Dixie Life leased approximately 1,000 square feet in an office complex located at 855 South Pear Orchard Road, Suite 305, Ridgeland, Mississippi, under the terms of a lease which expired on December 31, 1998. Dixie Life leases an office service area located at 1060 East County Line Road, Ridgeland, Mississippi, under the terms of a lease that expires on June 30, 1999.
INTERNATIONAL OPERATIONS. SMI entered into a lease on November 17, 1997 for approximately 4,500 square feet in an office building located at 13A, rue de Bitbourg, L-1273 Luxembourg, Grand Duchy of Luxembourg, under the terms of a lease which expires on November 16, 2003.
(a)Operating income represents income before extraordinary gains (charge), excluding net realized investment gains (less income taxes relating to such gains), gain on disposal of subsidiary and class action litigation and settlements.
(d)Includes medicare supplement premiums of $6.0 million related to the Savers Life acquisition. This business was sold effective July 1, 1998.
PURCHASED INSURANCE BUSINESS. In accordance with industry practice, when SMC purchases additional insurance business, it assigns a portion of the purchase price, called the present value of future profits, to the right to receive future cash flows arising from existing insurance policies. This asset is recorded when the business is purchased at the value of projected future cash flows on existing policies, less a discount to present value. As future cash flows emerge, they are treated as a recovery of this asset. Therefore, if cash flows emerging from the purchased or recaptured business during a period exactly equal the projections, they are offset by that period's amortization of the cost of the policies purchased. In that event, the only income statement effect from the purchased business is the realization of the discount that was initially deducted from the asset to reflect its present value. Changes in the future annual amortization of this asset are not expected to have a significant effect on the results of operations, because the amount of amortization is expected to be equal to the profits emerging from the purchased policies, net of interest on the unrecovered present value of future profits balance. This asset is amortized over the expected life of the related policies purchased. Present value of future profits is increased for the estimated effect of realizing unrealized investment losses and decreased for the estimated effect of realizing unrealized investment gains.
Recent prices (i.e., discount rates used in determining valuations) paid by others to acquire or recapture similar blocks of business.
SMC used a 13% discount rate to calculate the present value of future profits on business of the Savers Life and Midwestern Life acquisitions. Each is being amortized over 20 years based on the mix of their respective annuity and life business.
For more information related to Purchased Insurance Business refer to Note 4 to the Consolidated Financial Statements.
Amortization of DAC was $2.7 million, $1.5 million and $1.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. The increase in current year amortization expense resulted primarily from increased amortization of DAC as gross profits from business sold in recent years began to emerge. DAC is generally amortized over the expected lives of the policies, a period of approximately 20 years, in a constant relationship to the present value of estimated future gross profits. Interest is being accreted at the projected crediting rate on the policies, 7% during year one, 6.5% in year two, 5.5% in year three and 5% thereafter. DAC is increased for the estimated effect of realizing unrealized investment losses and decreased for the estimated effect of realizing unrealized investment gains. The offset to these amounts is recorded directly to shareholders' equity, net of taxes. Future expected amortization of DAC for the next five years before the effect of net realized and unrealized gains and losses, based on DAC at December 31, 1998 and current assumptions, is as follows (in thousands):
VARIANCES BETWEEN ACTUAL AND EXPECTED PROFITS. Actual experience on purchased and produced insurance may vary from projections due to differences in renewal premiums collected, investment spreads, mortality costs, persistency, administrative costs and other factors. Variances from original projections, whether positive or negative, are included in net income as they occur. To the extent that these variances indicate that future experience will differ from the estimated profits reflected in the capitalization and amortization of the cost of policies purchased or the cost of policies produced, current and future amortization rates may be adjusted.
Costs relating to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance, the acquisition expenses, approximately 13% of initial annuity premium deposits and 50% of premiums from universal and interest-sensitive life products for SMC, are capitalized as DAC. In accordance with SFAS No. 97, DAC with interest is amortized over the lives of the policies in a constant relationship to the present value of estimated future gross profits.
UNIT-LINKED PRODUCT ACCOUNTING. Separate account assets and liabilities are maintained primarily for contracts of which the majority represents unit-linked products where benefits on surrender and maturity are not guaranteed. They generally represent funds held in accounts to meet specific investment objectives of policyholders who bear the investment risk. Investment income and investment gains and losses accrue directly to such policyholders. SMC earns income from the investment management fee it charges on such unit-linked contracts, which ranges from .8% to 1.2% of the value of the underlying separate accounts. In addition, on certain contracts, SMC can potentially earn up to a 1.7% initiation fee on new business sold.
(a) Revenues exclude net investment gains, and gain on disposal of subsidiary
(1)The decrease in life insurance in force is due to the termination and recapture of a reinsurance agreement effective January 1, 1997. See "Business of SMC -- Reinsurance".
Net premium deposits for 1998, received from the sales of FPDA's, equity indexed annuities, interest sensitive annuities and other financial products increased $32.5 million or 66%, to $81.9 million. The increase relates to i) an increase in the agency base achieved through the recruitment of high volume agents and larger managing general agencies, ii) continued expansion of geographical concentration, iii) the introduction of a new equity-indexed annuity product in May 1998, which contributed $16.9 million of deposits for the period and iv) deposits collected from Savers Life and Midwestern Life of $3.6 million.
A change in premium deposits in a single period does not directly cause operating income to change, although continued increases or decreases in premiums may affect the growth rate of total assets on which investment spreads are earned.
During 1998 policy income increased $1.0 million or 18% to $6.5 million. The increase relates to $.8 million of surrender charges on certain FPDA products of Standard Life which is primarily the result of lowering credited rates on those products.
During 1997 policy income increased $3.0 million or 116% to $5.5 million. The increase in policy income resulted from an increase in mortality and administrative fees of $1.8 million from the inclusion of Shelby Life in operations for periods subsequent to November 1, 1996 and an increase in policy surrender charges from FPDA's of $.7 million from Standard Life.
Net investment income fluctuates with changes in i) the amount of average invested assets and ii) and the yield earned on invested assets.
During 1998 net investment income increased $5.1 million or 18%, to $33.7 million. Average invested assets increased by $89.8 million or 23% due to the growth in insurance liabilities from the acquisitions of Savers Life and Midwestern Life, which contributed $4.2 million of investment income for the period. Net investment income also increased due to the impact from the new equity indexed product of $.6 million.
During 1997 net investment income increased $8.5 million or 42%, to $28.6 million. Average invested assets increased by $99.0 million or 35% due to the growth in insurance liabilities of approximately $100 million from the acquisition of Shelby Life and increased sales of FPDA's.
Other income consists of fee income related to servicing blocks of business for unaffiliated companies, experience refunds, and commission income.
Other income for 1998 increased $2.0 million or 181%, to $3.1 million. This increase primarily relates to $1.8 million of fee income from the Savers Marketing Qual Choice administration agreement.
Life benefits and claims include i) paid life insurance, ii) benefits from annuity policies that incorporate significant mortality features, and iii) changes in future policy reserves. Throughout the Company's history, it has experienced both periods of higher and lower benefit claims. Such volatility is not uncommon in the life insurance industry and, over extended periods of time, periods of higher claim experience tend to offset periods of lower claims experience.
Health benefits and claims in 1998 include $4.8 million of Medicare supplement benefits incurred from March 12, 1998, the acquisition date of Savers Life through July 1, 1998, the effective date of the sale of the Medicare supplement block of business.
During 1998, interest credited on interest sensitive annuities and other financial products increased $3.5 million or 21%, to $19.8 million due to i) interest credited on the insurance liabilities of Savers Life and Midwestern Life of $2.4 million, ii) the impact from the new equity indexed product of $.6 million and iii) interest credited on the general growth of insurance liabilities from increased FPDA sales. These increases were somewhat offset by a decrease in the weighted average credited rate for the period.
Amortization in 1997 increased $.7 million or 25%, to $3.2 million and related to $.6 million of present value of future profit amortization of Shelby Life.
During 1998, other operating expenses increased $2.1 million or 21% , to $12.4 million . The majority of this increase relates to normal operating expenses from Savers Life and Midwestern Life.
In 1998, commission expense included $.8 million of Medicare supplement insurance commissions incurred from March 12, 1998, the acquisition date of Savers Life through July 1, 1998, the effective sale date of the Medicare supplement block of business.
Interest expense and financing costs for 1998 increased $.6 million or 24%, to $3.0 million, due to increased average borrowings for the period of $6.4 million primarily related to the acquisitions of Savers Life and Midwestern Life. This increase was offset somewhat by a decreased interest rate charged on the revolving line of credit.
Interest expense and financing costs for 1997 increased $1.6 million or 196% to $2.4 million. The increase resulted primarily from i) increased borrowing of $10.0 million in November 1996 from the amended credit agreement, ii) borrowings of $4.0 million from an unaffiliated insurance company in connection with the acquisition of Shelby Life, iii) additional borrowings of $5.6 million in connection with funding capital contributions to an insurance subsidiary and, iv) the redemption of Class S preferred stock.
Net realized investment gains were $ .4 million for 1998 and 1997.
International operations includes revenues earned and expenses incurred from abroad, primarily Europe, and includes fees collected on deposits from unit-linked products. The profitability for this segment primarily depends on the amount of separate account assets under management, the management fee charged on those assets and expense management.
The excess cost of assets acquired over the purchase price paid for SMI in December of 1993 of $6.9 million has been amortized over 5 years at $1.4 million per year and is fully amortized at December 31, 1998.
During 1997, benefits and claims increased $.3 million partially due to increased traditional life reserves.
Other operating expenses for 1998 increased $.3 million or 12%, to $2.6 million. The increase primarily relates to an increased level of business activity for the period. The number of separate account contracts administered increased 32%, to 3070.
Other operating expenses for 1997 declined $.6 million or 19%, to $2.3 million. The decrease primarily related to the a favorable impact of the US dollar relative to foreign currency.
Although the net impact of foreign currency translation is deemed to be immaterial, comparisons between 1998, 1997 and 1996 are impacted by the strengthening and destrengthening of the U.S. dollar relative to foreign currencies, primarily the Luxembourg franc. The impact of these translations have not been quantified on individual components.
Standard Management is a financial services holding company whose liquidity requirements are met through payments received from its subsidiaries. These payments include i) interest on surplus debenture, ii) dividends, iii) management fees and iv) rental income, which are subject to restrictions under applicable insurance laws and are used to pay operating expenses and meet debt service obligations. These internal sources of liquidity have been supplemented in the past by external sources such as a revolving credit agreements and long term debt and equity financing in the capital markets.
GENERAL: On a consolidated GAAP basis SMC reported net cash provided by operations of $.3 million and $7.8 million for 1998 and 1997, respectively. Although deposits received on SMC's interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, such funds are available for use by SMC. Cash provided by operations plus net deposits received, less net account balances returned to policyholders on interest sensitive annuities and other financial products, resulted in positive cash flow of $29.2 million and $19.6 million for 1998 and 1997, respectively. Cash generated on a consolidated basis is available to Standard Management only to the extent that it is generated at the Standard Management level or is available through dividends, interest, management fees or other payments from subsidiaries.
At February 28, 1999, Standard Management had "parent company only" cash and short-term investments of $.4 million. These funds are available to Standard Management for general corporate purposes. Standard Management's "parent company only" operating expenses (not including interest expense) were $3.1 million and $3.4 million for 1998 and 1997, respectively. In addition, Standard Management has available $1.0 million from its Amended Credit Agreement.
In 1998, the Company issued convertible redeemable preferred stock with a stated value of $6.5 million. Proceeds were used to reduce the borrowings from the Amended Credit Agreement. Holders are entitled to receive annual dividends of $7.75 per share. Refer to Notes 7 and 10 to the consolidated financial statements for additional information.
Standard Management anticipates the available cash from its existing working capital, plus anticipated 1999 dividends, management fees, rental income and interest payments on its surplus debentures receivable will be more than adequate to meet its anticipated "parent company only" cash requirements for 1999.
Principal payments: $3.3 million due March 2000, $4.3 million thereafter through March 2005
Interest payments required in 1999 based on December 31, 1998 balances will be $2.1 million
The following are characteristics of the subordinated convertible debt agreement at December 31, 1998:
Refer to Note 5 to the consolidated financial statements for additional information
From the funds borrowed by Standard Management pursuant to the Amended Credit Agreement and the subordinated convertible debt agreement, $27.0 million was loaned to Standard Life pursuant to Unsecured Surplus Debenture Agreements ("Surplus Debenture") which requires Standard Life to make quarterly interest payments to Standard Management at a variable corporate base rate plus 2% per annum, and annual principal payments of $1.0 million per year beginning in 2007 and concluding in 2033. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life's capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. Standard Management currently anticipates these quarterly approvals will be granted. Assuming the approvals are granted and the December 31, 1998 interest rate of 9.75% continues, Standard Management will receive interest income of $2.6 million from the Surplus Debenture in 1999.
MANAGEMENT FEES. Pursuant to a management services agreement, Standard Life paid Standard Management $2.0 million during 1998 and $2.0 million during 1997 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. Prior to its merger into Standard Life, Savers Life paid Standard Management $.8 million during 1998 for certain management services pursuant to a management services agreement. In addition, Dixie Life paid Standard Life $1.0 million during 1998 and $1.1 million during 1997 for certain management services provided. Both of these agreements provide that they may be modified or terminated by the Indiana and Mississippi departments of insurance in the event of financial hardship of Standard Life or Dixie Life.
Pursuant to the management services agreement, Premier Life (Luxembourg) paid Standard Management $.1 million during 1998 and 1997 for certain management and administrative services. The agreement provides that it may be modified or terminated by either Standard Management or Premier Life (Luxembourg).
FOREIGN CURRENCY RISK. SMI policyholders invest in assets denominated in a wide range of currencies. As policyholders are not permitted to invest directly in options, futures and derivatives, their investment and currency risk is limited to premiums they have paid. Although policyholders effectively bear the currency risk, SMI could be exposed to currency fluctuations if currencies within the conventional investment portfolio or certain actuarial reserves are mismatched. In order to minimize this risk, SMI continually matches the assets and liabilities of the portfolio and the reserves. In addition, Premier Life (Luxembourg) shareholder's equity is denominated in Luxembourg francs. Premier Life (Luxembourg) does not hedge currency risk because its shareholder's equity will remain in Luxembourg francs for the foreseeable future, thus, no significant realized foreign exchange gains or losses are anticipated. At December 31, 1998, there was an immaterial unrealized loss from foreign currency.
EURO CURRENCY. Effective January 1, 1999, the eleven participating European member union countries established fixed conversion rates between their legal currencies and the euro. The legal currencies in those countries will continue to be used as legal tender through January 1, 2002. Subsequent to this date, the legal currencies will be canceled and euro bills and coins will be used for cash transactions in the participating countries. During this three year dual-currency environment, conversion rates between the legal currencies will no longer be computed directly between one another. Instead, a special "triangulation" procedure must be followed by first converting one legal currency into its euro equivalent and then converting the euro equivalent into the other legal currency. Although the Company has not initiated an analysis plan for the euro conversion, SMC does not expect it to have a material impact on its operations or financial condition.
POSSIBILITY OF FUTURE DILUTION OF OWNERSHIP AND VOTING POWER. The SMC Board of Directors has the authority to issue up to .9 million additional shares of preferred stock and 12.4 million additional shares of common stock. The board's authority under SMC's charter typically does not require stockholder approval unless it is otherwise required for a particular transaction. Although SMC is not currently involved in any life insurance acquisitions, the Company regularly investigates such opportunities and could issue additional shares of SMC common or preferred stock in connection with an acquisition.
The value of these assets reflected in the December 31, 1998 balance sheet total $67.6 million or 7.1% of SMC's assets. SMC has established procedures to periodically review the assumptions used to value these assets and determine the need to make adjustments of such values in SMC's consolidated financial statements. SMC has determined that the assumptions used in the initial valuation of the assets are consistent with the current operations of SMC as of December 31, 1998.
IMPACT OF YEAR 2000. The Company updated its main operating computer systems in 1995 with Year 2000 ready systems at a cost of $.5 million. Since that time the Company has completed modifications or conversions of other portions of its software, hardware and imbedded chip technology so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. The Company believes that with such modifications and conversions, the Year 2000 issue will not pose significant operational problems for its computer systems. The total cost of the Year 2000 project is $.6 million including the $.5 million previously discussed. These costs are not material to the Company's financial statements and were funded through operating cash flows.