The principal operations of the insurance subsidiaries are conducted from Kansas City, Missouri and Dallas, and Austin, Texas. The Company's locations include leased office space located at 1055 Broadway, Kansas City, Missouri 64105 and 333 West 11th Street, Kansas City, Missouri 64105. These properties are leased from Broadway Square Partners, LLP, a Missouri limited liability partnership, of which a corporation controlled by a related party is a partner as described in the "Certain Relationships and Related Transactions" section included elsewhere in this Form 10-K. The leases expire on August 31, 2010 and August 31, 2013, respectively.
The following discussion analyzes significant items affecting the results of operations and the financial condition of the Company. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Statements using verbs such as "plan", "anticipate", "believe", "expect" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company's beliefs concerning future levels of sales and surrenders of the Company's products, investment spreads and yields or the earnings and profitability of the Company's activities.
As shown in the above tables, the Company's growth over the last two years has primarily occurred in the annuity balances of the asset accumulation operations. This growth has been derived from a combination of new sales and renewal premiums, primarily associated with the Company's equity-indexed annuity products. The reserve balances in the Company's life insurance operations, with the exception of the annuities, have remained fairly constant during the last two years. The Company has been able to issue sufficient new business to offset the surrenders and lapses in its older blocks of business.
Impairment of investment securities owned by the Company results in a realized investment loss when a market decline below cost is deemed to be other than temporary. Management regularly reviews each investment security against criteria that include the extent of the decline in the market value of the security, the duration of the decline and the financial health and prospects of the issuer of the security. The Company recorded a realized loss of $2.1 million on an individual security in its December 31, 2001 income statement as a result of its review process.
Other significant accounting policies do not involve the same level of estimation and management judgement as those described above. These accounting policies are described in Note 1 to the consolidated financial statements included elsewhere in this Form 10-K.
The Company manages its exposure to changes in the fair value of EIA embedded derivatives by purchasing exchange-traded and over-the-counter indexed call options and futures contracts on the same external index. Neither these assets nor the related EIA embedded derivatives are eligible for hedge accounting treatment under SFAS No. 133. The Company recognizes the change in fair values of these assets as a component of net investment income.
The adoption of SFAS No. 133 during 2001 has a significant impact on the comparability of income statement components versus 2000. The impact on individual income statement components is addressed in the discussion of the results for the year ended December 31, 2001 below.
Non insurance operations. Income before income taxes decreased $0.6 million from 2000 to 2001. The primary reason for the decrease was a $0.6 million decrease in income from Argus in 2001 compared to 2000. Income before income taxes decreased $2.1 million from 1999 to 2000. The primary reasons for the decrease were (i) a $1.8 million decrease in income from Argus in 2000 and (ii) a $0.5 million decrease in income from the real estate entities. The Company dividended its interest in Argus to FHC in December 2001.
The difference between the segment revenues and income before income taxes shown above and the amounts reported in the Company's consolidated financial statements appearing elsewhere in this report result from items not allocated to specific segments. The significant reconciling items which are not allocable to a segment are interest expense and a portion of (i) net investment income, (ii) operating expenses, (iii) net realized investment gains and losses and (iv) certain non-recurring transactions such as gains from the sale of subsidiaries. The net loss from reconciling items was $3.0 million less in 2001 than in 2000. The improvement from 2000 to 2001 resulted from (i) net realized investment losses of $1.1 million in 2001 compared to net realized investment losses of $6.6 million in 2000, (ii) $4.0 million of trading gains from the Company's trading portfolio in 2001, (iii) lower litigation settlement costs in 2001 and (iii) continued improvement in the reduction of operating expenses from 2000 to 2001. The positive factors in 2001 were partially offset by $9.9 million of losses related to the Company's decision in 2001 to exit certain business and relocate certain operations.
Net investment income. Net investment income totaled $211.1 million in 2001 compared to $225.5 million in 2000. Net investment income for the years ended December 31, 2001 and 2000 was comprised of the following (in millions):
The reduction in net investment income in 2001 was primarily due to a $19.1 million decrease in fair value of call options and futures contracts owned by the Company. The decrease in the fair value of these call options and futures contracts was offset by the decline in value of the options embedded in the Company's equity-indexed annuity liabilities. Excluding the decrease in the fair value of derivative assets, investment income for 2001 increased $4.7 million compared to 2000. Investment income on fixed maturity securities increased $11.8 million in 2001 based upon the increased amount of fixed maturity securities owned by the Company in 2001 versus 2000. Investment income earned on reinsurance funds held by reinsurer decreased $6.0 million from 2000 to 2001 because these funds decreased in 2001. The liabilities related to these reinsurance funds experienced similar reductions in 2000.
Net realized investment losses. Net realized investment losses totaled $1.1 million in 2001 compared to net realized investment losses of $6.6 million for 2000. During the years ended December 31, 2001 and 2000, the Company recorded realized gains on common stock of $5.5 million and $4.3 million, respectively. The Company also recorded realized losses on fixed maturity investments of $6.9 million and $11.4 million, respectively, during the years ended December 31, 2001 and 2000.
Other income. Other income totaled $7.1 million for 2001 compared to $10.8 million for 2000. The primary reason for this decrease was a reduction in servicing revenue on blocks of business which have been permanently coinsured to other insurance companies.
Amortization expense. Amortization expense totaled $42.9 million for 2001 compared to $68.0 million for 2000. The decrease resulted from (i) a revision of estimated future gross profits on blocks of universal life and annuity business and (ii) lower amortization expense in closed blocks of universal life and annuity business.
During 2001, the Company revised its estimates of the future gross profits on certain of its universal life-type and annuity products. The revisions primarily consisted of changes in estimated policy revenues and benefits paid to policyholder account balances. Certain of these revisions resulted from the anticipated impact of settling litigation in which the Company was the defendant. As a result of these changes in estimates, the Company recorded retrospective adjustments during 2001 which increased the cost of business acquired asset by $21.4 million and which decreased the deferred policy acquisition cost asset by $3.0 million.
The Company's closed blocks of universal life and annuity business experienced significantly lower levels of withdrawals during 2001 than during 2000. The decrease of $5.0 million in amortization expense related to these blocks was partially offset by the lower surrender charge revenue during 2001, as discussed above.
Restructuring expenses. During 2001, the Company made certain changes to its administrative and sales operations involved in the sale of insurance products to the tax-qualified market. Among other matters, the Company decided to relocate operations located in Austin to existing operations located elsewhere. Additionally, the Company decided to cease operations of an entity that previously provided administration for retirement and cafeteria plans to school districts and other clients. Among the factors leading to these decisions was the settlement of litigation in which the Company had been a defendant. The relocation of the remaining Austin operations will be completed in May 2002. In connection with these business decisions, the Company recorded a restructuring loss of $9.9 million consisting of several components. The Company determined that a portion of the goodwill related to these entities had become impaired. Based upon the Company's best estimate of the future results of operations of these entities, the goodwill asset was reduced by $4.7 million. The restructuring loss includes $1.5 million representing the unamortized cost of software developed for use by these entities and exit costs of $0.9 million for expected severance payments and for lease payments on the Austin office space beyond the date of the relocation. The remaining portion of the loss consists of the operating expenses of the third party administrator.
Income before income taxes increased $6.2 million to $22.4 million in 2000. The primary reasons for the increase were (i) lower death benefits, net of reserves for policyholder's benefits released on traditional death benefits, (ii) an increase in surrender charge revenue resulting from higher surrenders in 2000, (iii) a decrease in other operating expenses resulting from cost controls implemented in 2000, (iv) an increase in net investment income related to a reduction in the unrecovered ceding commission due the Reinsurer and (v) a decrease in interest expense, partially offset by (vi) an increase in net realized investment losses and (vii) a decrease in income from non-life insurance subsidiaries.
Net investment income. Net investment income totaled $225.5 million in 2000 compared to $227.6 million in 1999. Net investment income decreased due to (i) the transfer of the invested assets supporting the payroll-deduction business which was reinsured effective January 1, 2000, (ii) a $7.5 million decrease in net investment income on investments held by the Reinsurer, (iii) a $2.3 million decrease in income from equity subsidiaries, offset by (iv) a $1.9 million increase in net investment income related to a reduction in the unrecovered ceding commission due to the Reinsurer, (v) a $2.6 million increase in mortgage loan net investment income and (vi) an increase in net investment income on the Company's remaining bond portfolio.
The decrease related to investments held by the Reinsurer is due primarily to a $5.5 million decrease in net investment income on a closed block of annuity business. The decrease in investment income and the associated $4.5 million decrease of interest credited on policyholder fund values resulted from lower aggregate fund values.
Other income. Other income totaled $10.8 million in 2000 compared to $6.1 million in 1999. The increase primarily relates to a service fee received during 2000 from the reinsurer of a block of payroll-deduction life insurance business. The Company reinsured this business effective January 1, 2000; therefore, no such fee was received during 1999.
Amortization expense. Amortization expense totaled $68.0 million in 2000 compared with $73.6 million in 1999. Excluding the effect of the payroll-deduction business, amortization expense decreased $1.4 million from 1999 to 2000. Amortization expense related to the Company's universal life insurance business decreased $4.8 million due primarily to decreased administrative charges on this block of business. Offsetting this decrease was a $2.9 million increase in amortization expense related to a closed block of annuity business. The increase was due to higher levels of surrenders in 2000 and the related increase in surrender charge revenue on this block of business.
Other operating expenses. Other operating expenses totaled $84.4 million in 2000 compared with $91.0 million in 1999. During 2000, the Company reviewed the levels of general expenses in all of its operating and corporate departments. The Company identified sources of expense savings through increased cost controls which have reduced expenses by $3.9 million from 1999 to 2000. Other operating expenses also decreased due to lower expenses related to the Company's AFS marketing operations. In both 2000 and 1999, other operating expenses included $5.0 million of costs associated with litigation.
Americo has outstanding $100.0 million aggregate principal amount of senior subordinated notes that it issued in 1993. These senior subordinated notes bear interest at 9.25% and mature in May 2005. They became redeemable at the option of Americo beginning in 1998. The redemption prices are at par in May 2000 and thereafter. Several of Americo's insurance subsidiaries purchased a total of $8.5 million of the outstanding notes during 2000.
In connection with the acquisition of The Victory Life Insurance Company in July 1995, Americo issued notes payable to the seller with face amounts aggregating $17.0 million. Of the $17.0 million face amount of notes payable issued to the seller, $5.0 million mature in 2015 and the remaining $12.0 million mature in 24 equal semi-annual installments, the first of which was due in 1995. The notes are recorded in the Company's consolidated financial statements at their discounted value of $10.0 million, which assumes an average effective rate of 11.5%.
The surplus debentures contain restrictions which prevent United Fidelity from making principal and interest payments if such payments reduce United Fidelity's statutory capital and surplus below an amount specified in the surplus debenture agreements. The most restrictive minimum surplus requirement contained in the surplus debentures is $37.5 million; United Fidelity's capital and surplus at December 31, 2001 was $100.6 million. Any future payment of principal or interest on such surplus debentures will be limited by the ability of the subsidiaries of United Fidelity to pay dividends to United Fidelity and may be further limited by United Fidelity's RBC requirements. See "Business Regulation". The Company does not believe that United Fidelity will have any difficulty in meeting its obligations under these surplus debentures in the foreseeable future.
In order to meet its obligations under the surplus debentures, United Fidelity uses funds generated by its insurance operations and dividends from its insurance subsidiaries. The ability of the insurance subsidiaries to pay dividends is subject to regulatory restrictions. The insurance holding company statutes of Texas, in which the Company's insurance subsidiaries are domiciled, regulate payment of dividends by an insurance company to its parent. Generally, without the consent of the state's insurance commissioner, an insurance company may not pay dividends to its parent in excess of the greater of (i) the insurer's prior year statutory net gain from operations, and (ii) 10% of its prior year ending statutory capital and surplus, subject in either case to sufficient earned statutory surplus from which such dividends may be paid. Additionally, an insurance company is required to notify the respective insurance department prior to the payment of ordinary dividends.
The Company believes that its investment portfolio will allow it to satisfy all existing contractual obligations to policyholders. At December 31, 2001, the Company's investment portfolio included $59.7 million of cash and short-term investments, $74.5 million of marketable equity securities, $228.9 million of U.S. Treasury and government securities, mortgage-backed securities and asset-backed securities and $892.8 million of corporate bonds classified as available for sale, the vast majority of which management believes could be readily converted to cash.
The Company has accounted for its investment in the FHC preferred stock as an offset to its own preferred stock in stockholder's equity. Dividends on the Company's preferred stock, when payable, will also be substantially offset by the dividends payable on the FHC preferred stock.
Financial condition. Stockholder's equity decreased to $252.3 million at December 31, 2001 from $254.7 million at December 31, 2000. The decrease was the result of a decrease in net unrealized investment gains of $4.9 million and $9.6 million of dividends to FHC, partially offset by net income of $12.1 million. The dividends consisted of the Company's ownership interest in Argus and $2.0 million of cash. Net unrealized investment losses in 2001 were recorded due to a decrease in the market value of the Company's available for sale fixed maturities and equity securities. See Note 4 to the Company's Consolidated Financial Statements included elsewhere in this Form 10-K for further discussion of the components of the change in net unrealized investment gains.
Statutory capital and surplus of the Company's insurance subsidiaries at December 31, 2001 includes $19.8 million arising from financial reinsurance agreements, which amount is not included in stockholder's equity on a GAAP basis.
(1) The ratings set forth above are based on the ratings assigned by S&P and Moody's Investors Service, Inc. ("Moody's"). If S&P's ratings were unavailable, ratings assigned by Moody's were used. If ratings assigned S&P and Moody's were not equivalent, securities were categorized in this table based upon the rating assigned by S&P. Bonds not rated by S&P or Moody's are classified for the purpose of the table according to the rating assigned to them by the NAIC as follows: NAIC class 1 is included in the "A" rating; class 2 in "BBB" and class 3 through 6, "BB or below".
(3) Carrying amount is market value. The amortized cost of available for sale securities at December 31, 2001 was $1,308.8 million.
(4) Carrying amount is market value. The amortized cost of trading securities at December 31, 2001 was $57.7 million.
The Company continually reviews its non-investment grade debt securities (NAIC designations 3 through 6) for evidence of declines in value which are other than temporary. The Company does not anticipate any material increase in its investments in non-investment grade debt securities. At December 31, 2001, the Company's investment portfolio contained no securities which were in default as to principal or interest.
The Company maintains a mortgage-backed securities ("MBS") portfolio, which consists of "pass-through" obligations and collateralized mortgage obligations ("CMOs"). Approximately 90% of the MBS portfolio consists of securities or pools of securities either guaranteed by the U.S. government (including those issued by Government National Mortgage Association), or those issued by Federal National Mortgage Association and Federal Home Loan Mortgage Corporation.
At December 31, 2001, the Company's investment portfolio included $269.9 million of mortgage loans, which were collateralized primarily by multi-family apartments, office buildings and retail properties located in 27 states. Approximately 24% of the portfolio consisted of multi-family apartments, 26% consisted of office buildings, 28% consisted of industrial properties and 22% consisted of other types of properties. At December 31, 2001, approximately 13% of the mortgage loan portfolio was secured by properties in Texas, 18% by properties in Missouri, 9% by properties in Connecticut and 8% by properties in California and Florida. No more than 8% of the remaining portfolio was secured by properties in any one state.
At December 31, 2001, 0.2% of the mortgage loan portfolio consisted of loans with balloon payments that mature before January 1, 2003. At December 31, 2001, the Company had no mortgage loans delinquent by more than 90 days. There were no loans foreclosed upon and transferred to real estate owned in the Company's consolidated balance sheet at December 31, 2001. The favorable default experience is principally attributable to the Company's selectivity in the purchase of mortgages in connection with acquisitions of its life insurance subsidiaries and in its origination of new mortgage loans. In light of the current interest rate environment, the Company may experience prepayments on its mortgage loan portfolio, thus reducing its yield on such portfolio. The Company plans to continue applying its historical underwriting standards to future investments in mortgage loans.
Litigation. The Company and its subsidiaries are named in numerous pending actions as more fully described in "Legal Proceedings". Although plaintiffs in these actions generally are seeking indeterminate amounts, including punitive and treble damages, such amounts could be large. Although there can be no assurances, at the present time the Company does not anticipate that the ultimate liability arising from such pending litigation, after consideration of amounts provided in the consolidated financial statements, will have a material adverse effect on the financial condition of the Company. However, in light of the indeterminate amounts sought in such matters and the inherent unpredictability of legal proceedings, it is possible that an adverse outcome in any one or more of these matters could have a material adverse effect on the Company's operating results and cash flows in particular quarterly or annual periods.
Because of the restrictions described above under "Financial Condition and Liquidity-Liquidity" which are applicable to surplus debentures and the restrictions imposed by holding company statutes, an adverse outcome in the litigation referred to above could affect the ability of one or more of the Company's insurance subsidiaries to pay dividends or, in the case of United Fidelity, make payments under its surplus debentures to the Company. Further, were a subsidiary to suffer an adverse outcome, the Company might need to contribute capital to such subsidiary so that it could continue to maintain applicable statutory surplus and risk-based capital requirements. See "Business-Regulation-General Regulation and Risk-Based Capital Requirements". Because the Company is a holding company whose own cash and cash equivalents are limited, the Company might have to dispose of some of its assets in order to address a significant judgment suffered by it or one of its subsidiaries. Also, an adverse outcome could affect ratings which the Company's subsidiaries receive from rating agencies, which could affect their ability to compete. See "Business - -Competition and Ratings".
As part of its asset-liability management process, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under various interest rate scenarios. With the results of these computer-generated simulations, the Company can measure the potential gain or loss in fair value of its interest-rate sensitive instruments and seek to protect its economic value and achieve a predictable spread between what it earns on its invested assets and what it pays on its liabilities. At December 31, 2001, the Company's assets had an effective duration of 5.2 and its liabilities had an effective duration of 5.5. If interest rates were to decrease 10% from December 31, 2001 levels, the increase in the value of the Company's liabilities would exceed the increase in the value of the Company's assets by approximately $20 million. Because the Company actively manages its assets and liabilities and has developed strategies to reduce its exposure to loss as interest rate changes occur, it expects that actual losses would be less than the estimated potential loss.
The Company manages its exposure to changes in the fair value of EIA embedded derivatives by purchasing exchange-traded and over-the-counter indexed call options and futures contracts on the same external indices. Neither these assets nor the related EIA embedded derivatives are eligible for hedge accounting treatment under SFAS No. 133. The Company recognizes the change in fair values of these assets as a component of net investment income.
SFAS No. 142 supersedes the current accounting guidance for goodwill and intangible assets. Under SFAS No. 142, goodwill and indefinite-lived intangible assets will no longer be amortized but will be reviewed for impairment. Intangible assets with finite lives will continue to be amortized over their useful lives. The amortization provisions of SFAS No. 142 apply to goodwill and intangible assets acquired after June 30, 2001. For all other goodwill and intangible assets, the amortization provisions are effective upon adoption of SFAS No. 142. The impairment provisions of SFAS No. 142 are effective upon adoption of the statement. Adoption of SFAS No. 142 is required as of the beginning of fiscal years beginning after December 15, 2001. The Company does not expect that adoption of SFAS No. 142 will have a significant effect on its consolidated financial position or results of operations.
The FASB has also recently issued SFAS No. 143 "Accounting for Asset Retirement Obligations" and SFAS No. 144 "Accounting for Impairment or Disposal of Long-Lived Assets." SFAS No. 143 requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obligations are incurred. The liability is initially measured at fair value and the cost is capitalized by increasing the carrying amount of the related long-lived asset. SFAS No. 143 will be effective for financial statements for fiscal years beginning after June 15, 2002. The Company does not own long-lived assets of the type that will generally create retirement obligations. Therefore, adoption of SFAS No. 143 will not affect the Company's consolidated financial statements.