The following table sets forth selected historical financial information of the Company for the years ended December 31, 1996, 1995 and 1994, for the period from November 27, 1993 through December 31, 1993, for the period from January 1, 1993 through November 26, 1993 (for the Historical Integrity Companies) and for the year ended December 31, 1992 (for the Historical Integrity Companies). The financial information for the years ended December 31, 1996, 1995 and 1994 and for the periods from January 1, 1993 through November 26, 1993 and November 27, 1993 through December 31, 1993 has been derived from consolidated financial statements of the Company, prepared in conformity with GAAP, that have been audited by Ernst & Young LLP. The financial information for the Historical Integrity Companies for the year ended December 31, 1992 has been derived from financial statements of the Historical Integrity Companies.
Effective May 31, 1995, the Company acquired substantially all of the assets and business operations of SBM. This acquisition was accounted for as a purchase, and the results of operations of the acquired businesses are included in the Company's historical financial information from the date of acquisition. Because 1996 includes a full year of acquired SBM business operations compared to seven months in 1995, the results of operations for 1996, 1995 and 1994 are not completely comparable. "Historical Integrity Companies" refers to operations, for accounting and reporting purposes, prior to the Company's November 26, 1993 acquisition of the Integrity Companies. The Historical Integrity Companies' results of operations for 1993 and 1992 are presented for purposes of comparison; however, because of purchase accounting adjustments, the new capital structure and new management team resulting from that acquisition, the Company's results have differed from the results of the Historical Integrity Companies.
(1) The Company had no significant business activity until November 26, 1993, when it acquired the Integrity Companies from National Mutual. Results of operations prior to the acquisition for the period from January 1, 1993 through November 26, 1993 and the year ended December 31, 1992 are presented for comparative purposes.
(2) "Operating earnings" is defined as net income applicable to common shareholders, excluding, net of tax, realized investment gains and losses and non-recurring charges.
(4) Excludes from carrying amount shareholders' equity the net unrealized gains and losses on securities classified as available-for-sale, net of related amortization and taxes.
The Company specializes in the asset accumulation business, providing retail and institutional customers with products and services designed to serve the growing long-term savings and retirement markets.
The following discussion compares the results of operations for the Company for the three years ended December 31, 1996. As the Company acquired substantially all of the assets and business operations of SBM effective May 31, 1995, results for 1996 include a full year of acquired SBM business operations compared to seven months in 1995. Therefore, results of operations for 1996, 1995 and 1994 are not necessarily comparable.
During 1996, net income for the Company was $23.4 million compared to $11.9 million for 1995. Operating earnings (net income applicable to common shareholders, excluding, net of tax, realized investment gains and losses and non-recurring charges) were $22.6 million and $4.5 million for 1996 and 1995, respectively. The increase in operating earnings is primarily attributable to (i) an increase in net investment spread due to ongoing asset/liability management and deposit growth from the full year's effects of the May 31, 1995 acquisition of the SBM assets and business operations and additional sales of spread-based products and (ii) an increase in fee income as a result of a growing base of variable annuity deposits and institutional assets under management. Such increases in revenues were partially offset by an increase in operating expenses as a result of business growth.
Spread-based operating earnings were 1.05% and 0.90% of average spread-based assets under management of $3.22 billion and $2.47 billion during 1996 and 1995, respectively. This increase in spread-based margins is primarily attributable to ongoing asset/liability management, which generated higher net investment spreads. Fee-based operating earnings were 0.15% and 0.19% of average fee-based assets under management of $3.28 billion and $1.84 billion during 1996 and 1995, respectively. Fee-based margins for the 1996 period were slightly lower compared to the corresponding prior period primarily from the growth of institutional fee-based assets under management which generated lower margins than the Company's variable annuity deposits. Certain expenses including federal income taxes and unallocated corporate overhead are not reflected in spread-based and fee-based operating earnings.
Net investment spread for the years ended December 31, 1996 and 1995 was as follows:
Investment yield 7.75% 7.84% Average credited rate 5.67% 5.90% ------------------------ Investment spread 2.08% 1.94% ------------------------ ------------------------
Fee income increased to $17.8 million in 1996 from $11.3 million in 1995. This increase is in part attributable to variable annuity fees which are based on the market value of assets supporting the investment portfolio options of variable annuity customer deposits in separate accounts. Variable annuity fees increased to $10.8 million in 1996 from $7.2 million in 1995 principally due to asset growth from the receipt of variable annuity deposits and from a market-driven increase in the value of existing variable annuity deposits invested in mutual funds. Fee-based variable annuity deposits increased to $844.3 million in 1996 from $617.3 million in 1995. In addition, asset management fees earned by ARM Capital Advisors on off-balance sheet assets, related to defined benefit pension plans and the State Bond Mutual Funds, increased to $5.8 million in 1996 from $3.2 million in 1995. This increase in asset management fees reflects a significant increase in the average amount of corresponding off-balance sheet assets managed due to new defined benefit pension plan accounts. The average amount of off-balance sheet assets managed by ARM Capital Advisors was $2.16 billion in 1996 compared to $1.10 billion in 1995. With the proposed sale of 80% of ARM Capital Advisors and the sale of the State Bond Mutual Funds, asset management fee income is expected to decrease in the future.
Assets under management by type of product and service as of December 31, 1996 and 1995 were as follows:
Year Ended December 31, (IN MILLIONS) 1996 1995 - ------------------------------------------------- Retail: Spread-based $ 130.6 $115.4 Fee-based 200.1 177.7 ----------------------- Total retail* 330.7 293.1 Institutional: Spread-based 747.5 142.2 Fee-based - 272.9 ----------------------- Total institutional* 747.5 415.1 ----------------------- Total sales $1,078.2 $708.2 ----------------------- -----------------------
* Does not include new deposits related to off-balance sheet assets managed by ARM Capital Advisors for institutional clients and the State Bond Mutual Funds. Total retail sales for the years ended December 31, 1996 and 1995 were $342.7 million and $300.9 million, respectively, and total institutional sales for the years ended December 31, 1996 and 1995 were $2,401.5 million and $886.9 million, respectively, including such deposits.
Operating expenses increased to $31.1 million in 1996 from $23.0 million in 1995. The increase was primarily attributable to (i) the inclusion of twelve months of incremental operating expenses related to the acquired SBM operations in the 1996 results versus seven months for the comparable 1995 period, (ii) the expansion of product distribution channels, and (iii) a charge of $1.6 million to increase the reserve for anticipated future guaranty fund assessments.
Amortization of value of insurance in force related to operations increased to $7.3 million in 1996 from $7.1 million in 1995. The increase is attributable to amortization of the value of insurance in force established as an asset by the Company on May 31, 1995 in connection with the acquisition of SBM's insurance subsidiary.
$1.0 million for mergers and acquisitions activities that did not result in a transaction; and costs of $0.8 million related to the Company's filing of a public offering of common stock.
Other expenses, net were $5.4 million in 1996 compared to $0.7 million in 1995. The increase is primarily attributable to an increase in premiums and fees paid or accrued in 1996, net of a reduction in net benefits paid, under reinsurance agreements. Through the reinsurance agreements, one of which commenced December 31, 1995, substantially all mortality risks associated with single premium endowment deposits have been reinsured.
Realized investment gains, which are reported net of related amortization of deferred policy acquisition costs and value of insurance in force, were $0.9 million in 1996 compared to $4.0 million in 1995. Realized investment gains in 1996 include an estimated loss of $15.2 million related to the write-down to fair value of an investment in a corporate fixed maturity security and a gain of $4.5 million, before selling expenses, related to the sale of the State Bond Mutual Funds. Other 1996 and all 1995 realized investment gains and losses were interest-rate related and attributable to the ongoing management of the Company's fixed maturity securities classified as available-for-sale which can result in period-to-period swings in realized investment gains since securities are sold during both rising and falling interest rate environments. The ongoing management of securities is a significant component of the Company's asset/liability management strategy. The ongoing portfolio management process involves evaluating the various asset sectors (i.e., security types and industry classes) and individual securities comprising the Company's investment portfolios and, based on market yield rates, repositioning holdings from sectors perceived to be relatively overvalued to sectors perceived to be undervalued with the aim of improving cash flows. The Company endeavors to accomplish this repositioning without materially changing the overall credit, asset duration, convexity, and liquidity characteristics of its portfolios.
During 1995, net income for the Company was $11.9 million compared to a net loss of $16.8 million for 1994. Operating earnings were $4.5 million and $2.4 million for 1995 and 1994, respectively. The improvement in operating earnings in 1995 was primarily attributable to an increase in net investment spread, the acquired operations of SBM which generated operating earnings of approximately $3.5 million during the period from June 1, 1995 to December 31, 1995 and an increase in fee income from a growing base of variable annuity deposits and institutional assets under management. Such increases in operating earnings were partially offset by the accelerated amortization of certain acquisition-related deferred charges.
Net investment spread for the years ended December 31, 1995 and 1994 were as follows:
Year Ended December 31, ------------------------- (DOLLARS IN THOUSANDS) 1995 1994 - ------------------------------------------------------------------ Investment income $ 196,024 $ 149,142 Interest credited on customer deposits (146,867) (116,463) ------------------------- Net investment spread $ 49,157 $ 32,679 ------------------------- ------------------------- Investment yield 7.84% 7.30% Average credited rate 5.90% 5.88% ------------------------- Investment spread 1.94% 1.42% ------------------------- ------------------------- Average cash and investments $2,501,125 $2,042,785 Average customer deposits 2,488,866 1,980,807
Fee income increased to $11.3 million in 1995 from $8.4 million in 1994. This increase is in part attributable to variable annuity fees which are based on the market value of assets supporting the investment portfolio options of variable annuity deposits in separate accounts. Variable annuity fees increased to $7.2 million in 1995 from $4.3 million in 1994 principally due to asset growth from the receipt of variable annuity deposits and from increased market values. In addition, ARM Capital Advisors, which began operations in January 1995, added asset management fees earned on off-balance sheet assets managed for institutional clients. Offsetting these increases was a reduction in other fee income from $4.1 million in 1994 to $0.9 million in 1995 primarily related to variable life insurance business which was sold in 1994.
* Does not include off-balance sheet assets managed by ARM Capital Advisors for institutional clients and the State Bond Mutual Funds. Total fee-based assets under management and total assets under management at December 31, 1995 were $2,443.7 million and $5,364.2 million, respectively, including such assets. Both ARM Capital Advisors and the State Bond Mutual Funds were acquired in 1995.
The increase in the spread-based deposits was primarily attributable to the SBM acquisition and sales of GICs. The increase in the fee-based line of business is primarily due to fees related to funds managed by ARM Capital Advisors under investment management and investment advisory contracts that were acquired on January 5, 1995, assets managed under contract for the State Bond Mutual Funds that were acquired effective May 31, 1995, and new sales.
Year Ended December 31, ------------------------ (IN MILLIONS) 1995 1994 - ------------------------------------------------- Retail: Spread-based $115.4 $131.1 Fee-based 177.7 231.1 ------------------------ Total retail 293.1 * 362.2 Institutional: Spread-based 142.2 _ Fee-based 272.9 59.3 ------------------------ Total institutional 415.1 * 59.3 ------------------------ Total sales $708.2 $421.5 ------------------------ ------------------------
* Does not include new deposits related to off-balance sheet fee-based assets managed by ARM Capital Advisors for institutional clients and the State Bond Mutual Funds. Total retail and institutional sales for the year ended December 31, 1995 were $300.9 million and $886.9 million, respectively, including such deposits. Both ARM Capital Advisors and the State Bond Mutual Funds were acquired in 1995.
Operating expenses increased to $23.0 million in 1995 from $21.5 million in 1994. The increase was primarily attributable to additional expenses attributable to ARM Capital Advisors, which began operations in 1995, and the acquired SBM businesses.
Commissions, net of deferrals were $1.6 million for the year ended December 31, 1995 consisting primarily of renewal and trailer commissions of approximately $1.3 million on fixed
Amortization of acquisition-related deferred charges was $9.9 million in 1995 compared to $2.2 million in 1994. The increase was primarily attributable to the accelerated amortization of $4.3 million of certain costs and charges deferred during 1993 and 1994. During the third quarter of 1995, Company management determined that changes in facts and circumstances had resulted in a change in their original estimate of the periods benefited by these costs and charges. As a result of this change in estimate, the remaining unamortized balances of these deferred costs and charges were fully amortized as of September 30, 1995.
Other expenses, net were $0.7 million in 1995 compared to other income, net of $5.0 million in 1994. The 1994 results include the benefits of favorable mortality experience and a gain from the sale of the Company's variable life business.
Federal income tax expense during 1995 was $7.0 million compared to a federal income tax benefit during 1994 of $6.0 million. This change was attributable to income before federal income taxes of $18.9 million in 1995 compared to a loss before federal income taxes of $22.8 million in 1994.
INTEGRITY COMPANIES Effective November 26, 1993, the Company acquired N.M. U.S. Limited (the holding company for National Mutual's U.S. operations) and its wholly owned subsidiaries, Integrity and National Integrity, from National Mutual, for an aggregate purchase price of $121.0 million. Immediately following the acquisition, N.M. U.S. Limited changed its name to Integrity Holdings Inc. The Company financed the acquisition by issuing new common equity and its perpetual preferred stock for proceeds of approximately $70.0 million and $50.0 million, respectively, and through $40.0 million of bank financing obtained under a Credit Agreement.
The Company continues to actively pursue material acquisitions of companies and blocks of business, marketing partnerships and reinsurance opportunities with other insurance companies, with the goal of realizing additional economies of scale and enhanced profitability.
Agency pass-through certificates are MBSs which represent an undivided interest in a specific pool of residential mortgages. The payment of principal and interest is guaranteed by the U.S. government or U.S. government agencies. CMOs are pools of mortgages that are segregated into sections, or tranches, which provide prioritized retirement of bonds rather than a pro rata share of principal return as in the pass-through structure. The underlying mortgages of agency CMOs are guaranteed by the U.S. government or U.S. government agencies. Of the non-agency CMOs, 53.9% use mortgage loans or mortgage loan pools, letters of credit, agency mortgage pass-through securities and other types of credit enhancement as collateral. The remaining 46.1% of the non-agency CMOs use commercial mortgage loans as collateral.
The Company manages prepayment exposure on CMO holdings by diversifying not only within the more stable CMO tranches, but across alternative collateral classes such as commercial mortgages and Federal Housing Administration project loans, which are generally less volatile than agency-backed, residential mortgages. Additionally, prepayment sensitivity is evaluated and monitored, giving full consideration to the collateral characteristics such as weighted average coupon rate, weighted average maturity and the prepayment history of the specific collateral. MBSs are subject to risks associated with prepayments of the underlying collateral pools. Prepayments cause these securities to have actual maturities different from those projected at the time of purchase. Securities that have an amortized cost that is greater than par (i.e., purchased at a premium) that are backed by mortgages that prepay faster than expected will incur a reduction in yield or a loss, versus an increase in yield or a gain if the mortgages prepay slower than expected. Those securities that have an amortized cost that is less than par (i.e., purchased at a discount) that are backed by mortgages that prepay faster than expected will generate an increase in yield or a gain, versus a decrease in yield or a loss if the mortgages prepay slower than expected. The reduction or increase in yields may be partially offset as funds from prepayments are reinvested at current interest rates. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. The Company has gross unamortized premiums and unaccreted discounts of MBSs of $28.7 million and $45.7 million, respectively, at December 31, 1996. Although the interest rate environment has experienced significant volatility during 1996 and 1995, prepayments and extensions of cash flows from MBSs have not materially affected investment income of the Company.
Asset-backed securities ("ABS") are securitized bonds which can be backed by, but not limited to, collateral such as home equity loans, second mortgages, automobile loans and credit card receivables. Home equity loan collateral represents 54.6% of the Company's investments in the ABS market. The typical structure of an ABS provides for favorable yields, high credit rating and stable prepayments.
credit risk is greater with respect to such non-investment grade securities. The Company attempts to reduce the risks associated with non-investment grade securities by limiting the exposure to any one issuer and by closely monitoring the creditworthiness of such issuers. Additionally, the Company's investment portfolio has minimal exposure to real estate, non-indemnified mortgage loans and common equity securities, which represent less than 0.1% of cash and investments as of December 31, 1996.
Amortized Cost ------------------------ Percent Estimated NAIC Designation (Comparable S&P Rating) Amount of Total Fair Value - ------------------------------------------------------------------------------ (DOLLARS IN MILLIONS)
Pursuant to Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company classifies its entire fixed maturities portfolio as available-for-sale. Fixed maturities classified as available-for-sale are carried at fair value and changes in fair value, net of related value of insurance in force and deferred policy acquisition cost amortization and deferred income taxes, are charged or credited directly to shareholders' equity.
The Company manages assets and liabilities in a closely integrated manner, with the aim of reducing the volatility of investment spreads during a changing interest rate environment. As a result, adjusting shareholders' equity for changes in the fair value of the Company's fixed maturities and equity securities without reflecting offsetting changes in the value of the Company's liabilities or other assets creates volatility in reported shareholders' equity but does not reflect the underlying economics of the Company's business. The Company's accompanying consolidated financial statements include fair value balance sheets which demonstrate that the general rise in interest rates during 1996 did not have a material effect on the financial position of the Company when all assets and liabilities are adjusted to estimated fair values.
On October 23, 1996, the Company filed a registration statement with the Securities and Exchange Commission with respect to the public offering of a yet to be determined number of shares of Class A common stock, par value $.01 per share. The Company's decision to proceed with the offering is subject to market and other conditions. See Note 10 to "Notes to Consolidated Financial Statements."
The Company generated cash flows of $192.9 million, $138.4 million and $105.7 million from operating activities during the years ended December 31, 1996, 1995 and 1994, respectively. These
At December 31, 1996, the Company reported an asset for deferred federal income taxes of $35.6 million on the carrying amount balance sheet. Such amount reflects deferred tax assets of $56.2 million, net of valuation allowance of $38.8 million, in excess of deferred tax liabilities of $20.6 million. The net deferred tax assets represent deductible temporary differences and net operating loss carryforwards. Based on historical operating results and projections of future taxable ordinary income, management believes that the net tax benefit recorded will be fully utilized.
Factors that could cause actual results to differ materially from the forward-looking statements related to the demand for variable and equity-indexed annuity type products include, but are not limited to, a change in population demographics, development of alternative investment products, a change in economic conditions, and changes in current federal income tax laws. In addition, there can be no assurance that (i) the Company has correctly identified and assessed all of the factors affecting its business; (ii) the publicly available and other information on which the Company has based its analyses is complete or correct; (iii) the Company's analyses are correct; or (iv) the Company's strategy, which is based in part on these analyses, will be successful.
Additional financial statement schedules are included on pages S-3 through S-10. Reference is made to the Index to Financial Statement Schedules on page S-1 herein.