Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Torchmark owns and occupies a 290,000 square foot facility located in McKinney, Texas (a north Dallas suburb). This facility is Torchmark’s corporate headquarters and also houses the operations of United American.
Liberty owns a 487,000 square foot building in Birmingham, Alabama which until 2010 served as Liberty’s home office. During 2010, Liberty vacated this building and currently operates its home office activities out of a 34,000 square foot facility leased in a Birmingham suburb. Approximately 15,000 square feet of storage space has also been leased near the new home office facility. Liberty also operates a company-owned district office used for agency sales personnel. Liberty is currently in the process of selling its former home office building, opting instead to operate from leased facilities.
The tables in Note 14-Business Segments reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for each of the years in the three-year period ending December 31, 2011. Additionally, this Note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles to net income. That summary is reproduced below from the Consolidated Financial Statements to present our overall operations in the manner that we use to manage the business.
As shown in the above chart, after tax segment operations, before discontinued operations, rose each year over the prior year from $469 million in 2009 to $498 million in 2010 to $514 million in 2011. The primary contributor to the growth in both 2011 and 2010 was the underwriting margin in our life insurance segment, which margins rose $31 million in 2011 and $28 million in 2010. The life insurance segment is our strongest segment and is the largest contributor to earnings in each year presented. Growth in 2010 was also affected positively by the $21 million increased contribution of excess investment income, the measure of profitability of the investment segment. Excess investment income in 2010 increased over 2009 investment segment income largely because of the unusually large holdings in low-yielding cash and short-term investments held in 2009 due to the uncertain economic climate at that time. These short-term holdings were invested in 2010 as financial conditions improved. Excess investment income was also negatively affected in 2009 because of our issuance of a $300 million 9 1/4%
debt security in June, 2009 (net proceeds of $296 million) and repayment of a $99 million 8 1/4% security which matured in August, 2009. These transactions resulted in a net increase in our financing costs in 2009 and reduced excess investment income. Growth in 2011 earnings was negatively affected by a decline in the health insurance segment underwriting margin of $8 million, and a $5 million decline in excess investment income from the investment segment. The 2011 decline in health contribution was largely a result of the discontinuance of sales of certain limited-benefit health insurance products because of healthcare reform. The decline in excess investment income was due to the continuing low-interest rate environment which has pressured investment yields and spreads over policy benefit requirements, discussed more fully under the captain Investments in this report.
Total revenues were flat in 2011 at $3.38 billion compared with $3.37 billion in 2010. Revenues increased 8% in 2010 over revenues of $3.12 billion in 2009. Life premium rose 4% or $63 million in 2011 and $72 million in 2010. Net investment income rose 2% or $17 million in 2011, compared with $44 million in 2010. However, growth in revenues in 2011 and 2010 were negatively affected by the declines in health premium described further under this caption.
As previously mentioned, the investment segment’s pretax profitability, or excess investment income, increased $21 million in 2010 but declined $5 million in 2011. Profitability in this segment is based on three major components: net investment income, required interest on net policy liabilities (interest applicable to insurance products), and financing costs. In recent years, growth in net investment income has been restricted in relation to the growth in the size of our portfolio. One reason that investment income has grown at a lower rate than mean invested assets has grown in recent years is that new investments have been made at yield rates lower than the yield rates earned on securities that matured or were otherwise disposed of. Also, there is sometimes a lag between the time when proceeds from maturities and dispositions are received and when the proceeds are reinvested, in which the funds are held in cash. Growth in total investment income has also been somewhat negatively affected by Torchmark’s share repurchase program (described later under this caption), which has diverted cash that could have otherwise been used to acquire investments. In 2011, net investment rose 3% while the portfolio (at amortized cost) grew 4%, in accordance with the general pattern in recent periods. However, in 2010, the growth in net investment income slightly exceeded the growth in the average portfolio for the first time in many years, primarily as a result of the special constraints on the growth in 2009 net investment income. During 2009, due primarily to uncertainty
about liquidity in the financial markets, we held significantly more cash and short term investments than we normally would. Additionally, in 2009, we sold a significant portion of higher-yielding but lower-rated fixed maturities and reinvested the proceeds in lower-yielding but higher-rated bonds in 2009 and early 2010 to improve our risk-adjusted return. These factors contributed to reduced 2009 net investment income.
Torchmark’s current investment policy limits new investment acquisitions to investment-grade fixed maturities generally with longer maturities (often exceeding twenty years) that meet our quality and yield objectives. Approximately 96% of our invested assets at fair value consist of fixed maturities of which 95% were investment grade at December 31, 2011. The average quality rating of the portfolio was A-. The portfolio contains no securities backed by sub prime or Alt-A mortgages, no direct investment in residential mortgages, no direct investment in European Sovereign debt, no counterparty risks, no credit default swaps, or derivative contracts. See the analysis of excess investment income and investment activities under the caption Investments in this report and Note 4-Investments in the Notes to Consolidated Statements of Operations for a more detailed discussion of this segment.
Life Insurance. Life insurance is our largest insurance segment, with 2011 life premium representing 65% of total premium. Life underwriting income before other income and administrative expense represented 75% of the total in 2011. Additionally, investments supporting the reserves for life products result in the majority of excess investment income attributable to the investment segment.
We completed the process of combining selected United American (UA) Exclusive Agency Branch Offices with the Liberty National Exclusive Agency during 2011. For this reason, all data will be reported on a combined basis in this report.
The Direct Response operation accounted for 34% of our life insurance premium during 2011, increasing 5% over 2010 premium. Life premium for this channel rose 6% in 2010 and 5% in 2009. Net sales were flat in 2011 after a 4% increase in 2010 to $137 million. First-year collected premium declined 1% to $89 million in 2011 after a 6% gain in 2010. The average face amount of policies issued in 2011 was approximately $20 thousand.
The Liberty Exclusive Agency agent counts have also decreased due to issues related to its health insurance business. This agency’s health insurance marketing efforts had historically been focused on limited-benefit hospital-surgical plans. These plans were subject to intense competition from other companies which offered lower-margin products providing agents with products that were easier to sell, thus discouraging sales of our products and ultimately resulting in decreases in agent counts. In addition, these limited-benefit hospital-surgical plans became less marketable due to healthcare reform developments. Sales of these limited-benefit hospital/surgical plans were discontinued after September, 2010. These developments caused further increases in agent turnover. In response, the agency has shifted its marketing focus to a product mix more weighted towards life insurance and supplemental health insurance products (not affected by healthcare reform) that have higher margins and persistency. Additionally, we are in the process of changing the cost structure of this agency to a more commission-driven model. Going forward, branch office operating expenses will be the responsibility of the branch managers and all new agent recruits will be independent contractors rather than employees. We are also implementing new agent recruiting and training programs similar to those used at American Income. We believe these changes will increase the Agency’s profitability and stability in the long run.
Total health premium represented 35% of Torchmark’s total premium income in 2011. Excluding Part D premium, health premium represented 28% of total premium income in 2011, compared with 29% in 2010 and 32% in 2009. Health underwriting margin, excluding Part D, accounted for 21% of the total in 2011, compared with 23% in 2010 and 25% in 2009. These declines in the health percentages are indicative of the growth in the premium and profitability of our life segment in relation to our health segment. Health results have also been affected by the discontinuance of sales of the previously-mentioned health products. The following table indicates health insurance premium income by distribution channel for each of the last three years.
Health insurance, excluding Medicare Part D. Health premium other than Part D has declined in each successive year presented, falling 6% in 2011 to $734 million and 7% in 2010. Net sales decreased 1% in 2011 to $64 million after a decline of 33% in 2010. First-year collected premium has also declined in each period considered. These declines in sales and premium resulted from several factors: (1) our previously-mentioned emphasis on life sales, due to life’s superior margins and its greater contribution to investment income; (2) the discontinuance of sales of various limited-benefit health products; and (3) the decline in agent counts in certain distribution units that market health products.
Medicare Supplement provides the greatest amount of health premium, partially because Medicare Supplement products are generally more persistent than the limited-benefit products, but also because of more stable sales in recent periods. Medicare Supplement premium also continues to grow in relation to our limited-benefit health premium. Medicare Supplement premium represented 60% of non-Part D health premium in 2011, compared with 58% in 2010 and 55% in 2009.
The Liberty National Exclusive Agency represented 39% of all Torchmark non-Part D health premium income at $290 million in 2011. The Liberty Agency markets Medicare Supplements and limited-benefit health products consisting primarily of cancer insurance. In 2011, health premium income in this Agency declined 12% from prior year premium of $331 million. Premium also fell 15% in 2010 from $389 million. First-year collected premium declined 20% to $13 million in 2011, after declining 52% a year earlier. As noted earlier, the discontinuance of sales of certain health products and the earlier increased competition in the health insurance market had caused steep declines in the agent count in this Agency. As of December 31, 2011, this Agency had 1,345 agents, a decline of 33% from the 2010 year end count of 2,001. In 2010, the number of agents fell 19% from 2,471 at year end 2009. The decline in agent counts has resulted in decreased new sales, translating into declines in premium. Net sales for 2011 rose 19% from $14 million in 2010 to $17 million due to the introduction of new products. In 2010, this Agency’s net sales fell 52%. Also discussed under the Life Insurance caption are efforts designed to strengthen this Agency.
Health premium at this agency rose 1% in 2011 to $80 million, after having increased 5% to $79 million in 2010. However, net health sales declined 27% to $10 million in 2011. Net sales were $13 million in both 2010 and 2009. Net health sales comprised only 6% of the American Income Agency’s total net sales in 2011.
Direct Response, primarily a life operation, also offers health insurance, which is predominantly Medicare Supplements sold directly to employer or union sponsored groups. In both 2011 and 2010, net health sales were $5 million. In 2011, net health sales for this group represented approximately 4% of Direct Response’s total life and health net sales. Direct Response health premium income has risen each year over the prior year. Health premium rose 5% in 2011 to $57 million and 17% in 2010.
enrollees. At December 31, 2011, United American had approximately 225 thousand enrollees for the 2012 Part D plan, compared with 144 thousand for the 2011 plan year and 158 thousand for the 2010 plan year. Growth for the plan year 2012 was largely a result of a new lower cost Part D plan which allowed us to pick up a large number of low-income automatic enrollees and to grow our own individual sales. The new product is priced to achieve the same underwriting margin as our existing product. Our Medicare Part D product is sold through the Direct Response operation and to groups through the UA Independent Agency. Part D net sales were $115 million in 2011, compared with $39 million in 2010 and $43 million in 2009. We count only sales to new first-time enrollees in net sales, and the majority of premium income was from previous enrollees.
We believe that the Medicare Part D program is a meaningful component of our health product offerings because of our experience with the senior-age market and with Medicare Supplements, the government assurances with regard to the risk-sharing agreements for participating insurers, limited-risk due to the incremental income added to our health insurance margins, and the renewal of the business every year. Due to our experience with service to the senior-age market and the use of our existing Direct Response marketing system, entry to this business required little new investment. However, as with any government-sponsored program, the possibility of regulatory changes could change the outlook for this market.
As presented in the following table, Torchmark’s health insurance underwriting margin before other income and administrative expense declined 5% in 2011 to $162 million but remained flat at $170 million in 2010. As a percentage of premium income, margins were stable in all periods at approximately 17%.
Total Medicare Part D premium and health premium excludes $1.0 million in 2011, $516 thousand in 2010, and $2.5 million in 2009 of risk-sharing premium paid to the CMS consistent with the Medicare Part D contract. This risk-sharing amount is a portion of the excess or deficiency of actual over expected claims, and therefore we view this payment as a component of policyholder benefits in our segment analysis.
Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2011.
(2) Deconsolidation of trusts liable for Trust Preferred Securities required by accounting guidance. See Note 11-Debt in the Notes to Consolidated Financial Statements.
(3) Net of deferred acquisition costs, excluding the associated unrealized gains and losses thereon.
Excess investment income is reduced by required interest on net insurance policy liabilities and the interest paid on corporate debt. Information about interest credited to policy liabilities is shown in the following table.
The combined average interest discount rate has risen in each of the last three years due to changes in the mix of the in force business. For more specific information on life and health discount rates, please refer to Note 6-Future Policy Benefit Reserves in the Notes to Consolidated Financial Statements.
Financing costs increased $2 million or 3% in 2011. They rose $6 million or 8% in 2010. The increase in financing costs in 2010 reflects the issuance in June 2009 of $300 million principal amount 9¼% Senior Notes due in 2019. In 2010, we incurred a full year of interest on this issue. The 2011 increase in interest on short-term debt was primarily a result of the $2.1 million increase in financing charges on our letter of credit facility, arising from the December, 2010 restructuring of our credit facility. More information on this facility is disclosed under the caption Short-Term Borrowings in the Financial Condition section of this report and in Note 11-Debt in the Notes to Consolidated Financial Statements. The 2010 decrease was due to a decline in short-term rates over the previous year, but was also impacted by a 22% decline in the average balance of commercial paper outstanding compared with 2009.
Investment Acquisitions. Torchmark’s current investment policy calls for investing almost exclusively in investment-grade fixed maturities generally with long maturities (maturity date more than 20 years after acquisition date) that meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. Further, we believe this strategy is appropriate because our strong positive cash flows are generally stable and predictable. If such longer-term securities do not meet our quality and yield objectives, we consider investing in short-term securities, taking into consideration the slope of the yield curve and other factors at the time. During calendar years 2009 through 2011, Torchmark invested almost exclusively in fixed-maturity securities, primarily with longer-term maturities as presented in the chart below.
New cash flow available for investment is primarily provided through our insurance operations, but has also been affected by other factors. Issuer calls, as a result of the low-interest environment experienced during the past three years are a factor. Issuers are more likely to call bonds when rates are low because they often can refinance them at a lower cost. Calls increase funds available for investment,
Portfolio Analysis. Because Torchmark has recently invested almost exclusively in fixed-maturity securities, the relative percentage of our assets invested in various types of investments varies from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2011 with the latest industry data.
Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities. An analysis of our fixed-maturity portfolio by component at December 31, 2011 and December 31, 2010 is as follows:
Credit Risk Sensitivity. Credit risk is the level of certainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. Approximately 88% of our fixed-maturity holdings at book value are in corporate securities (including redeemable preferred and asset-backed securities). As we continue to invest in corporate bonds with relatively long maturities, credit risk is a concern. We mitigate this ongoing risk, in part, by acquiring only investment-grade bonds and by analyzing the financial fundamentals of each prospective issuer. We continue to monitor the status of issuers on an ongoing basis. We also seek to reduce credit risk by maintaining investments in a large number of issuers over a wide range of industry sectors.
The following table presents the relative percentage of our fixed maturities by industry sector at December 31, 2011.
The CDO considered temporarily impaired was carried at an amortized cost of $23.4 million and had a fair value of $7.7 million. The CDO considered other-than-temporarily impaired was previously written down and carried at an amortized cost of $37.0 million, based on the present value of expected cash flows at the original purchase yield. This CDO had a fair value of $22.7 million at December 31, 2011. The collateral underlying these CDOs is primarily trust preferred securities issued by banks and insurance companies, and no sub-prime or Alt-A mortgages are included in the collateral.
In reaching these conclusions concerning the other-than-temporary impairment of our CDOs, we reviewed and discussed with the collateral managers of each of these CDOs the current status of the collateral underlying our investments, the credit events (defaults and deferrals in underlying collateral) experienced to date, and the possibility of future credit events. We calculated expected future cash flows using assumptions for expected future credit events that reflect actual historical experience and expected future experience. We reviewed the actual versus expected cash flows received to date and the impact that potential future credit events could have on our expected future cash flows. We calculated the magnitude of future credit events that could be experienced without negatively impacting the recovery of our investment and our expected yield rate. While there is a possibility that future credit events will exceed our current expectations, we believe there is ample evidence to support our conclusions.
An analysis of the fixed-maturity portfolio by a composite rating at December 31, 2011 is shown in the table below.
The portfolio has a weighted average quality rating of A- based on amortized cost. Approximately 93% of the portfolio at amortized cost was considered investment grade. Our investment portfolio contains no securities backed by sub-prime or Alt-A mortgages (loans for which some of the typical documentation was not provided by the borrower). We have no direct investments in residential mortgages, nor do we have any counterparty risks as we are not a party to any credit default swaps or other derivative contracts. We do not participate in securities lending. There are no off-balance sheet investments, as all investments are reported on our Consolidated Balance Sheets. We have no direct exposure to European sovereign debt.
Market Risk Sensitivity. Torchmark’s financial securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 96% of the book value of our investments is attributable to fixed-maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio exceeding the book value of the portfolio and increases in interest rates cause the fair value to decline below the book value. Under normal market conditions, we do not expect to realize these unrealized gains and losses because it is generally our investment strategy to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offset the impact of rates on the investment portfolio. However, in accordance with GAAP, these liabilities are not marked to market.
The following table illustrates the market risk sensitivity of our interest-rate sensitive fixed-maturity portfolio at December 31, 2011 and 2010. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of the fixed-maturity portfolio. The data measures the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
The following table summarizes our tax-effected realized gains (losses) by component for each of the years in the three-year period ended December 31, 2011.
Short-Term Borrowings. An additional source of parent company liquidity is a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. As of December 31, 2011, we had available $177 million of additional borrowing capacity under this facility, as compared with $203 million a year earlier. For detailed information about this line of credit facility, see the Commercial Paper section of Note 11-Debt.
There have been no difficulties in accessing the commercial paper market under this facility during the three years ended December 31, 2011.
Consolidated Liquidity. Consolidated net cash inflows provided from operations were $859 million in 2011, compared with $1.03 billion in 2010, and $976 million in 2009. In addition to cash inflows from operations, our companies have received $230 million in investment calls and tenders and $180 million of scheduled maturities or repayments during 2011. Maturities, tenders, and calls totaled $639 million in 2010 and $761 million in 2009.
(3) Pension obligations are primarily liabilities in trust funds that are calculated in accordance with the terms of the pension plans. They are offset by invested assets in the trusts, which are funded through periodic contributions by Torchmark in a manner which will provide for the settlement of the obligations as they become due. Therefore, our obligations are offset by those assets when reported on Torchmark’s Consolidated Balance Sheets. At December 31, 2011, these pension obligations were $332 million, but there were also assets of $258 million in the pension entities. The schedule of pension benefit payments covers ten years and is based on the same assumptions used to measure the pension obligations, except there is no interest assumption because the payments are undiscounted. Please refer to Note 10-Postretirement Benefits in the Notes to Consolidated Financial Statements for more information on pension obligations.
As noted under the caption Summary of Operations in this report, we reactivated our share repurchase program during the first quarter of 2010. We previously had suspended the program indefinitely in March, 2009 due to general economic conditions at that time. However, since reactivation, we have made share purchases each quarter of 2010 and 2011. Under this program, we acquired 19 million shares at a cost of $788 million in 2011 (average of $41.68 per share), 6 million shares for $204 million in 2010, and 3 million shares for $47 million in 2009. The majority of purchased shares are retired each year. Please refer to the description of our share repurchase program under the caption Summary of Operations in this report.
Torchmark has recently increased the dividend on its common shares. In the first quarter of 2010, the dividend was increased from $.0933 per share to $.10 per share and in the fourth quarter of 2010, it was further increased to $.1067 per share. In the second quarter of 2011, it was again raised to $.12 per share.
Shareholders’ equity was $4.2 billion at December 31, 2011, compared with $4.0 billion at December 31, 2010. During the twelve months since December 31, 2010, shareholders’ equity was reduced by the $788 million in share purchases under the repurchase program and another $185 million to offset the dilution from stock option exercises, but has been increased by the $518 million of net income and by after tax unrealized gains of $538 million in the fixed maturity portfolio as conditions in financial markets have improved.
** Includes Torchmark’s 7.1% Junior Subordinated Debentures in each period in the amount of $124 million.
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 10.7 times in 2011, compared with 11.3 times in 2010 and 9.3 times in 2009. This times-interest-earned ratio is computed by dividing interest expense into the sum of pre-tax income from continuing operations and interest expense. A discussion of our interest expense is included in the discussion of financing costs under the caption Investments in this report.
Credit Ratings. The chart below presents Torchmark’s credit ratings as of December 31, 2011.
The financial strength of our major insurance subsidiaries is also rated by Standard & Poor’s and A. M. Best. The following chart presents these ratings for our four largest insurance subsidiaries at December 31, 2011.
Policy Acquisition Costs (ASU 2010-26). This accounting guidance amends the accounting for costs associated with acquiring or renewing insurance contracts in order to address the diversity in practice surrounding the capitalization and deferral of these costs. This guidance will be effective for Torchmark beginning January 1, 2012. Please refer to Unadopted Accounting Guidance in Note 1 - Significant Accounting Policies in the Notes to Consolidated Financial Statements for more information concerning the effects of adoption.
Health Insurer’s Fees Paid to the Federal Government (ASU 2011-06). Private health insurance carriers will be required to pay a new fee to the Federal government beginning in calendar year 2014 under the Patient Protection and Affordable Care Act. This guidance addresses questions about how to recognize and classify the fees, basically requiring that it be expensed ratably throughout the year. It is effective for Torchmark beginning in the year 2014. Because the majority of Torchmark’s health products are excluded from the mandate, the impact of adoption should be immaterial.
Approximately 81% of our liabilities for future policy benefits at December 31, 2011 were traditional insurance liabilities whereby the liability is determined as the present value of future benefits less the present value of the portion of the gross premium required to pay for such benefits. The assumptions used in estimating the future benefits for this portion of business are set at the time of contract issue. These assumptions are “locked in” and are not revised for the lifetime of the contracts, except where there is a premium deficiency, as defined in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements under the caption Future Policy Benefits. Otherwise, variability in the accrual of policy reserve liabilities after policy issuance is caused only by variability of the inventory of in force policies. Torchmark had no premium deficiency event for its traditional business during the three years ended December 31, 2011.
Policy Claims and Other Benefits Payable. This liability consists of known benefits currently payable and an estimate of claims that have been incurred but not yet reported to us. The estimate of unreported claims is based on prior experience and is made after careful evaluation of all information available to us. However, the factors upon which these estimates are based can be subject to change from historical patterns. Factors involved include the litigation environment, regulatory mandates, and the introduction of policy types for which claim patterns are not well established, and medical trend rates and medical cost inflation as they affect our health claims. Changes in these estimates, if any, are reflected in the earnings of the period in which the adjustment is made. We believe that the estimates used to produce the liability
for claims and other benefits, including the estimate of unsubmitted claims, are the most appropriate under the circumstances. However, there is no certainty that the resulting stated liability will be our ultimate obligation. At this time, we do not expect any change in this estimate to have a material impact on earnings or financial position consistent with our historical experience.
Defined benefit pension plans. We maintain funded defined benefit plans covering most full-time employees. We also have unfunded nonqualified defined benefit plans covering certain key and other employees. Our obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset, at least in part, by the growth in value of the assets in the funded plans. At December 31, 2011, our gross liability under these funded plans was $282 million, but was offset by assets of $258 million.
The actuarial assumptions used in determining our obligations for pensions include employee mortality and turnover, retirement age, the expected return on plan assets, projected salary increases, and the discount rate at which future obligations could be settled. These assumptions have an important effect on the pension obligation. A decrease in the discount rate or rate of return on plan assets will cause an increase in the pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. Small changes in assumptions may cause material differences in reported results for these plans. While we have used our best efforts to determine the most reliable assumptions, given the information available from company experience, economic data, independent consultants and other sources, we cannot be certain that actual results will be the same as expected. Our discount rate, rate of return on assets, and projected salary increase assumptions are disclosed and the criteria used to determine those assumptions are discussed in Note 9-Postretirement Benefits in the Notes to Consolidated Financial Statements. The assumptions are reviewed annually and revised, if necessary,
based on more current information available to us. Note 9 also contains information about pension plan assets, investment policies, and other related data.
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2011
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries (“Torchmark”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
discontinued operations are separately disclosed in Note 3 - Discontinued Operations in the Notes to the Consolidated Financial Statements. Because the business has been sold or classified as held for sale and its operations are discontinued, the financial results of the business are excluded from the Notes to the Consolidated Financial Statements, other than in Note 3, the Consolidated Statements of Cash Flows, and Note 2 - Statutory Accounting.
Gains and losses realized on the disposition of investments are determined on a specific identification basis. Income attributable to investments is included in Torchmark’s net investment income. Net investment income for the years ended December 31, 2011, 2010, and 2009 included $552 million, $522 million, and $487 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocated to insurance policyholders’ liabilities.
Current accounting guidance is such that if an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is to be considered other-than-temporarily impaired and the full amount of impairment must be charged to earnings. Otherwise, losses on fixed maturities which are other-than-temporarily impaired are separated into two categories, the portion of loss which is considered credit loss and the portion of loss which is due to other factors. The credit loss portion is charged to earnings while the loss due to other factors is charged to other comprehensive income.
Future Policy Benefits: The liability for future policy benefits for universal life-type products is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 81% of total future policy benefits, is provided on the net level premium method based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. Assumptions used are based on Torchmark’s previous experience with similar products. Once established, assumptions for these products are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions. These estimates are periodically reviewed and compared with actual experience. If it is determined that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover unamortized acquisition costs, then a premium deficiency exists. Such a deficiency would be recognized immediately by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future policy benefits. From that point forward, the liability for future policy benefits would be based on the revised assumptions.
For 2011 and 2010, the Federal income benefits accrued during the year, net of the amortization associated with guaranteed interests, were recorded in “Income taxes.” Amortization associated with non-guaranteed interests and interests providing for state premium tax benefits was reflected as a component of “Net investment income.” For years prior to 2010, the Federal income tax benefits accrued during the year, net of the amortization associated with all interests, were recorded in “Income taxes.” All state premium tax benefits, net of the related amortization, were recorded in “Net investment income.” At December 31, 2011, $281 million associated with the Federal interests was included in “Other assets” with the remaining $12 million state-related interests included in “Other invested assets.” At December 31, 2010, the comparable amounts were $269 million and $14 million, respectively. Any unpaid commitments to invest are recorded in “Other liabilities.” In the segment analysis, the amortization associated with the non-guaranteed interests is reflected as a component of “Income tax expenses,” and not “Net investment income,” consistent with the treatment of the guaranteed interests. Management views this presentation as a more accurate matching of costs with the associated revenues with respect to the low-income housing interests.
Goodwill: The excess cost of business acquired over the fair value of their net assets is reported as goodwill. Goodwill is subject to annual impairment testing based on certain procedures outlined by GAAP. The procedures involve measuring the carrying value of each reporting unit of Torchmark’s segments, including the goodwill of that unit, against the estimated fair value of the corresponding unit. If the carrying value of a unit including goodwill exceeds its estimated fair value, then the goodwill in that unit could potentially be impaired. In that event, further testing is required under the accounting guidance to determine the amount of impairment, if any. If there is an impairment in the goodwill of any reporting unit, it is written down and charged to earnings in the period of test.
The fair value method requires the use of an option valuation model to value employee stock options. Torchmark has elected to use the Black-Scholes valuation model for option expensing. A summary of assumptions for options granted in each of the three years 2009 through 2011 is as follows:
The expected term is generally derived from Company experience. However, expected terms of grants made under the Torchmark Corporation 2005 Incentive Plan (2005 Plan) and the 2007 Long-Term Compensation Plan (2007 Plan), involving grants made in the years 2005 through 2010, were determined based on the simplified method as permitted by Staff Accounting Bulletins 107 and 110. This method was used because the 2005 and 2007 Plans limited grants to a maximum contract term of seven years, and Torchmark had no previous experience with seven-year contract terms. Prior to 2005, substantially all grants contained ten-year terms. Because a large portion of these grants vest over a three-year period, the Company did not have sufficient exercise history during 2010 or previous years to determine an appropriate expected term on these grants. Beginning in 2011, all grants with seven-year terms are based on Company experience. The Torchmark Corporation 2011 Incentive Plan replaced the previous plans and allows for option grants with a ten-year contractual term which vest over five years in addition to seven-year grants which vest over three years as permitted by the previous plans. The Company has no historical experience with five-year vesting, and will therefore use the simplified method to determine the expected term for these grants until such experience is developed. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested).
Torchmark management views all stock-based compensation expense as a corporate or Parent Company expense and, therefore, presents it as such in its segment analysis (See Note 14-Business Segments). It is included in “Other operating expense” in the Consolidated Statements of Operations.
The excess, if any, of shareholder’s equity of the insurance subsidiaries on a GAAP basis over that determined on a statutory basis is not available for distribution to Torchmark without regulatory approval. More information on the restrictions on the payment of dividends can be found in Note 12-Shareholders’ Equity.
Torchmark’s statutory financial statements are presented on the basis of accounting practices prescribed by the insurance department of the state of domicile of each insurance subsidiary. All states have adopted the National Association of Insurance Commissioners’ (NAIC) statutory accounting practices (NAIC SAP) as the basis for statutory accounting. However, certain states have retained the prescribed practices of their respective insurance code or administrative code which can differ from NAIC SAP. There are no significant differences between NAIC SAP and the accounting practices prescribed by the states of domicile for Torchmark’s life insurance companies that affect statutory surplus.
During the third quarter of 2010, Torchmark’s subsidiary, Liberty, entered into an agreement to sell its wholly-owned subsidiary, United Investors Life Insurance Company (United Investors), to an unaffiliated insurance carrier. The sale was completed as of December 31, 2010. United Investors marketed primarily term and interest-sensitive life insurance, fixed annuities, and, prior to 2009, variable annuities. Consideration for the sale consisted of $343 million in cash at the closing, as well as post-closing proceeds receivable from the buyer of approximately $21 million which was received in early 2011. The transaction resulted in a pretax loss of approximately $38 million ($35 million after tax), which has been reported as a realized loss on the disposal of a discontinued operation in 2010. Due to the sale, Torchmark’s consolidated financial statements are presented to reflect the transactions as discontinued operations.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2011 and 2010 is as follows:
Proceeds from sales including discontined assets were $326 million in 2010 and $900 million in 2009.
Level 1 - fair values are based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date.
Level 2 - fair values are based on inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability, or inputs that can otherwise be corroborated by observable market data.
When third-party vendor prices are not available, the Company attempts to obtain at least three quotes from broker/dealers for each security. When at least three quotes are obtained, and the standard deviation of such quotes is less than 3%, (suggesting that the independent quotes were likely derived using similar observable inputs), the Company uses the median quote and classifies the measurement as Level 2. At December 31, 2011 and 2010, there were no assets valued as Level 2 in this manner with broker quotes.
The following tables represent the fair value of assets measured on a recurring basis at December 31, 2011 and 2010:
Unrealized gain/loss analysis. As conditions in financial markets have improved since early 2009, unrealized gains in the portfolio have occurred and losses have declined. Net unrealized losses on fixed maturities of $455 million at December 31, 2009 became net unrealized gains of $108 million at December 31, 2010. During 2011, net unrealized gains rose to $964 million at December 31, 2011. At December 31, 2011, investments in securities in the financial sector were in a $14 million unrealized gain position compared with an unrealized loss position of $115 million at December 31, 2010. Investments in securities in the other sectors had net unrealized gains of $950 million in 2011 and $223 million in 2010. The following tables disclose gross unrealized investment losses by class of investment at December 31, 2011 and December 31, 2010. Torchmark considers these investments to be only temporarily impaired.
Torchmark had $125 thousand in fixed maturities at book value ($130 thousand at fair value) that were non-income producing during the twelve months ended December 31, 2011. Torchmark had $3.0 million in investment real estate at December 31, 2011 which was non-income producing during the previous twelve months. Torchmark did not have any other invested assets that were non-income producing during the twelve months ended December 31, 2011.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 2011 is as follows:
Claims paid in each of the years 2009 through 2011 were settled for amounts less than anticipated when estimated at the previous year end. The most significant components of these favorable variances were in Torchmark’s UA Independent, Liberty National Branch, and Medicare Part D distribution channels. The Company’s estimates at each point have reflected the emerging data and trends. In the Medicare Part D channel, the Company is required to estimate claim discounts that will be received from drug manufacturers. In each of the years 2009 through 2011, the discounts from the drug manufacturers received in the current year but related to prior year claims were higher than anticipated when the claim liability was determined.
In each of the years 2009 through 2011, deferred income tax expense was incurred because of certain differences between net income before income taxes as reported on the Consolidated Statements of Operations and taxable income as reported on Torchmark’s income tax returns. As explained in Note 1-Significant Accounting Policies, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
Torchmark’s Federal income tax returns are routinely audited by the Internal Revenue Service (IRS). The IRS completed its examination of the Company’s 2005, 2006, and 2007 tax years during 2009. The Company recorded a $2.5 million tax benefit to reflect the results of the examination, including a reduction in its liability for uncertain tax positions relating to these years. The statutes of limitation for the assessments of additional tax are closed for all tax years prior to 2008. Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from future tax examinations and other tax-related matters for all open tax years.
Torchmark’s continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company recognized interest income of $0, $124 thousand, and $1.7 million, net of Federal income tax benefits, in its Consolidated Statements of Operations for 2011, 2010, and 2009, respectively. The Company had an accrued interest receivable of $2.7 million and $4.1 million, net of Federal income tax benefits, as of 2011 and 2010, respectively. The Company had no accrued penalties at December 31, 2011 or 2010.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plans covering the majority of employees are funded. Contributions are made to funded pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $8.6 million in 2011, $13 million in 2010, and $15 million in 2009. Torchmark estimates as of December 31, 2011 that it will contribute an amount not to exceed $20 million to these plans in 2012. The actual amount of contribution may be different from this estimate.
The other supplemental benefit pension plan is limited to a very select group of employees and was closed as of December 31, 1994. It provides the full benefits that an employee would have otherwise received from a defined benefit plan in the absence of the limitation on benefits payable under a qualified plan. This plan is unfunded. Liability for this closed plan was $3 million at December 31, 2011 and $4 million at December 31, 2010. Pension cost for both supplemental defined benefit plans is determined in the same manner as for the qualified defined benefit plans.
Plan assets in the funded plans consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair value. Torchmark measures the fair value of its financial assets, including the assets in its benefit plans, in accordance with accounting guidance which establishes a hierarchy for asset values and provides a methodology for the measurement of value. Please refer to Note 4-Investments under the caption Fair Value Measurements for a complete discussion of valuation procedures. The following table presents the assets of Torchmark’s defined benefit pension plans for the years ended December 31, 2011 and 2010.
Allowed investments are limited to equities, fixed maturities, and short-term investments (invested cash). There is also a guaranteed annuity contract to fund the obligations of the American Income Pension Plan. The assets are to be invested in a mix of equity and fixed income investments that best serve the objectives of the pension plan. Factors to be considered in determining the asset mix include funded status, annual pension expense, annual pension contributions, and balance sheet liability. Equities include common and preferred stocks, securities convertible into equities, mutual funds that invest in equities, and other equity-related investments. Equities must be listed on major exchanges and adequate market liquidity is required. Fixed maturities consist of marketable debt securities rated investment grade at purchase by a major rating agency. Short-term investments include fixed maturities with maturities less than one year and invested cash. Short-term investments in commercial paper must be rated at least A-2 by Standard & Poor’s with the issuer rated investment grade. Invested cash is limited to banks rated A or higher. Investments outside of the aforementioned list are not permitted, except by prior approval of the Plan’s Trustees. At December 31, 2011, there were no restricted investments contained in the portfolio. Plan contributions have been invested primarily in fixed maturities during the three years ending December 31, 2011.
The portion of other comprehensive income that is expected to be reflected in pension expense in 2012 is as follows:
Funded debt: During 2006, Torchmark established Torchmark Capital Trust III (Trust III) to facilitate the public offering of 4.8 million shares of $25 par value Trust Preferred Securities. Trust III completed the offering for total proceeds of $120 million. It then exchanged $3.7 million of its common stock and the $120 million of proceeds from the offering for $124 million of Torchmark Junior Subordinated Debentures, due June 1, 2046. Trust III pays quarterly dividends on the Trust Preferred Securities at an annual rate of 7.1%, and receives quarterly payments at the same annual rate from Torchmark on the Junior Subordinated Debentures. All payments due to be paid by Trust III on the Trust Preferred Securities are guaranteed by Torchmark (see Note 15). The securities are redeemable on June 1, 2046. They are callable by Trust III at any time.
Commercial Paper: In December, 2010, Torchmark entered into a credit facility with a group of lenders allowing unsecured borrowings and stand-by letters of credit up to $600 million. The facility includes a provision which allows Torchmark to increase the facility limit by $200 million if certain conditions are met. The Company also has the ability to request up to $250 million in letters of credit to be issued against the facility. The agreement is set to terminate on January 7, 2015. The credit facility is further designated as a back-up credit line for a commercial paper program, where Torchmark may borrow from either the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility limit less any letters of credit issued. Interest is charged at variable rates. At December 31, 2011, Torchmark had $225 million face amount ($225 million carrying amount) of commercial paper outstanding, $198 million of letters of credit issued, and no borrowings under the line of credit. During 2011, the short term borrowings under the facility averaged approximately $206 million, and were made at an average yield of .4%, compared with an average balance of $196 million and also at an average yield of .4% a year earlier. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire facility.There is also an issuance fee for letters of credit issued. Torchmark is subject to certain covenants for the agreements regarding capitalization and earnings, with which it was in compliance at December 31, 2011 and throughout the three-year period ended December 31, 2011. Borrowings on the credit facilities are reported as short-term debt on the Consolidated Balance Sheets.
Earnings Per Share: A reconciliation of basic and diluted weighted-average shares outstanding used in the computation of basic and diluted earnings per share is as follows, retroactively adjusted for the three-for-two stock split:
Stock options to purchase 3.5 million shares, 10.3 million shares, and 14.1 million shares, during the years 2011, 2010, and 2009, respectively, are considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
All share and per share amounts within this note have been retroactively adjusted for the three-for-two stock split.
Certain employees, directors, and consultants have been granted fixed equity options to buy shares of Torchmark stock at the market value of the stock on the date of grant, under the provisions of the Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring according to the terms of the grant. Options generally expire the earlier of employee termination or option contract term, which ranges from seven to eleven years. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Director grants generally vest in six months. Stock options awarded in connection with compensation deferrals by certain directors and executives generally vest over a range of ten years. Beginning in 2011, with the approval by Shareholders of the Torchmark Corporation 2011 Incentive Plan, some employee grants vest one-fourth over two years and the remaining three-fourths vest one-fourth over each of the next three years. All employee options vest immediately upon retirement on or after the attainment of age 65. Torchmark generally issues shares for the exercise of stock options from treasury stock. The Company generally uses the proceeds from option exercises to buy shares of Torchmark common stock in the open market to reduce the dilution from option exercises.
Additional information about Torchmark’s stock-based compensation as of December 31, 2011 and 2010 is as follows:
The measure of profitability for the Investment segment is excess investment income, which represents the income earned on the investment portfolio in excess of net policy requirements and financing costs associated with Torchmark’s debt. Other than the above-mentioned interest allocations and an intersegment commission, there are no other intersegment revenues or expenses. Expenses directly attributable to corporate operations are included in the “Corporate” category. Stock-based compensation expense is considered a corporate expense by Torchmark management and is included in this category. All other unallocated revenues and expenses on a pretax basis, including insurance administrative expense, are included in the “Other” segment category. The following tables set forth a reconciliation of Torchmark’s revenues and operations by segment to its major income statement line items.
During 2011, management changed the definition of total segment profits before tax to exclude the amortization of low-income housing interests, which management views as a tax expense. Accordingly, the 2010 total segment profits before tax and applicable tax amount have been updated for comparison purposes.
Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2.0 million per life. Life insurance ceded represented .5% of total life insurance in force at December 31, 2011. Insurance ceded on life and accident and health products represented .3% of premium income for 2011. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represented 3.0% of life insurance in force at December 31, 2011 and reinsurance assumed on life and accident and health products represented 1.2% of premium income for 2011.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $4.8 million in 2011, $4.9 million in 2010, and $4.9 million in 2009. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2011 were as follows: 2012, $2.7 million; 2013, $2.4 million; 2014, $2.0 million; 2015, $2.0 million; 2016, $1.4 million and in the aggregate, $13.2 million.
As of December 31, 2011, securities of state and municipal governments represented 11% of invested assets at fair value. Such investments are made throughout the U.S. At year-end 2011, 5% or more of the state and municipal bond portfolio at fair value was invested in securities issued within the following states: Texas (34%), Ohio (8%), Washington (7%), and Alabama (5%). Otherwise, there was no significant concentration within any given state.
Corporate debt and equity investments are made in a wide range of industries. Below are the ten largest industry concentrations held in the corporate portfolio at December 31, 2011, based on fair value:
At year-end 2011, 5% of invested assets at fair value was represented by fixed maturities rated below investment grade (BB or lower as determined by the weighted average of available ratings from rating services). Par value of these investments was $787 million, amortized cost was $701 million, and fair value was $579 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in their fair value.
Guarantees: At December 31, 2011, Torchmark had in place four guarantee agreements, all of which were either parent company guarantees of subsidiary obligations to a third party, or parent company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2011, Torchmark had no liability with respect to these guarantees.
On November 14, 2011, plaintiff filed an amended complaint based upon the same facts asserting only breach of contract claims on behalf of a purported nationwide restitution/monetary relief class or, in the first alternative, a purported multiple-state restitution/monetary relief class or, in the second alternative, a purported Arkansas statewide restitution/monetary relief class. Restitution and/or monetary relief for United American’s alleged breaches of contract, costs, attorney’s fees and expenses, expert fees, prejudgment interest and other relief are sought on behalf of the plaintiff and members of the class. On December 7, 2011, United American filed a Motion to Dismiss the plaintiff’s amended complaint and on January 11, 2012, plaintiff filed a response thereto. Discovery has commenced and is ongoing.
The following is a summary of quarterly results for the two years ended December 31, 2011. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.