accumulation, life, and fixed benefit accident and sickness insurance products throughout the United States and Canada. The Company's products are sold through several distribution channels, including independent general agents, exclusive agents, financial institutions and payroll deduction programs, and are targeted primarily to lower and middle-income individuals in rural and suburban areas. These products are primarily small premium accident and sickness insurance policies with defined fixed benefit amounts, traditional whole life and universal life insurance with low face amounts, and accumulation products such as single premium deferred annuities.
The purchase and sale agreements for the Career Sales Division, Professional and United Life Assets are subject to regulatory approvals and other closing conditions.
In the third quarter of 1998, the Company made the decision to dispose of KIVEX, an internet service provider. The Company has engaged the investment banking firm of ING Barings Furman Selz in this regard and is currently soliciting interest from prospective purchasers. To date, the Company has not entered into a definitive agreement to sell KIVEX. In addition, the Company has made the decision to sell Marketing One, excluding those assets included with the sale of United Life.
The Company has recently engaged Wasserstein, Perella & Co. ("Wasserstein Perella") to review the Company's capital structure and its recapitalization and restructuring alternatives. Wasserstein Perella is presently evaluating the Company's business plan alternatives and capital structure and will advise and assist it with developing strategies, tactics and timetables to effectuate financing, refinancing, sale, recapitalization or restructuring transactions, as appropriate. These transactions may take the form of: (i) a restructuring or recapitalization of the Company's equity (including preferred or preference shares), debt securities or other indebtedness or obligations, including an exchange transaction or otherwise; (ii) a sale of the Company or any subsidiary; and (iii) a sale or placement of the Company's equity or debt securities or obligations with one or more lenders or investors or any loan or financing, or rights offering. There can be no assurance: (i) the Company will be successful in developing and implementing one or more of these transactions; (ii) the form the transactions will ultimately take; or (iii) the timing to complete the process.
On January 5, 1998, following shareholder approval at the 1997 annual meeting of shareholders, the Company consummated the acquisition of the interests of Fickes and Stone Knightsbridge Interests for total consideration estimated to be $10.6 million (not including acquisition expenses). Mr. Fickes will receive consideration in the form of estimated annual interest payments, ranging from $301,000 to $330,000, on April 15 each year through 2001 and will be issued 173,160 shares of the Company's Common Stock on April 15, 2001. The Company issued 173,160 shares to Mr. Stone in July 1998.
As a result, the Company began to realign its existing operating companies and incurred restructuring costs aggregating approximately $19.1 million during the year ended December 31, 1997, directly and indirectly associated with the initial divisional restructuring which had no future economic benefit ("restructuring costs").
The restructuring costs recognized the following for the years ended December 31, 1998 and 1997:
The Company incurred approximately $6.3 million and $4.7 million of pre-tax incremental costs ("period costs") associated with the corporate restructuring for the years ended December 31, 1998 and 1997, respectively. Such costs are included in the Company's Results of Operations as underwriting and other administrative expenses.
complex and interdependent systems could lead to a significant business interruption. Such an interruption could result in a decline in current and long-term profitability and business franchise value.
The Company's overall year 2000 compliance initiatives, include the following components: (i) assessment of all business critical systems (business critical systems includes computer and other systems), processes and external interfaces and dependancies; (ii) remediation or upgrading of business critical systems; (iii) testing of both modified and updated systems as well as integrated systems testing; (iv) implementation of modified and updated systems; and (v) contingency planning. As a part of the process, the Company has written letters and corresponded with its outside vendors and critical business partners concerning year 2000 compliance efforts and follows up periodically. Of those parties that have responded, the Company's most significant third party vendors and business partners have indicated that they have a plan for year 2000 compliance or believe that they are currently year 2000 compliant.
The Company has engaged outside vendors and focused certain employees' full time efforts to help in the full array of its year 2000 initiative. This includes systems assessment and monitoring advice, actual code remediation, communication and consultation with critical business partners and additional data center and testing resources. The Company originally projected to incur internal and external costs associated with such expertise ranging from $10.6 million to $14.5 million, which were anticipated to be incurred primarily during 1998 and early 1999. Based upon revised projections during the fourth quarter of 1998, the Company anticipates incurring internal and external costs of $5.0 million during 1999. The Company estimates it has incurred internal and external costs aggregating $13.4 million and $1.9 million for the years ended December 31, 1998 and 1997, respectively.
The Company has provided certain assurances to each respective purchaser of the Businesses Held for Sale with respect to each entity's ability to process date-sensitive information for the year 2000 and beyond. Although the Company believes that it will be able to meet the year 2000 representations and warranties provided to the respective purchasers, there can be no assurances. Failure of the Company to meet such representations and warranties could result in a decision by the purchaser not to consummate the transaction and/or indemnification claims for breach of contract.
The following table shows the cash sources and uses of the parent company on a projected basis for 1999 and on an actual basis for the years ended December 31, 1998, 1997 and 1996:
Cash from Subsidiaries. Cash generated by the Company's insurance subsidiaries is made available to PennCorp principally through periodic payments of principal and interest on surplus debentures issued by PLAIC, Constitution and Pioneer Security (collectively, the "Surplus Note Companies"). With respect to Constitution and Pioneer Security, the surplus debenture payments are made to non-insurance intermediate holding companies and paid to the Company in the form of dividends and tax sharing payments. The amounts outstanding under the surplus debentures totaled $453.1 million and $358.3 million as of December 31, 1998 and 1997, respectively. The surplus debentures generally require (subject to availability of statutory capital and surplus and in some instances, regulatory approval) principal and interest payments to be made periodically in amounts sufficient to allow PennCorp to meet its cash requirements.
The Surplus Note Companies rely upon dividends and tax sharing payments from their respective insurance subsidiaries. Each of the insurance subsidiaries is in turn subject to regulatory restrictions with respect to the maximum amount of dividends that can be paid to the Surplus Note Companies within a twelve month period without prior regulatory
Additional Borrowings. During each of the years in the three year period the Company borrowed under then existing bank credit facilities to primarily fund acquisitions or repay existing indebtedness. See Cash Uses below for the use of proceeds from the additional borrowings.
Reduction in Notes Payable. In conjunction with the Company's 1998 acquisition of the SW Financial Controlling interest, the Company borrowed under its existing $450 million revolving bank credit facility (the "Bank Credit Facility") to repay indebtedness of SW Financial aggregating $115.0 million upon acquisition. In addition, during 1998 the Company used existing liquidity to repay $11.0 million of indebtedness under the company's Bank Credit Facility. During 1997, the Company utilized proceeds from the Bank Credit Facility to retire indebtedness aggregating $100.0 million outstanding under a prior bank credit agreement. The Company utilized proceeds from its February 1996 Common Stock Offering to repay approximately $137.0 million of subsidiary indebtedness. Also during 1996, the Company entered into a new $175 million credit facility and utilized $100.0 million to repay a bridge loan facility entered into to effectuate the SW Financial investment in December 1995 and repurchase $35.4 million of principal amount of the Company's 9 1/4% Senior Subordinated Debenture due 2003 (the "Notes").
Issuance of Surplus Notes to Subsidiaries. The Company issued a $155.0 million surplus note to PLAIC in order to provide funding to PLAIC for the purchase and capital contributions necessary to effectuate the United Life acquisition.
Redemption of Preferred Stock. In March 1997 the Company utilized proceeds available under its then existing credit facility to redeem all of the outstanding Series B Preferred Stock for $14.7 million.
During 1999, the Company anticipates receiving approximately $25.2 million in the form of principal and interest payments or dividends and tax sharing payments for the Surplus Note Companies as a result of the ordinary dividend flow from the Surplus Notes Companies insurance subsidiaries. In addition, the Company anticipates receiving principal payments under the surplus debentures as a result of the sales of the Career Sales Division, Professional and the United Life Assets by the Surplus Note Companies. Total cash proceeds anticipated by the Company from such sales aggregates approximately $258.5 million. The Company anticipates utilizing $237.0 million to repay indebtedness and the remainder of such proceeds to fund interest costs and operating expenses of the parent company. Consummation of the Career Sales Division, Professional and the United Life Assets sales transactions is subject to regulatory approvals and other material closing conditions. Please refer to the reports on Form 8-K filed on January 11, 1999 and March 11, 1999 for more information on these sale transactions. Included as Exhibits 2.1 and 2.2 on the Form 10-K are the definitive purchase and sale agreements for the Career Sales Division and Professional, respectively. There can be no assurances that the Career Sales Division, Professional or the United Life Assets sales will be consummated or that the cash proceeds will be in the amount anticipated by the Company.
The net proceeds available to the Company from the asset sales may vary significantly from current estimates as a result of (i) minimum levels of statutory capital and surplus required to be delivered at closing for certain insurance subsidiaries, (ii) amounts to be held in escrow, (iii) valuation of certain consideration to be received by the Company, (iv) the timing of the closing and (v) various indemnification obligations included in each purchase and sale agreement. Specifically, the purchase and sale agreement for the Career Sales Division requires the purchaser to be satisfied with disability claims reserve liabilities and other active life reserves. The Company has engaged an actuarial consulting firm to provide analysis to the purchaser regarding such reserves. The Company is aware of potential deficiencies aggregating approximately $16.2 million in the statutory determination of disability claims reserves that will likely impact the total consideration the Company is to receive. The Company and the purchaser have not engaged in discussions to resolve the disability claims reserve issue. In addition, the purchase and sale agreement for the United Life Assets requires the Company to purchase certain residential mortgage loans from United Life, should the loans not meet specified criteria under the purchase and sale agreement or should United Life not be able to provide clear title to the loans. The residential loans are part of a servicing agreement with United Companies Financial Corporation, the "servicer," which has recently filed for bankruptcy. The servicer currently maintains within its control all applicable loan documents. Should the Company be unable to obtain satisfactory control of all of the applicable documents, the Company's anticipated net proceeds from the United Life Asset sale could be reduced by approximately $12.6 million. Such reduction would have a material impact on the liquidity of the Company.
Cash Flow from Operating Activities. Cash flow from operating activities, excluding the parent company, were $34.2 million, $74.6 million and $135.4 million, respectively, for the years ended December 31, 1998, 1997 and 1996. The decreasing trend in cash flow from operating activities for the years ended December 31, 1998, 1997 and 1996, is primarily attributable to the accounting treatment for KB Management. During the years ended December 31, 1997 and 1996, the Company maintained a 45% economic interest in KB Management. As of January 2, 1998, the Company purchased the remaining interest in KB Management (see Note 3 of Notes to Consolidated Financial Statements). From the formation of KB Management in 1995, KB Management provided certain management and acquisition services to the Company. From its formation through the year ended December 31, 1996, the transaction and management fees derived by KB management were sufficient to offset the majority of the administrative costs which in turn minimized the costs associated with the Company's 45% economic interest in KB Management. During 1997, KB Management operating and administrative expenses grew disproportionately to the ability of KB Management to engage and consummate acquisitions and other business transactions which would generate fee income and the Company recognized a net loss related to its 45% economic interest. With acquisition of the remaining interest in KB Management on January 2, 1998, the net loss derived by KB Management for the year ended December 31, 1998, was effectively recognized as a 100% economic interest by the Company. Supplemental factors to the decreasing trend in cash flow from operating activities were increasing costs associated with: (i) Year 2000 remediation at all of the insurance subsidiaries, (ii) the strategic business evaluations and associated restructuring of the Company and (iii) the accelerating expansion and transition of KIVEX from a regional to a national internet service provider.
During 1995, the Company established a portfolio of "trading securities" to provide the Company with the opportunity to undertake interest rate hedging strategies, to participate in short-term relative value trades and to invest in special situations with the goal of generating short-term trading profits. As of December 31, 1997, the Company held no investments in its trading portfolio.
The Company continuously evaluates its investment portfolio and the conditions under which it might sell securities, including changes in interest rates, changes in prepayment risk, liquidity needs, asset liability matching, tax planning strategies and other economic factors. Those securities that the Company believes would be subject to sale prior to the specified maturity date are included in "securities available for sale," which amounted to $2,589.7 million, $2,719.0 million and $2,993.9 million at December 31, 1998, 1997 and 1996, respectively. Of those securities available for sale, 93.0%, 92.5% and 92.1% were rated BBB or above by Standard & Poor's at December 31, 1998, 1997 and 1996, respectively.
During the years ended December 31, 1998, 1997 and 1996, the Company sold $1,019.9 million, $801.1 million and $373.7 million of fixed maturity and equity securities, and purchased $1,054.7 million, $1,021.5 million and $955.8 million of fixed maturity and equity securities, respectively. Such sales and purchases were primarily effected in order to meet cash flow demands associated with policyholder surrenders that in the aggregate increasingly exceeded policyholder deposits as well as improve the quality of the investment portfolio or avoid prepayment risks.
Cash Flow from Financing Activities. Cash used by financing activities, excluding the parent company, were $391.4 million, $325.9 million and $62.0 million for the years ended December 31, 1998, 1997 and 1996, respectively. The majority
of the cash outflow is attributable to policyholder surrenders exceeding deposits by $354.1 million in 1998, $275.7 million in 1997 and $205.2 million in 1996.
Policy Revenues. Policy revenues include: (i) premiums received on traditional life products (ii) mortality and administrative fees earned on universal life insurance and annuities and (iii) surrender charges on terminated universal life and annuity products. In accordance with GAAP, premiums on universal life and annuity products are accounted for as deposits to insurance liabilities.
Premiums, net of reinsurance, by major product line for the years ended December 31, 1998, 1997 and 1996 are as follows:
Net Investment Income. Net investment income decreased 8.9% to $183.6 million in 1998 due to a decrease in invested assets and reduced yields on investments. Average invested assets declined approximately $110.3 million in 1998 compared with 1997 and decreased $1.7 million from 1997 compared to 1996. Most of this decrease resulted from the need to liquidate invested assets to provide cash to fund surrenders of annuities issued by Security Life, which totaled $179.0 million in 1998. Most of these annuities had reached the end of their surrender fee period. A continued decline in the invested asset base and related investment income is anticipated as surrenders are expected to remain high over the next few years as more annuities in force reach the end of the surrender fee periods. The decrease in invested assets due to surrenders was partially offset by premiums on new and existing life policies and investment income collected, less commissions and operating expenses. Weighted average yields on invested assets have decreased to 7.1% in 1998 compared to 7.4% in 1997 and 7.5% in 1996. The decline reflects a decrease in higher yielding but less liquid asset classes such as mortgages, real estate and collateral loans. Also impacting investments yields were lower new money rates available to the Company to invest as a result of extensive maturities and calls of higher yielding investments and slightly higher investment expenses as a result of the decision in 1997 to utilize outside investment managers.
Other Income. Other income increased $2.6 million in 1998 compared to 1997. During 1998, the Company received approximately $1.0 million resulting from a settlement received associated with securities owned in the past. Most of the remaining differences between the years reflect changes in consideration received on supplemental contracts. Supplemental contract revenue is derived from annuity contracts which have reached the annuitization period. Consideration from supplemental contracts recognized as other income is offset by policyholder benefits, resulting in no net effect on the Company's results of operations.
During 1998, policyholder benefits increased 10.4% to $215.4 million compared with 1997. Death benefits increased $9.6 million or 12.3% compared with 1997. Most of this increase was due to higher incidence of mortality at Southwestern Life during the first half of 1998 compared to prior periods. Death benefits may vary significantly from period to period. Change in future policy benefits and other benefits increased 9.1% to $127.8 million in 1998. During 1997, future policy benefits were reduced approximately $23.9 million related to the adjustment of certain deficiency reserves on a block of
Southwestern Life interest sensitive business. During 1997, management began implementing a plan intended to reduce the anticipated losses associated with these policies. Such actions included contractually allowable reductions in credited rates and increases in cost of insurance and expense charges.
The Company is continually evaluating actuarial assumptions associated with interest sensitive life insurance contracts in which the determination of policy reserves is highly sensitive to assumptions such as withdrawal rates, investment earnings rates, mortality rates, and premium persistency. Currently reflected in the Company's financial statements are policy reserves and account values associated with such contracts, which aggregated approximately $525.4 million and $504.6 million as of December 31, 1998 and 1997, respectively. If developing trends were to continue, the Company would be required to record additional reserves or reduce intangible assets, which could have a material impact on the Company's financial position and results of operations. Management is also assessing the potential impact of future management actions, which might mitigate the financial impact of these trends. Types of management actions would likely include, but are not limited to, the redetermination of non-guaranteed charges and/or benefits under the contracts, asset segmentation, and reinsurance. There are risks associated with management action including potential sales disruption and the threat of litigation.
The Company is continuing to refine its actuarial estimates, likely management action plans and associated sensitivity testing of such interdependencies on policy reserves associated with these contracts which could result in changes in such estimates in the future.
Insurance Related Expenses. For 1998, insurance related expenses (including commissions, amortization of deferred policy acquisition costs and amortization of present value of insurance in force) decreased to $29.6 million in 1998 from $32.9 million in 1997. Insurance related expenses increased $8.4 million in 1997 compared to 1996. Amortization of deferred policy acquisition costs increased $7.2 million in 1998 compared to 1997 and increased $4.8 million in 1997 compared with 1996. These increases principally reflect the growing block of policies in force, which have been sold subsequent to the Company's acquisitions of Security Life and Southwestern Life. Also included in the $7.2 million increase in amortization is approximately $3.2 million of 1998 deferred costs for Security Life which was written off as unrecoverable from future profits as a result of shifts in the mix of products sold during the year. Amortization of present value of future profits decreased $10.8 million to $12.9 million in 1998. This decrease resulted from unlocking assumptions regarding the future profitability of certain interest sensitive life insurance products at Southwestern Life and from lower amortization associated with blocks of pre-purchase business. Amortization of present value of future profits increased $5.3 million in 1997 compared to 1996. This increase resulted from unlocking assumptions regarding future profitability of certain interest sensitive life insurance products of Security Life.
The Payroll Sales Division includes the operations of AA Life and OLIC. AA Life markets and underwrites customized life insurance and accumulation products to U.S. military personnel and federal employees through a general agency force. OLIC provides individual fixed benefit and life products utilizing a network of independent agents primarily in the southeastern United States through employer-sponsored payroll deduction programs.
Policy Revenues. Premiums received, net of reinsurance, by major product line for the years ended December 31, 1998, 1997 and 1996 are as follows:
Total policy revenues were consistent between 1998 and 1997. Policy revenues increased $4.3 million for AA Life in 1998 but were offset by a decrease of $ 4.1 million for OLIC. OLIC's decline was anticipated as a result of the Company's decision to cease marketing products through any "non-payroll" production sources during 1997. Policy revenues increased in 1997 compared to 1996 primarily as a result of new business sales for AA Life.
Net Investment Income. Net investment income increased 2.3% in 1998 from 1997 to $39.0 million and increased 5.9% in 1997 compared to 1996. The increase in net investment income was primarily the result of an increase in the average invested assets which increased approximately $14.9 million in 1998 compared to 1997 and increased $16.6 million in 1997 compared to 1996. The increases in invested assets is primarily attributed to modest increases in business in force at AA Life.
Insurance Related Expenses. Insurance related expenses (including commissions, amortization of deferred policy acquisition costs and amortization of present value of insurance in force) increased $12.8 million in 1998 compared to 1997. During 1998, OLIC accelerated amortization of deferred acquisition costs by $10.7 million primarily as a result of refinements in persistency assumptions and unlocking of the estimates of future profits. Amortization of deferred policy acquisition costs at AA Life increased $2.7 million in 1998 compared to 1997 primarily reflecting the growing block of in force policies sold since the Company's acquisition of AA Life. These increases were partially offset by lower commissions in 1998 compared to 1997 primarily resulting from OLIC's decision to cease writing certain products in 1997. Insurance related expenses increased $10.5 million to $29.4 million in 1997 compared to 1996. Amortization of deferred policy acquisition costs increased $8.5 million primarily as a result of refinements to amortization schedules for AA Life to reflect the unlocking of assumptions regarding future profitability and as a result of the growing block of policies in force, which had been sold subsequent to the Company acquisition of AA Life. In addition, amortization of present value of insurance in force for OLIC also increased from 1996 to 1997 primarily as a result of unlocking of assumptions regarding future profitability.
Other Income. Other income decreased $4.3 million (11.1%) to $33.9 million in 1998 compared to 1997. Other income increased $3.7 million in 1997 compared to 1996. The substantial decrease in other income in 1998 compared to 1997 is attributable to a decline in the amortization of Union Bankers' deferred gain associated with a third party Medicare reinsurance contract. The decrease in amortization is attributable to a decline in the underlying premium in force subject to the reinsurance arrangement, over time, which results in lower amortization of the gain. Also contributing to the decline in other income was reduced revenues for Marketing One resulting from the cancellation of a number of marketing relationships. These decreases are partially offset by increases in revenue from KIVEX and increased fee income for United Life. The increase in other income from 1997 compared to 1996 is principally attributable to Union Bankers' amortization of deferred gain. The amortization was higher in 1997 due to a full year amortization of the gain and higher than expected lapses of its Medicare policies. The deferred gain was primarily generated as a result of a June 1996 agreement.
in Union Bankers policyholder benefits, reflecting less business in force as a result of the decision to cease sales of major medical and life business, the cession of the remaining 20% of the Medicare business and the runoff of existing business.
Insurance Related Expenses. Insurance related expenses (including commissions, amortization of deferred policy acquisition costs and amortization of present value of insurance in force) decreased $6.6 million to $86.7 million in 1998 compared to 1997. This followed an $9.9 million (9.6%) decrease in 1997 compared to 1996. Amortization of present value of insurance in force decreased $11.6 million principally as a result of the Company recording an impairment provision associated with assets of Businesses Held for Sale resulting in the elimination of substantially all insurance assets subject to amortization. Specifically, Penn Life and Union Bankers wrote off $98.1 million of present value of insurance in force which reduced amortization. This was partially offset by an increase in amortization of deferred policy acquisition costs of $5.3 million, which included (i) an increase at Professional of $1.8 million in 1998 compared to 1997 as a result of higher than expected lapses on fixed benefit products, (ii) an increase of $1.7 million for United Life as a result of unlocking future assumptions regarding the profitability of certain annuity products and (iii) an increase at Union Bankers of $1.9 million as a result of higher lapses. Non-deferrable commissions decreased approximately $1.0 million at Union Bankers principally due to the decision to stop writing new major medical and life business. Most of the decrease in 1997 compared to 1996 relates to a $14.5 million decrease in non-deferrable commissions at Union Bankers, reflecting the Medicare reinsurance contract which ceded 80% of its Medicare business including new sales, higher lapses, and the decision to stop selling major medical and life policies. The Medicare reinsurance contract also resulted in lower amortization of deferred policy acquisition costs and present value of insurance in force at Union Bankers. However, this was more than offset by increases in amortization of deferred policy acquisition costs and present value of insurance in force at United Life and Professional primarily as a result of higher than expected lapses.
Other Operating Expenses. Other operating expenses (including general operating, overhead and policy maintenance) increased $4.6 million (5.4%) in 1998 compared to 1997. KIVEX's operating expenses increased $7.4 million reflecting costs associated with its expansion into new cities. In addition, the companies included in Businesses Held for Sale experienced increased costs as a result of additional non-deferrable expenses such as consulting, overhead and other costs associated with the divisional realignment, which are not considered restructuring costs. Offsetting the increases in operating expenses is reduced amortization of costs in excess of net assets acquired associated with the assets of the Businesses Held for Sale. During 1998, a total of $114.5 million of costs in excess of net assets acquired were written off as part of the impairment provision, which decreased amortization by approximately $2.8 million in 1998 compared to 1997. Other operating expenses decreased $7.3 million (7.8%) in 1997 compared to 1996. Union Bankers' expenses decreased $6.6 million principally as a result of receiving an expense allowance on the Medicare reinsurance contract for a full year in 1997 and only a partial year in 1996.
During the years ended December 31, 1997 and 1996, the Company maintained a 45% economic interest in KB Management. As of January 2, 1998, the Company purchased the remaining interest in KB Management (see Note 3 of Notes to Consolidated Financial Statements). From the formation of KB Management in 1995, KB Management provided certain management and acquisition services to the Company. From its formation through the year ended December 31, 1996, the transaction and management fees derived by KB management were sufficient to offset the majority of the administrative costs which in turn minimized the costs associated with the Company's 45% economic interest in KB Management. During 1997, KB Management operating and administrative expenses grew disproportionately to the ability of KB Management to engage and consummate acquisitions and other business transactions which would generate fee income and the Company recognized a net loss related to its 45% economic interest. With acquisition of the remaining interest in KB Management on January 2, 1998, the net loss derived by KB Management for the year ended December 31, 1998, was effectively recognized as a 100% economic interest by the Company.
The strategic business evaluation and associated restructuring of the Company begun in the early part of 1997 (see Note 21 of Notes to Consolidated Financial Statements) was primarily funded by the Company on behalf of the subsidiaries. As a result, a significant portion of the associated pre-tax incremental costs ("period costs") were funded by the Company. Period costs recognized by the Company increased to $5.7 million for the year ended December 31, 1998, from $1.8 million for the year ended December 31, 1997. Included in expenses for the year ended December 31, 1998 were $6.8 million associated with severance and other employment agreements and a $3.0 million write-off associated with a small marketing entity which was shut down in anticipation of the sale of Professional and not considered restructuring.
The 1996 consolidated life return of Constitution and its subsidiaries is currently under examination by the Internal Revenue Service. Tax years prior to 1996 are closed by statute to examination for the Constitution consolidated life insurance company tax group. The ultimate effect of the current examination is not known at this time.
Net Investment Gains (Losses). The Company maintains an investment portfolio that focuses on maximizing investment income, without exposure to unwarranted interest rate and credit risk. The Company actively manages asset duration and liquidity risks. As a result of this strategy, the Company routinely sells positions in securities no longer meeting its criteria. Sales of securities resulted in the Company realizing gains, on a pro forma basis, of $14.1 million, $19.3 million and $0.2 million, during 1998, 1997 and 1996, respectively. During 1998 and 1997, the Company liquidated securities available for sale in order to meet cash flow demands associated with policyholder surrenders that in the aggregate exceeded policyholder deposits by $354.1 million and $275.7 million, respectively. During 1997, the Company liquidated most of its equity holdings and private placement bond holdings.
The Audit Committee of the Board of Directors, which is composed of outside directors, serves in an oversight role to assure the integrity and objectivity of the Company's financial reporting process. The committee meets periodically with representatives of management, as well as the independent and internal auditors, to review matters of a material nature related to financial reporting and the planning, results and recommendations of audits. The independent and internal auditors have free access to the Audit Committee, without management present, to discuss any matter they believe should be brought to the attention of the committee. The committee is also responsible for making recommendations to the Board of Directors concerning the selection of the independent auditors.
We have audited the accompanying consolidated balance sheets of PennCorp Financial Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PennCorp Financial Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles.
PENNCORP FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (In thousands, except per share amounts)
The financial statements are prepared in accordance with generally accepted accounting principles ("GAAP"). These principles are established primarily by the Financial Accounting Standards Board ("FASB") and the American Institute of Certified Public Accountants ("AICPA"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as well as revenues and expenses. Accounts that the Company deems to be acutely sensitive to changes in estimates include deferred policy acquisition costs, policy liabilities and accruals, present value of insurance in force, costs in excess of net assets acquired, the fair value of assets and liabilities classified as held for sale and deferred taxes. In addition, the Company must determine the requirements for disclosure of contingent assets and liabilities as of the date of the financial statements based upon estimates. As additional information becomes available, or actual amounts are determinable, the recorded estimates may be revised and reflected in operating results. Although some variability is inherent in these estimates, management believes the amounts provided are adequate. In all instances, actual results could differ from estimates.
Fixed maturities and equity securities classified as available for sale are recorded at fair value, as they may be sold in response to changes in interest rates, prepayment risk, liquidity needs, the need or desire to increase income, capital or other economic factors. Changes in unrealized gains and losses related to securities available for sale are recorded as accumulated other comprehensive income, a separate component of shareholders' equity, net of applicable income taxes and amount attributable to deferred policy acquisition costs and present value of insurance in force related to universal life and
accumulation products. Securities classified as trading securities are reported at fair value with realized gains and losses and changes in unrealized gains and losses included in the determination of net income as a component of other income. During 1997 and 1996, the Company carried a certain equity investment in an affiliate on the equity basis of accounting as a result of its percentage ownership and lack of voting control. Mortgage-backed fixed maturity securities held for investment or available for sale are amortized using the interest method including anticipated prepayments at the date of purchase. Significant changes in estimated cash flows from original assumptions are reflected in the period of such change. Mortgage loans on real estate are recorded at cost, adjusted for amortization of premium or discount and provision for loan loss, if necessary. Policy loans, short-term investments, and other investments are recorded at cost.
The present value of insurance in force represents the anticipated gross profits to be realized from future revenues on insurance in force at the date such insurance was purchased, discounted to provide an appropriate rate of return and amortized, with interest based upon the policy liability or contract rate, over the years that such profits are anticipated to be received in proportion to the estimated gross profits. Accumulated amortization was $96,273 and $192,049 as of December 31, 1998 and 1997, respectively.
For each of the periods presented, the Company has made certain valuation determinations with respect to pre-acquisition contingencies or allocations. For the year ended December 31, 1998, the Company made a valuation determination with respect to preacquisition contingencies. The Company reduced tax liabilities and associated costs in excess of net assets acquired associated with the SW Financial and United Life acquisitions by $6,407 and $647, respectively, as a result of the Company resolving certain acquisition date contingencies.
For the year ended December 31, 1997, the Company determined the following with respect to certain material acquisition contingencies or allocations: (i) the Company increased deferred tax assets and reduced associated costs in excess of net assets acquired associated with the Security Life acquisition by $19,600 as a result of the Company resolving certain acquisition date tax contingencies, (ii) the Company reduced both deferred tax liabilities and associated costs in excess of net assets acquired associated with the Marketing One acquisition by $1,100 as a result of the Company resolving certain acquisition date tax contingencies, and (iii) the Company reduced costs in excess of net assets acquired and increased certain mortgage loan values by $1,100, associated with the acquisition of United Life, as a result of final appraisals becoming available.
For the year ended December 31, 1996, the Company determined the following with respect to certain material acquisition contingencies or allocations: (i) the Company incurred additional costs associated with the acquisition of United Life of $2,500, which resulted in a corresponding increase to costs in excess of net assets acquired, (ii) the Company decreased real estate and mortgage loan loss valuations of Security Life by $6,800, which resulted in a decrease in costs in excess of net assets acquired of $4,400 and deferred tax assets of $2,400, and (iii) the Company increased certain policy reserves of Security Life aggregating $10,000, which resulted in a corresponding increase to costs in excess of net assets acquired of $10,000.
policyholders and amounts that have been assessed to compensate the life insurance subsidiaries for services to be provided in the future.
Policy and contract claims represent estimates of both reported claims and claims incurred but not reported based on experience. The Company has been closely monitoring the development of claims reserve experience for Penn Life. The methodology previously utilized has experienced, what appears to be, a deterioration of the adequacy of its claims reserves associated with disability income products sold prior to the Company's ownership. During 1998, the Company changed its methodology in recording these reserves. The effect of the change in methodology is inseparable from the effect of the change in accounting estimate and is accordingly reflected in operations as a change in accounting estimate for 1998.
Shares purchased are recorded at cost as a reduction of shareholders' equity. Shares abandoned by the associated shareholders are recorded at no cost.
The financial statement accounts of the Company's Canadian operations, which are denominated in Canadian dollars, are translated into U.S. dollars as follows: (i) Canadian currency assets and liabilities are translated at the rates of exchange as of the balance sheet dates and the related unrealized translation adjustments are included as accumulated other comprehensive income, a separate component of shareholders' equity, and (ii) revenues, expenses and cash flows, expressed in Canadian dollars, are translated using a weighted average of exchange rates for each of the periods presented.
In December 1997, the AICPA issued Statement of Position ("SOP") 97-3. SOP 97-3 provides: (1) guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments, (2) guidance on how to measure the liability, (3) guidance on when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges, and (4) requirements for disclosure of certain information. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. The Company's present accounting methodology for guaranty fund and other reinsurance assessments substantially conforms to the requirements of this SOP.
The Company acquired United Life in 1996 for a total purchase price of $110,056 including expenses incurred of $9,706 and earnings through the date of consummation of the acquisition of $3,608. The United Life acquisition has been accounted for as a purchase transaction in accordance with generally accepted accounting principles, the fair value of net assets acquired amounted to $82,580 (as adjusted) resulting in $27,476 (as adjusted) of costs in excess of net assets acquired which will be amortized over 20 years.
On February 18, 1998, the Company announced it had engaged the investment banking firms Salomon Smith Barney, Inc. and Fox-Pitt, Kelton Inc. to review strategic alternatives for maximizing shareholder value, including the sale of the Company's Career Sales Division and certain other non-strategic subsidiaries.
Separate selected pro forma financial information is presented in Note 17 to illustrate the effects of the purchase of the SW Financial Controlling Interests and the Fickes and Stone Knightsbridge Interest as well as the sale of Businesses Held for Sale for the years ended December 31, 1998 and 1997.
The Company has adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" which requires that companies disclose segment data on a basis that is used internally by management for evaluating segment performance and allocating resources to segments. The Company defines its operating divisions based on the distribution channels of its products. The Company has three reportable operating segments: (i) Financial Services Division, which is based in Dallas, Texas, and markets life insurance and fixed annuities through independent general agents; (ii) Payroll Sales Division, which is based in Waco, Texas, and markets and underwrites customized life insurance and accumulation products to U.S. military personnel and federal employees through a general agency force and provides individual fixed benefit and life products through employer-sponsored payroll deduction programs; and (iii) Businesses Held for Sale.
The Company's Chief Executive Officer evaluates performance of each segment based on profit or loss from operations excluding (i) restructuring costs, (ii) net gains on the sale of investments, (iii) impairment valuation associated with Businesses Held for Sale, (iv) interest expense, (v) income taxes and (vi) equity in earnings of unconsolidated subsidiaries. The accounting policies of segments are the same as those described in the summary of significant accounting policies (see Note 2 of Notes to Consolidated Financial Statements). Segment data for 1997 and 1996 have been restated to conform to the 1998 presentation.
Included in fixed maturities available for sale as of December 31, 1998 and 1997, are below investment-grade securities with an amortized cost of $177,263 and $165,511 and a fair value of $163,252 and $167,518, respectively. Included in fixed maturities available for sale as of December 31, 1998, are unrated securities with an amortized cost of $18,211 and a fair value of $18,239. Included in fixed maturities available for sale as of December 31, 1997 are unrated securities with an amortized cost and a fair value of $26,563.
As of December 31, 1998, net unrealized appreciation in equity securities available for sale of $27 consisted of gross unrealized gains of $27. As of December 31, 1997, net unrealized appreciation in equity securities available for sale of $173 consisted of gross unrealized gains of $242, less gross unrealized losses of $69.
The Company's commercial and residential mortgage portfolios had net carrying values $36,882 and $240,879, respectively, and, fair values of approximately $38,865 and $248,052, respectively, as of December 31, 1998 and 1997.
On August 5, 1997, the Company purchased $40,000 of SW Financial Notes from the liquidating trust for the creditors of ICH Corporation, SW Financial's former parent. SW Financial had issued the SW Financial Notes as part of the acquisition consideration paid to the liquidating trust. The SW Financial Notes were purchased by the Company at par and were included in other investments as of December 31, 1997. Interest due under the SW Financial Notes is currently set at 7.0%, per annum.
On January 2, 1998, the Company acquired the SW Financial Controlling Interest (see Note 3 of the Notes to Consolidated Financial Statements).
The Company accounted for its investment in SW Financial utilizing the equity method for the years ended December 31, 1997 and 1996. The consolidated condensed results of operations for the years ended December 31, 1997 and 1996 and financial position of SW Financial at December 31, 1997, are provided below:
Expected future cash flows used in determining such values are based on actuarial determinations of future premium collection, mortality, morbidity, surrenders, operating expenses and yields on assets held to back policy liabilities as well as other factors. Variances from original projections, whether positive or negative, are included in income as they occur and will affect the present value of insurance in force amortization rates for insurance products accounted for under SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from Sales of Investments." To the extent that these variances indicate that future cash flows will differ from those included in the original scheduled amortization of the present value of insurance in force, future amortization may be adjusted. Recoverability of the present value of insurance in force is evaluated annually and appropriate adjustments are then determined and reflected in the financial statements for the applicable period.
As a result of changes in methodology (described below) and estimates of insured events in prior years, the liability for health policy and contract claims increased net of reinsurance by $31,545 in 1998 and $6,344 in 1997 and decreased, net of reinsurance by $6,816 in 1996.
-------------- (a) Interest costs under the Unsecured 9 1/4% Senior Subordinated Notes due 2003 (the "Notes") totaled $10,622, $11,461 and $13,545 during 1998, 1997 and 1996, respectively. As of December 31, 1998, the effective rate for the Notes was approximately 9 1/4%. (b) Interest costs under the $450,000 revolving credit facility totaled $30,680 and $9,188 during 1998 and 1997. The effective rate of interest as of December 31, 1998 was approximately 8.4%, including facility fees of 0.75% as of December 31, 1998. During 1997 and 1996, the Company had a $175,000 revolving credit facility for which it incurred interest costs of $1,855 and $1,558, respectively.
Covenants and Liquidity. The Notes and the revolving bank credit agreement (the "Bank Credit Facility") impose certain covenants on the Company, including covenants restricting the amount of additional indebtedness the Company may incur, limit its ability to engage in future acquisitions and certain other business transactions, and the amount of dividends the Company may declare and pay (see Note 12 of Notes to Consolidated Financial Statements), and requires the Company to maintain specified financial ratios and meet specified financial tests. At December 31, 1998, the Company and its subsidiaries were either in compliance with or had received waivers from all applicable covenants.
On March 30, 1999, the Company entered into an amendment (the "amendment") to its existing Bank Credit Facility. The amendment provides for additional covenants and revises certain financial covenants to the Bank Credit Agreement. In addition, the amendment changes the maturity date of the Bank Credit Facility to May 2000. Significant additional covenants include the requirement for the Company to repay indebtedness at specified dates and amounts throughout 1999, based upon anticipated dates and cash proceeds to be received from the consummation of the Career Sales Division, Professional and the United Life Asset sales. The timing and required debt reduction follows:
April 30, 1999 $ 40,000 May 31, 1999 127,000 June 30, 1999 70,000
The Company's ability to meet the debt reduction covenants of the Bank Credit Facility is dependent on being able to consummate the sales of Career Sales Division, Professional and the United Life Assets (see Note 3 to Notes to Consolidated Financial Statements) to generate sufficient cash proceeds. Failure to consummate such transactions could result in action from ratings agencies, state regulatory agencies, and/or creditors. Based upon current conditions and circumstances, management intends and believes the Company has the ability to consummate such sales to generate sufficient cash proceeds to meet the covenants.
The amendment requires the Company to work with the bank group on aggregating cash at the parent company level, provide information on asset sale transactions, obtain the bank's consent to the potential sale of KIVEX and meet certain cash flow payment requirements from the Surplus Note Companies on specified dates. In addition, the amendment eliminates the Company's ability to pay dividends on its common and preferred stock and severely limits ability of the Company to effectuate the sale of capital securities or to borrow funds available under the Bank Credit Facility. With respect to borrowings, the Company may only borrow funds, up to $7,000, for the payment of interest under the Bank Credit Facility and the Notes subject to certain restrictions. Upon consummation of the Career Sales Division divestiture, the commitment will be reduced to $5,000. Finally, the amendment modifies pricing spreads, fees and other costs associated with the Bank
Projected Cash Sources and Uses in 1999. During 1999, the Company anticipates receiving approximately $25,200 in the form of principal and interest payments or dividends and tax sharing payments for the Surplus Note Companies as a result of the ordinary dividend flow from the Surplus Notes Companies insurance subsidiaries. In addition, the Company anticipates receiving principal payments under the surplus debentures as a result of the sales of the Career Sales Division, Professional and the United Life Assets by the Surplus Note Companies. Total cash proceeds anticipated by the Company from such sales aggregates approximately $258,500. The Company anticipates utilizing $237,000 to repay indebtedness and the remainder of such proceeds to fund interest costs and operating expenses of the parent company.
The net proceeds available to the Company from the asset sales may vary significantly from current estimates as a result of (i) minimum levels of statutory capital and surplus required to be delivered at closing for certain insurance subsidiaries, (ii) amounts to be held in escrow, (iii) valuation of certain consideration to be received by the Company, (iv) the timing of the closing and (v) various indemnification obligations included in each purchase and sale agreement. Specifically, the purchase and sale agreement for the Career Sales Division requires the purchaser to be satisfied with disability claims reserve liabilities and other active life reserves. The Company has engaged an actuarial consulting firm to provide analysis to the purchaser regarding such reserves. The Company is aware of potential deficiencies aggregating approximately $16,200 in the statutory determination of disability claims reserves that will likely impact the total consideration the Company is to receive. The Company and the purchaser have not engaged in discussions to resolve the disability claims reserve issue. In addition, the purchase and sale agreement for the United Life Assets requires the Company to purchase certain residential mortgage loans from United Life, should the loans not meet specified criteria under the purchase and sale agreement or should United Life not be able to provide clear title to the loans. The residential loans are part of a servicing agreement with United Companies Financial Corporation, the "servicer," which has recently filed for bankruptcy. The servicer currently maintains within its control all applicable loan documents. Should the Company be unable to obtain satisfactory control of all of the applicable documents, the Company's anticipated net proceeds from the United Life Asset sale could be reduced by approximately $12,600. Such reduction would have a material impact on the liquidity of the Company.
For the year ended December 31, 1996, the Company realized an after-tax extraordinary charge of $2,372. The charge represents (i) the write-off of $816 of deferred financing costs related to the retirement of certain indebtedness of the Company and its subsidiaries, and (ii) the write-off of $1,556 of deferred financing, swap cancellation and other costs related to the repurchase of approximately $35,354 in principal amount of the Notes.
The provisions for income tax expense (benefit) attributable to income (loss) before income taxes, equity in earnings of unconsolidated affiliates and extraordinary charge are as follows for the years ended December 31:
The valuation allowance for deferred tax assets as of December 31, 1998 and 1997, was $44,784 and $10,367, respectively. The net change in the total valuation allowance for the years ended December 31, 1998 and 1997, was an increase (decrease) of $23,492 and ($5,525) (including $5,000 that was used in 1997 to reduce costs in excess of net assets acquired), respectively. The 1998 increase in valuation allowance is largely attributable to deferred tax assets resulting from net operating losses generated by the Company's non-life members. During 1997, an additional $14,635 increase to the deferred tax asset was used to reduce costs in excess of net assets acquired related to the Security Life acquisition as acquisition date tax contingencies were resolved.
As of December 31, 1998, the Company has life consolidated net operating loss carryforwards of approximately $97,362 for tax return purposes, of which $47,813 relates to Retained Businesses, which, if not utilized will begin to expire in 2005. The Company has life consolidated capital loss carryforwards of approximately $7,516 of which, $5,792 relates to Retained Businesses, which, if not utilized, will expire in 2001. In addition, OLIC and Peninsular have available, on a separate return basis, acquired net operating loss carryforwards of approximately $10,417. The utilization of acquired net operating loss carryforwards is limited in any one year to the lesser of (i) the life insurance group's consolidated taxable income or (ii) the subsidiary's taxable income computed on a separate return basis. The acquired net operating loss carryforwards will expire in 2004 and 2005.
Under provisions of the Life Insurance Company Tax Act of 1959, certain special deductions were allowed to life insurance companies for federal income tax purposes. These special deductions were repealed by the Tax Reform Act of 1984, and the untaxed balances were frozen at their December 31, 1983 levels. These balances aggregate approximately $42,301 for the Company's life insurance subsidiaries and are subject to taxation if certain levels of premium income or life insurance reserves are not maintained, or if the life insurance companies make excess distributions to shareholders. In addition, on February 1, 1999, the Clinton administration released its Fiscal Year 2000 Budget which included a revenue raising provision that would require life insurance companies to include the balance of these special deductions in income
The following is a reconciliation of net income (loss) applicable to common stock as well as common stock used to compute basic and diluted earnings (loss) per share for the years ended December 31:
During the year ended December 31, 1998, 83,260 stock options were exercised and issued to certain employees as discounted restricted common stock of the Company with vesting periods of three and four years. During the year ended December 31, 1998, the Company recognized $2,751 of deferred compensation associated with the issuance of this common stock and $2,267 of compensation expense. As of December 31, 1998, the balance of deferred compensation was $484 and was recorded as an offset to shareholders' equity.
Associated with the restructuring and the consolidation of all corporate functions into the Company's Dallas location, certain employees were severed. For the year ended December 31, 1998, two notes receivable secured by 7,500 shares of common stock were discharged and 88,280 shares of common stock were abandoned as a result of the severance. The result was to increase treasury stock, and decrease notes receivable secured by common stock, by $261.
The Company issued 2,875,000 shares of $50 redemption value (liquidation preference, $50 plus accrued and unpaid dividends) $3.50 Series II Convertible Preferred Stock (the "Series II Convertible Preferred Stock") on August 2, 1996. The Series II Convertible Preferred Stock is convertible at the option of the holder, unless previously redeemed, into 1.4327
shares of common stock for each share, subject to adjustment in certain events. As of December 31, 1998, the estimated fair value of the Series II Convertible Preferred Stock, based upon market-maker quotes, was $23,431 or $8.15 per share.
The Company issued 2,300,000 shares of $50 redemption value (liquidation preference, $50 plus accrued and unpaid dividends) $3.375 Convertible Preferred Stock (the "Convertible Preferred Stock") on July 14, 1995. The Convertible Preferred Stock is convertible at the option of the holder, unless previously redeemed, into 2.2124 shares of common stock for each share, subject to adjustment in certain events. As of December 31, 1998, the estimated fair value of the Convertible Preferred Stock, based upon active market quotes, was $20,125 or $8.75 per share.
The Company has suspended the payment of cash dividends on its outstanding $3.375 Convertible Preferred Stock, $3.50 Series II Convertible Preferred Stock and Common Stock. Under the amended terms of the Company's Bank Credit Facility the Company may not pay dividends on its Common Stock or Preferred Stock issues. Under the terms of the two series of convertible preferred stock, if dividends are in arrears for six or more quarterly dividend periods (whether or not consecutive), the holders of the convertible preferred stock, voting as a single class, will have the right to elect two directors of the Company. In addition, for as long as there are dividend arrearages on the convertible preferred stock, the Company will be prohibited from paying dividends on the Common Stock or purchasing, redeeming or otherwise acquiring Common Stock.
As part of agreements effective July 1998, the Company issued to the Chairman of the Board of Directors as well as the three senior officers of the Company, 1,550,000 stock appreciation rights at $3.88 per share. The stock appreciation rights provide compensation to each individual in an amount equal to the excess of the fair value of each stock appreciation right over the fair value of each stock appreciation right at the date of grant. Compensation, if any, is payable in either shares of common stock of the Company or cash, at the election of the recipient. As of December 31, 1998, there has been no compensation expense accrued associated with these stock appreciation rights.
As part of an employment agreement effective August 1990, the Company issued to a former officer of the Company, warrants to purchase up to 570,760 shares of the common stock of the Company at any time up to 10 years from the date of the agreement. The warrants are exercisable at a price of $4.00 per share which was fair value on the date of grant and as such no compensation is recorded.
The following table summarizes data relating to stock options and warrants activity and associated weighted average option exercise price information for the years ended December 31:
The fair value of each option and warrant grant used to determine the pro forma amounts indicated in the previous table is estimated on the date of grant using the following weighted average assumptions for 1998, 1997 and 1996:
For the years ended December 31, 1998 and 1999 PLIC has received a permitted statutory accounting practice allowing PLIC to utilize its own experience and other modification factors in the determination of statutory disability income claims reserves. If PLIC were to utilize the model regulation for the determination of disability income claims reserves, management estimates that the amount of additional statutory claims reserves necessary to be recorded would be approximately $16,200. If PLIC were to record such additional reserves on a statutory basis, its risk based capital would be reduced significantly which in turn could lead to regulatory action. For the year ended December 31, 1999, PLIC will be required, in the event of the non-completion of the Career Sales Division divestiture, to increase its disability claims reserves by approximately $5,300 and receive capital contributions of at least $5,300 to offset such reserve increases.
During 1998, the Company implemented SFAS No. 132, "Employer's Disclosures about Pensions and Other Postretirement Benefits." This accounting standard revised the disclosure requirements for pensions and other postretirement benefit plans, but does not change the measurement or financial statement recognition of such plans.
The Company has an established bonus plan for insurance subsidiary officers. The amount available to pay awards for any year is determined by a committee of senior executives of the Company and is subject to the review and recommendation of the Compensation Committee and approval of the Board of Directors of the Company. Awards are based primarily on the achievement of specified operating objectives and the performance of eligible participants. The Company accrued or paid $3,390, $1,417 and $1,144 under this plan during the years ended December 31, 1998, 1997 and 1996, respectively.
Components of net periodic benefit cost include the following for the year ended December 31, 1998 and 1997:
For measurement purposes, an annual rate increase ranging from 5.5% to 7% in the health care cost trend rate was assumed for 1998; the rate was assumed to decrease gradually to 4% by year 2015 and remain at that level thereafter. The weighted average discount rates used in determining the accumulated postretirement benefit obligation ranged from 6.5% to 7.5%. The health care cost trend rate assumption has a significant effect on the amounts reported. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
On September 1, 1997, the Company, through its insurance subsidiaries, purchased $25,000 of ACO Acquisition Corp. (subsequently re-named Acordia, Inc. ("Acordia") subordinated indebtedness and the Company purchased $20,000 of ACO Brokerage Holdings Corporation ("ACO"), an affiliate of Acordia, preferred stock. The Acordia subordinated notes pay interest on a current basis at 12.5%, per annum, payable in semi-annual installments. Acordia was 28.6% owned by KB Investment Fund I, LP (formerly Knightsbridge Capital Fund I, L.P.) (the "KB Fund"). PennCorp received fees aggregating $1,100 in 1997 from Acordia for its underwriting and participation in the subordinated notes and preferred stock offering. Knightsbridge Management, L.L.C. ("KM") received sponsor fees and other fees aggregating $1,714 in 1997 from Acordia for its role in consummating the Acordia acquisition.
For the years ended December 31, 1997 and 1996, PennCorp paid or accrued $2,385 and $2,548 in transaction fees and expenses to KM related to the Washington National, United Life and SW Financial transactions, respectively. During 1997 and 1996, certain of the Company's affiliates and subsidiaries paid management fees to KM amounting to $5,325 and $3,333, respectively. SW Financial and United Life incurred KM investment advisory fees totaling $4,358 and $2,426 during 1997 and 1996, respectively. In addition during 1996, PennCorp received a $1,000 stand-by commitment fee from SW Financial for contingent financing on a real estate transaction. SW Financial did not draw upon the commitment which has expired.
During 1998 and 1997, the Company's insurance subsidiaries paid management and commitment fees aggregating $718 and $444, respectively, to investment funds managed by a member of the Board of Directors.
The Company and its subsidiaries are obligated under operating leases, primarily for office space. Rent expense, net of sublease income, was $5,299, $5,178 and $8,416 in 1998, 1997 and 1996, respectively.
1999.............................................................. $ 3,821 2000.............................................................. 2,690 2001.............................................................. 2,676 2002.............................................................. 2,521 2003.............................................................. 2,375 2004 and thereafter............................................... 2,242 ----------- Total minimum payments required................................ $ 16,325 ===========
The defendants and the plaintiffs' counsel entered into a stipulation of settlement on March 28, 1997 (the "Original Proposed Settlement"). The Original Proposed Settlement consisted of the following principal elements: (i) Messrs. Stone and Fickes will cancel the 335,564 SW Financial common stock warrants they hold for no consideration enabling PennCorp
to purchase the SW Financial Controlling Interest for $67,500, reducing the price to be paid by PennCorp for the SW Financial Controlling Interest by approximately $2,000, (ii) the PennCorp Board will proceed with the purchase of The Fickes and Stone Knightsbridge Interests, having received a fairness opinion of a nationally recognized investment banking firm with respect to the price to be paid for The Fickes and Stone Knightsbridge Interests, (iii) the PennCorp Board will proceed with the acquisition of the SW Financial Controlling Interest, having received a fairness opinion of a nationally recognized investment banking firm with respect to the price to be paid for the SW Financial Controlling Interest, (iv) the PennCorp Board will submit the purchases of The Fickes and Stone Knightsbridge Interests and the SW Financial Controlling Interest to a shareholder vote of a majority of the PennCorp stockholders present at a meeting and entitled to vote, and stockholders must approve both transactions, (v) Messrs. Stone and Fickes will abstain from voting on the proposals to approve the purchase of The Fickes and Stone Knightsbridge Interests and the SW Financial Controlling Interest, and (vi) the plaintiffs' counsel will be entitled to conduct confirmatory discovery.
On August 25, 1998, the first of ten class-action complaints were filed in the United States District Court for the Southern District of New York against the Company and certain of its current or former directors and officers.
During a pre-trial conference on November 9, 1998, all parties agreed to the consolidation of all of the actions and the Court appointed lead plaintiffs on behalf of shareholders and noteholders. The Court also approved the selection of three law firms as co-lead counsel for shareholders and noteholders. Pursuant to a schedule agreed to at the conference, a consolidated and amended complaint was filed on January 22, 1999. A First Consolidated Amended Class Action Complaint naming, as defendants, the Company, David J. Stone, formerly Chairman and Chief Executive Officer, and Steven W. Fickes, formerly President and Chief Financial Officer was filed on March 15, 1999 (the "Complaint").
The Company expects that this litigation will not affect its ability to operate through December 31, 1999. While it is not feasible to predict or determine the final outcome of these proceedings or to estimate the amounts or potential range of loss with respect to these matters, management believes that if there is an adverse outcome with respect to such proceedings it would have a material adverse impact on the Company and affect its ability to operate as is currently intended.
The life insurance companies are required to be members of various state insurance guaranty associations in order to conduct business in those states. These associations have the authority to assess member companies in the event that an insurance company conducting business in that state is unable to meet its policyholder obligations. Assessments from guaranty associations, which have not been material, are recorded as assessments when received.
In May 1998, the three senior executive of the Company entered into two year employment agreements with the Company which have various annual bonus and termination provisions. For the year ended December 31, 1998, the Company has accrued compensation expense of $1,800 and $3,036 for the annual bonus and termination provisions, respectively, of these employment agreements. Termination provisions are payable upon the expiration of the employment agreement or termination by the officer for "good reason" as defined in the employment agreement.
Many computer and software programs were designed to accommodate only two digit fields to represent a given year (e.g. "98" represents 1998). It is highly likely that such systems will not be able to accurately process data containing date information for the year 2000 and beyond. The Company is highly reliant upon computer systems and software as are many of the businesses with which the Company interacts. The Company's ability to service its policyholders and agents is dependent upon accurate and timely transaction processing. Transaction processing in turn is dependent upon the Company's highly complex interdependent computer hardware, software, telecommunications and desktop applications. The inability of the Company or any of its integral business partners to complete year 2000 remediation efforts associated with these highly complex and interdependent systems could lead to a significant business interruption. Such an interruption could result in a decline in current and long-term profitability and business franchise value.
Although the Company believes that its operating divisions, outside vendors and most critical business partners will be sufficiently compliant that the year 2000 issue should not cause a material disruption in the Company's business, there can be no assurance that there will not be material disruptions to the Company's business or an increase in the cost of the Company doing business. Although the Company believes that the year 2000 issues should not cause a material disruption in the Company's business, the Company has developed various contingency plans associated with remediation tasks which the Company believes are at a higher risk for potential failure.
The Company has outstanding commitments to invest up to $7,600 in various unaffiliated limited partnership funds and other investments.
The Company has a contingent obligation for mortgage loans previously sold aggregating $5,905 as a result of the Company acting as a servicing conduit.
As a result of the tremendous growth of the Company and the diversification of the underlying business units resulting from acquisition over time, the Company began a strategic business evaluation in the third quarter of 1996. The review resulted in the Company establishing three divisional platforms, Career Sales Division, Payroll Sales Division and Financial Services Division in 1997.
As a result, the Company began to realign its existing operating companies and incurred restructuring costs aggregating approximately $19,071 during the year ended December 31, 1997, directly and indirectly associated with the initial divisional restructuring which had no future economic benefit ("restructuring costs").
On January 2, 1998, and January 5, 1998, respectively, the Company acquired the SW Financial Controlling Interest and the Fickes and Stone Knightsbridge Interest. The acquisition allowed the Company to complete its divisional restructuring which began in 1997. As a result, the Company incurred restructuring costs aggregating approximately $11,767 for the year ended December 31, 1998, directly and indirectly associated with the divisional restructuring.
Cash and Short-term Investments, Accounts and Notes Receivable: The carrying value approximates their fair value due to the short-term maturity of these instruments.
Mortgage Loans: The fair values are estimated using discounted cash flow analyses, based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations.
On March 22, 1999, the Company received regulatory approval for the sale of Professional. The Company anticipates the transaction, subject to certain closing conditions, will be finalized on or about March 31, 1999.
The Company's fourth quarter 1998 reported loss primarily resulted from an additional impairment provision associated with assets of Businesses Held for Sale totaling $57,475. In addition, the Company unlocked certain actuarial assumptions on interest sensitive blocks of business resulting in additional amortization of deferred policy acquisition costs and present value of insurance in force amounting to approximately $16,250 and incurred restructuring costs of $7,228.
The Company's fourth quarter 1997 reported loss was primarily a result of reserve strengthening aggregating $12,373 associated with the Businesses Held for Sale and certain non-recurring charges including transaction costs, period restructuring costs and other costs aggregating $5,222, associated with the Retained Businesses. In addition, the Company unlocked certain actuarial assumptions on interest sensitive blocks of business resulting in additional amortization of deferred policy acquisition costs and present value of insurance in force amounting to $6,944.
SOUTHWESTERN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME for the Years Ended December 31, 1997 and 1996 (In thousands)
In August 1997, the Company acquired from ICH the remaining 17% interest in ICH Funding and certain other assets and released ICH from indemnification obligations relative to certain tax, litigation and other matters. Minority interest in ICH Funding, totaling $1,486 at December 31, 1996 is included in accrued expenses and other liabilities as of December 31, 1996.
Liabilities for future policy benefits for traditional life products generally have been computed on the net level premium method, based on estimated future investment yield, mortality, and withdrawals. For accident and health products, liabilities for future policy benefits are established equal to the excess of the present value of future benefits to or on behalf of policyholders over discounted net future premiums. Estimates used are based on the Company's experience adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. Liabilities for future policy benefits for interest sensitive products include the balance that accrues to the benefit of the policyholders and amounts that have been assessed to compensate the life insurance subsidiaries for services to be provided in the future.
Estimated costs of acquiring new business which vary with, and are primarily related to, the production of new business, have been deferred to the extent that such costs are deemed recoverable from future revenues. Such estimated costs include commissions and certain costs of policy issuance and underwriting. Costs deferred on accident and health and traditional life policies are amortized, with interest, over the anticipated premium-paying period of the related policies in proportion to the ratio of annual premium revenue to expected total premium revenue to be received over the life of the policies. Expected premium revenue is estimated by using the same mortality, morbidity and withdrawal assumptions used in computing liabilities for future policy benefits. For interest sensitive products and limited pay life products, policy acquisition costs are amortized in relation to the emergence of anticipated gross profits over the life of the policies.
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 amortized cost and fair value of investments in fixed maturities available for sale at December 31, 1997 and 1996 by categories of securities are as follows:
For the year ended December 31, 1997, net realized gains on sale of fixed maturities consisted of gross gains of $2,779 and gross losses of $2,226. For the year ended December 31, 1996, net realized gains on sale of fixed maturities consisted of gross gains of $2,923 and gross losses of $1,538.
Following are changes in unrealized appreciation (depreciation) on investments for the years ended December 31, 1997 and 1996:
Total policy liabilities and accruals consist of the following as of December 31, 1997 and 1996:
Interest costs under the bank term debt totaled $2,229 and $2,250 for the years ended December 31, 1997 and 1996, respectively. The interest rate of the term debt is based on, at the Company's option, either a floating rate (based on the base rate of the First National Bank of Chicago) plus a margin of 2.25% or a Eurodollar rate (based on LIBOR) plus a margin of 3.25%. At December 31, 1997, the effective rate of the term loans was approximately 9.63%. The bank term debt was repaid on January 2, 1998.
In conjunction with the bank debt, the Company entered into interest rate protection agreements in the form of a series of interest rate caps in the notional amount of $62,500 which expire May 1998. These entitle the Company to revenue should three-month LIBOR exceed the cap rate of 7.5%. At December 31, 1997, three-month LIBOR was 5.81%.
In addition, certain of PennCorp's insurance subsidiaries purchased $10,000 liquidation value of 5.5% Mandatorily Redeemable Preferred Stock, par value $0.01 per share (the 5.5% Preferred Stock) of Southwestern Life Acquisition Corporation, a wholly-owned subsidiary of SWF. During 1996 SLAC was dissolved and the 5.5% Preferred Stock was exchanged for 5.5% Preferred Stock of Southwestern Life Companies, Inc. (SLC), also a wholly-owned subsidiary of SWF. The 5.5% Preferred Stock accrues dividends payable in cash or, subject to certain conditions, through the issuance of additional shares of 5.5% Preferred Stock. The 5.5% Preferred Stock is not subject to optional redemption and matures on December 31, 2005. If SLC fails to satisfy its mandatory redemption obligation or if dividends payable on the 5.5% Preferred Stock are in arrears for four or more quarterly dividend periods, the holders of the 5.5% Preferred Stock will be entitled to elect 49.0% of the members of the Board of Directors of SLC and, upon receipt of regulatory approval, a majority of the Board of Directors of SLC. The 5.5% Preferred Stock is the only preferred stock of SLC authorized for issuance. The holders of the 5.5% Preferred Stock are entitled to class voting rights under certain circumstances, including in connection with a merger of SLC or a sale of all or substantially all its assets or the authorization or issuance of senior pari passu preferred stock, and as otherwise provided by law. For the years ended December 31, 1997 and 1996, 59 and 59 additional shares were issued with a redemption value of $594 and $590, respectively in lieu of cash to satisfy dividend requirements.
The Company and its non-insurance subsidiaries file a consolidated federal income tax return. The Company's life insurance subsidiaries also file a consolidated federal income tax return.
Total income taxes for the years ended December 31, 1997 and 1996 are as follows:
The valuation allowances at December 31, 1997 and 1996, are attributable to deferred tax assets principally arising from differences in the book and tax bases of invested assets subject to capital gains treatment that existed as of the date of acquisition of the company's insurance subsidiaries. To the extent that income tax benefits relative to such tax assets are ultimately realized, the reduction in the related valuation allowance would be allocated to reduce costs in excess of net assets acquired.
Other Investments: The fair value of Company's investment in residual interests in mortgage-backed securities was obtained from an independent broker-dealer. The fair values of other miscellaneous invested assets have not been estimated due to their relative immateriality.