The Company owns an office complex in Springfield, Illinois, which houses the primary insurance operations. The office buildings in this complex contain 57,000 square feet of office and warehouse space, and are carried at $1,525,958. The facilities occupied by the Company are adequate relative to the Company's present operations.
The purpose of this section is to discuss and analyze the Company's consolidated results of operations, financial condition and liquidity and capital resources for the two years ended December 31, 2011. This analysis should be read in conjunction with the consolidated financial statements and related notes, which appear elsewhere in this report. The Company reports financial results on a consolidated basis. The consolidated financial statements include the accounts of UTG and its subsidiaries at December 31, 2011.
The Company accounts for its investments in debt and equity securities pursuant to FASB Codification 320-10 section 5, 15, 25, 30, 35, 45, 50, and 55 and 942-10 section 50, Accounting for Certain Investments in Debt and Equity Securities. The Company has classified all of its investments as available-for-sale with the exception of certain securities classified as trading securities. Available-for-sale investments are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss) in the Consolidated Balance Sheets for available-for-sale securities. Trading securities are carried at fair value with unrealized gains and losses reported in income in the Consolidated Statements of Operations. Premiums and discounts on debt securities purchased at other than par value are amortized and accreted, respectively, to interest income in the Consolidated Statements of Operations, using the constant yield method over the period to maturity. Net realized gains and losses on investments are computed using the specific identification method and are reported in the Consolidated Statements of Operations.
Net investment income decreased approximately 55% when comparing 2011 to 2010. The overall gross investment yields for 2011 and 2010 are 5.66% and 9.82%, respectively. The majority of the decrease in investment income is from the Company’s trading securities and discount mortgage loan portfolio. Approximately $8,232,000, of gross investment income is attributable to the discount mortgage loan portfolio, including $3,940,000 in discount accruals which declined from $12,898,000 in 2010. The Company reported a loss of $2,342,000 from the shift in trading securities during the year compared to income of $5,131,000 from a year ago. Trading securities are discussed in more detail below.
While management believes the discounted loans will continue to have favorable earnings and outcomes as they are worked through, there can be no assurance this will remain true in future periods. Changes in the current economy such as an even greater downturn than recently experienced could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. As such, management has taken a conservative approach with these investments and has classified all discounted mortgage loans held as non-accrual. In such status, the Company is recording interest income on a cash basis and is recording any accrual of discount on the loans held when realized. Discount accruals reported during 2011 were the result of the loan basis already being fully paid.
In mid August 2011, the investment market took a sudden sharp decline. The U.S. debt ratings were lowered and concerns of European nations’ debt and potential defaults were in the forefront. During this time, certain of the Company’s trading securities were also negatively impacted resulting in losses of approximately $7.1 million during the second half of 2011. These losses primarily resulted from holdings relating to market volatility and options relating to U.S. Treasury securities. The Company had a positive earnings track record in its trading securities accounts up until this point.
Management continues to view the Company’s investment portfolio with utmost priority. Significant time has been spent internally researching the Company’s risk and communicating with outside investment advisors about the current investment environment and ways to ensure preservation of capital and mitigate any losses. Management has put extensive efforts into evaluating the investment holdings. Additionally, members of the Company’s board of directors and investment committee have been solicited for advice and provided with information. Management has reviewed the Company’s entire portfolio on a security level basis to be sure all understand our holdings, potential risks and underlying credit supporting the investments. Management intends to continue its close monitoring of its bond holdings and other investments for additional deterioration or market condition changes. Future events may result in Management’s determination that certain current investment holdings may need to be sold which could result in gains or losses in future periods. Such future events could also result in other than temporary declines in value that could result in future period impairment losses.
In summary, the Company’s basis for future revenue growth is expected to come from the following primary sources: expansion of TPA revenues, conservation of business currently in force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources and products offered to enhance these opportunities.
Net amortization of cost of insurance acquired decreased 7% in 2011 compared to 2010. Cost of insurance acquired is established when an insurance company is acquired. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. The cost of policies purchased represents the actuarially determined present value of the projected future profits from the acquired policies. Cost of insurance acquired is comprised of individual life insurance products including whole life, interest sensitive whole life and universal life insurance products. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The Company utilizes a 12% discount rate on the remaining unamortized business. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. Persistency is a measure of insurance in force retained in relation to the previous year. The Company's average persistency rate for all policies in force for 2011 and 2010 has been approximately 95.8% and 96.0%, respectively. The Company monitors these projections to determine the adequacy of present values assigned to future profits. No impairments were recorded in the periods reported.
Operating expenses increased approximately 4% in 2011 compared to 2010. Management continues to place significant emphasis on expense monitoring and cost containment. Maintaining administrative efficiencies directly impacts net income.
Interest expense decreased approximately 14% during 2011 compared to 2010. This decrease is the result of a lower outstanding balance of debt as well as the general decline in interest rates. The Company made principal payments of $3,600,000 during 2011 on its long-term debt to FTN Financial. During 2010, the Company made principal payments of $3,600,351. The loan matures on December 7, 2012 with a final principal payment due of $3,291,411.
At December 31, 2011, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. The Company has identified securities it may sell and classified them as "investments held for sale". Investments held for sale are carried at market, with changes in market value charged directly to shareholders' equity. To provide additional flexibility and liquidity, the Company has categorized all fixed maturity investments as “investments held for sale”.
The following table summarizes the Company's fixed maturities distribution at December 31, 2011 and 2010 by ratings category as issued by Standard and Poor's, a leading ratings analyst.
In recent periods there have been significant downgrades to many bond issues outstanding including a downgrade of U.S. issued debt during 2011. During the fourth quarter of 2011, the Company took advantage of the unusually high price spreads on U.S. government treasury securities relative to other types of bonds in the marketplace, by selling a portion of its U.S. treasury holdings realizing gains of approximately $6,412,000. The Company began re-deploying its excess cash balances into BBB and BB rated corporate debt issues. Interest spreads on these investments are higher than historic trends and Management believes this is an opportunity to enhance yield and provide more recurring investment income. Lower rated bonds are viewed by the marketplace to inherently hold more risk. The trade-off on this risk is a higher interest yield. Each investment is analyzed prior to acquisition to determine if Management is comfortable with the increased risk relative to the yield. Management believes there are opportunities currently available in this area where certain corporate bond issues have been more harshly impacted by the marketplace than may really be justified. It is this type of bond Management is primarily searching for to invest in.
Mortgage loan investments represent 8% and 14% of total assets of the Company at year-end 2011 and 2010, respectively. A significant portion of the Company’s mortgage loan investments result from opportunities available through FSNB, an affiliate of Mr. Jesse T. Correll. Mr. Correll is the CEO and Chairman of the Board of Directors of UTG, and directly and indirectly through affiliates, its largest shareholder. FSNB has been able to provide the Company with additional expertise and experience in underwriting commercial and residential mortgage loans, which provide more attractive yields than the traditional bond market. FSNB services all the mortgage loans of the Company. The majority of this amount was in the form of loans purchased at a discount from failed banks. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan amount to cover costs incurred by FSNB relating to the processing and establishment of the loan. The Company paid $136,457 and $190,297 in servicing fees and $89,651 and $508,283 in origination fees to FSNB during 2011 and 2010, respectively.
Sub-prime mortgage lending has received significant attention. Default rates have risen sharply on these loans causing a negative impact in the economy in general. While the Company does not have a material direct exposure to sub-prime mortgage loans, the Company could still be negatively impacted indirectly primarily through fixed maturity holdings in financial institutions that do have sub-prime loan exposures. Declines in values relating to such entities will negatively impact the Company through unrealized investment losses. Should any of these entities declare bankruptcy, the Company would then report a realized loss on its investment. Management monitors events relating to this topic.
Total investment real estate holdings represent approximately 14% and 12% of the total assets of the Company, net of accumulated depreciation, at year-end 2011 and 2010, respectively. The Company has transferred several investments to real estate in the past year. The gain on real estate is mainly attributable to the sale of timber from Cumberland Woodlands of approximately $6,313,000, which is a one-time event. Expected returns on these investments exceed those available in fixed income securities. However, these returns may not always be as steady or predictable.
Cost of insurance acquired decreased approximately 9% in 2011 compared to 2010. When an insurance company is acquired, the Company assigns a portion of its cost to the right to receive future cash flows from insurance contracts existing at the date of the acquisition. The cost of policies purchased represents the actuarially determined present value of the projected future cash flows from the acquired policies. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. In 2011 and 2010, amortization decreased the asset by $1,231,015 and $1,324,731, respectively. No impairments of this asset were recorded for the periods presented.
On November 14, 2011, ACAP was merged into UTG. Under the terms of the merger, ACAP shareholders received shares of UTG in exchange for their ACAP shares. ACAP was a 73% owned subsidiary of UG. The merger reduced the corporate structure and provided certain efficiencies and economies to the Companies.
The Company is currently in the process of merging its two life companies, American Capitol Insurance Company and Universal Guaranty Life Insurance Company.
At December 31, 2011, the Company has outstanding notes payable of $9,531,645 as compared to $10,372,239 a year ago. Approximately $3,290,000 of this debt is related to the acquisition of ACAP Corporation. The Company has four lines of credit available for operating liquidity or acquisitions of additional lines of business. The outstanding balances on these lines of credit were $6,000,000 and $2,290,000 as of December 31, 2011 and 2010, respectively. The Company's debt is discussed in more detail in Note 12 to the consolidated financial statements.
A portion of the Company’s funds has been dedicated to an experienced team of market professionals with the goal of grinding out a reasonable return with lower overall volatility and reduced risk. The portfolio contains exchange traded equities and options which have been classified as trading securities on the balance sheet.
Total shareholders' equity increased approximately 16% in 2011 compared to 2010. This increase is primarily due to the net income of $6,316,615 for the year as well as unrealized gains included in other comprehensive income.
The Company has three principal needs for cash - the insurance companies’ contractual obligations to policyholders, the payment of operating expenses and servicing its outstanding debt. Cash and cash equivalents as a percentage of total assets were 19% and 4% as of December 31, 2011 and 2010. Fixed maturities as a percentage of total invested assets were 47% and 45% as of December 31, 2011 and 2010, respectively.
Cash used in operating activities was $(10,487,204) and $(2,986,295) in 2011 and 2010, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years. As such, premium revenues continue to decline. Management anticipates future cashflows from operations to remain similar to historic trends.
Net cash used in financing activities was $(3,921,255) and $(4,542,564) for 2011 and 2010, respectively. Cash used in financing activities during both years was primarily the result of debt reduction.
On December 8, 2006, UTG borrowed funds from First Tennessee Bank National Association through execution of an $18,000,000 promissory note. The note is secured by the pledge of 100% of the common stock of UG. The promissory note carries a variable rate of interest based on the 3 month LIBOR rate plus 180 basis points. Interest is payable quarterly. Principal is payable annually beginning at the end of the second year in five installments of $3,600,000. The loan matures on December 7, 2012. The Company made principal payments of $3,600,000 during 2011. During 2010, the Company made principal payments of $3,600,351. At December 31, 2011 and 2010, the outstanding principal balance on this debt was $3,291,411 and $6,891,411, respectively.
In November 2007, the Company became a member of the Federal Home Loan Bank (FHLB). This membership allows the Company access to additional credit up to a maximum of 50% of the total assets of UG. To be a member of the FHLB, UG was required to purchase shares of common stock of FHLB. Borrowing capacity is based on 50 times each dollar of stock acquired in FHLB above the "base membership" amount. UG's current line of credit with the FHLB is $15,000,000. During 2011, UG had borrowings of $0 against this line of credit and repayments of $2,000,000. During 2010, UG had borrowings of $2,000,000 and repayments of $0 at a rate of 0.25%. At December 31, 2011 and 2010, the outstanding principal balance on this debt was $0 and $2,000,000, respectively.
In June 2006, the Company renewed a five-year contract for services related to its purchase of the “ID3” software system. This contract was replaced effective May 28, 2011. The new contract provides for a lifetime license for the ID3 system but obligates the Company, for a three year period, to pay $28,250 per month for hosting services; and to pay $8,666 per month for maintenance, for a five year period. While the contract allows the Company to exit either obligation early, substantial penalties would be incurred.
Most states also have insurance holding company statutes, which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. The insurance subsidiaries are subject to such legislation and registered as controlled insurers in those jurisdictions in which such registration is required. Statutes vary from state to state but typically require periodic disclosure, concerning the corporation that controls the registered insurers and all subsidiaries of such corporation. In addition, prior notice to, or approval by, the state insurance commission of material inter-corporate transfers of assets, reinsurance agreements, management agreements (see Note 9 to the consolidated financial statements), and payment of dividends (see Note 3 to the consolidated financial statements) in excess of specified amounts by the insurance subsidiaries, within the holding company system, are required.
At year-end 2011, UG had one ratio outside the normal range. AC had four ratios outside the normal range. Each of the ratios outside the normal range was anticipated by Management. UG’s ratio relates to the Company’s affiliated investments. The Company has made investments in real estate projects, which have been consolidated into these financial statements through limited liability companies. The limited liability companies were created to provide additional risk protection to the Company. AC’s ratios outside the normal range relate to net change in capital and surplus, gross change in capital and surplus, net income to total income and change in asset mix. The Company’s unrealized gains shifted to unrealized losses during 2011 contributing to the drop in capital and surplus. The drop in the net income to total income ratio is the result of the net loss recognized and drop in total income compared to 2010. AC sold bonds and held a large cash balance at year end 2011 compared to a much lower cash balance at year end 2010.
At December 31, 2011, UG has a ratio of approximately 3.7, which is 370% of the authorized control level. AC’s ratio is approximately 7.0, which is 700% of the authorized control level. Accordingly, both companies meet the RBC requirements.
On July 30, 2002, President Bush signed into law the “SARBANES-OXLEY” Act of 2002 (“the Act”). This Law, enacted in response to several high-profile business failures, was developed to provide meaningful reforms that protect the public interest and restore confidence in the reporting practices of publicly traded companies. The implications of the Act to public companies, (which includes UTG) are vast, widespread, and evolving. The Company has implemented requirements affecting the current reporting period, and is continually monitoring, evaluating, and planning implementation of requirements that will need to be taken into account in future reporting periods. As part of the implementing these requirements, the Company has developed a compliance plan, which includes documentation, evaluation and testing of key financial reporting controls.
In December 2011, Accounting Standards Board (“FASB”) issued the Accounting Standards Update (“ASU”) No 2011-12 Comprehensive Income (Topic 220) Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. In order to defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this Update supersede certain pending paragraphs in Update 2011-05. The amendments are being made to allow the Board time to re-deliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the Board is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before Update 2011-05. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company does not expect the adoption of ASU 2011-12 to have a material impact on its consolidated financial statements.
In December 2011, FASB issued the ASU No. 2011-10 Property, Plant, and Equipment (Topic 360) Derecognition of in Substance Real Estate-a Scope Clarification. Under the amendments in this Update, when a parent (reporting entity) ceases to have a controlling financial interest (as described in Subtopic 810-10) in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt, the reporting entity should apply the guidance in Subtopic 360-20 to determine whether it should deregognize the in substance real estate. Generally, a reporting entity would not satisfy the requirements to derecognize the in substance real estate before the legal transfer of the real estate to the lender and the extinguishment of the related nonrecourse indebtedness. That is, even if the reporting entity ceases to have a controlling financial interest under Subtopic 810-10, the reporting entity would continue to include the real estate, debt, and the results of the subsidiary’s operations in its consolidated financial statements until legal title to the real estate is transferred to legally satisfy the debt. The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2012. The Company does not expect the adoption of ASU 2011-10 to have a material impact on its consolidated financial statements.
In June 2011, the FASB issued the ASU No. 2011-05 Comprehensive Income (Topic 220) Presentation of Comprehensive Income. Under the amendments to Topic 220, Comprehensive Income, in this Update, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. Regardless of whether an entity chooses to present comprehensive income in a single continuous statement or in two separate but consecutive statements, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The amendments in this Update should be applied retrospectively. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company does not expect the adoption of ASU 2011-05 to have a material impact on its consolidated financial statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Common stock - no par value, stated value $.001 per share.
UTG and its subsidiaries are collectively referred to as (“The Company”). The Company’s significant accounting policies are summarized as follows.
Trading securities - at fair value, with gains or losses resulting from changes in fair value recognized in earnings. Trading securities include exchange traded equities, exchange traded equity options, and futures.
Mortgage loans on real estate - at unpaid principal balances, adjusted for amortization of premium or discount and valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected.
Discounted mortgage loans - during 2010 and 2011, the Company purchased non-performing loans at a deep discount through an auction process led by the federal government. In general, the discounted loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted loans at its original purchase price. Management works the loans with the borrower to reach a settlement on the loan or they foreclose on the underlying collateral which is primarily commercial real estate. For cash payments received during the work out process, the Company records these payments to interest income on a cash basis. For loan settlements reached, the Company records the amount in excess of the carrying amount of the loan as a discount accretion to investment income at the closing date. Management reviews the discount loan portfolio regularly for impairment. If an impairment is identified (after consideration of the underlying collateral), the Company records an impairment to earnings in the period the information becomes known.
With each reporting period, management reviews its investment portfolio for securities whose value has declined below amortized cost to assess whether the decline is other than temporary. Included in the analysis are considerations of the severity and duration of the decline in fair value, the length of time expected to recover, the financial condition of the issuer, and whether the Company either plans to sell the security or it is more-likely-than-not that it will be required to sell the security before recovery of its amortized cost. If there is deemed to be an other than temporary decline in the value of any individual equity security, the Company reclassifies the associated net unrealized loss out of accumulated other comprehensive income with a corresponding charge to investment income. For debt securities available for sale that are determined to have an other than temporary impairment (“OTTI”), the credit component of the OTTI is recognized in earnings and the non-credit component is recognized in accumulated other comprehensive income (loss) in situations where the Company does not intend to sell the security and it is more-likely-than-not that the Company will not be required to sell the security.
For financial reinsurance arrangements, the Company reports the initial ceding commission received as an “other liability” on its financial statements. Financial results in subsequent periods are reported in the various line items of the income statement as with other reinsurance agreements, with the repayment amount reported in the line item “amortization of DAC”. The net impact to the statement of operations in any subsequent period represents the fees paid to the reinsurer on the current outstanding balance of the initial ceding commission.
INCOME TAXES - Income taxes are reported Pursuant to FASB Codification 740-10. Deferred income taxes are recorded to reflect the tax consequences on future periods of differences between the tax bases of assets and liabilities and their financial reporting amounts at the end of each period. The principal assets and liabilities giving rise to such differences are deferred policy acquisition costs, differences in tax basis of invested assets, cost of insurance acquired, future policy benefits, and gains on the sale of subsidiaries.
EARNINGS PER SHARE - Earnings per share (EPS) are reported pursuant to FASB Codification 260-10. The objective of both basic EPS and diluted EPS is to measure the performance of an entity over the reporting period. Basic EPS is computed by dividing net income/(loss) attributable to common shares (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. In addition, the numerator also is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares.
IMPAIRMENT OF LONG LIVED ASSETS - The Company evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long lived assets may warrant revision or that the remaining balance of an asset may not be recoverable. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. During 2011, other-than-temporary impairments of $3,360,430 were taken on real estate as a result of appraisal valuations and management’s analysis and determination of value. During 2011, other-than-temporary impairments of $982,354 were taken on mortgage loans as a result of appraisal valuations and management’s analysis and determination of value.
In December 2011, FASB issued the ASU No. 2011-11 Balance Sheet (Topic 210) Disclosure about Offsetting Assets and Liabilities. The amendments in this Update require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company does not expect the adoption of ASU 2011-11 to have a material impact on its consolidated financial statements.
In December 2011, FASB issued the ASU No. 2011-10 Property, Plant, and Equipment (Topic 360) Derecognition of in Substance Real Estate-a Scope Clarification. Under the amendments in this Update, when a parent (reporting entity) ceases to have a controlling financial interest (as described in Subtopic 810-10) in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt, the reporting entity should apply the guidance in Subtopic 360-20 to determine whether it should derecognize the in substance real estate. Generally, a reporting entity would not satisfy the requirements to derecognize the in substance real estate before the legal transfer of the real estate to the lender and the extinguishment of the related nonrecourse indebtedness. That is, even if the reporting entity ceases to have a controlling financial interest under Subtopic 810-10, the reporting entity would continue to include the real estate, debt, and the results of the subsidiary’s operations in its consolidated financial statements until legal title to the real estate is transferred to legally satisfy the debt. The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2012. The Company does not expect the adoption of ASU 2011-10 to have a material impact on its consolidated financial statements.
In September 2011, FASB issued the ASU No. 2011-08 Intangibles - Goodwill and Other (Topic 350) Testing Goodwill for Impairment. Under the amendments in this Update, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit, as described in paragraph ASC 350-20-35-4. If the carrying amount of a reporting unit exceeds its fair value, then the entity is required to perform the second step of the goodwill impairment test to measure the amount of the impairment loss, if any, as described in paragraph ASC 350-20-35-9. Under the amendments in this Update, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company does not expect the adoption of ASU 2011-08 to have a material impact on its consolidated financial statements.
FASB ASC Topic 740-10 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The recognition threshold is based on a determination of whether it is more likely than not that a tax position will be sustained upon examination based on the technical merits of the position. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized. Management believes the Company has no material uncertain income tax provisions at December 31, 2011 or 2010.
The Company’s Federal income tax returns are periodically audited by the Internal Revenue Service (“IRS”). In February 2011, the federal income tax return for 2009 of UTG underwent an IRS examination. The examination was closed with no adjustments to the return. There is no examination ongoing currently, nor is management aware of any pending examination by the IRS. 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 consolidated financial statements for any potential assessments that may result from future tax examinations and other tax-related matters for all open tax years.
At December 31, 2011 and 2010, respectively, the Company had gross deferred tax assets of $2,879,079 and $3,243,631, and gross deferred tax liabilities of $16,624,830 and $16,624,909, resulting from temporary differences primarily related to the life insurance subsidiaries. Allowances are established as a result of uncertainty in the Company’s ability to utilize the loss carryforwards which is dependent on generating sufficient taxable income prior to expiration of the loss carryforward. The Company has not experienced any reductions of deferred tax assets due to the lapse of applicable statute of limitations.
The Company regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Based on an evaluation of the issues, including, but not limited to, intentions to sell or ability to hold the fixed maturity and equity securities with unrealized losses for a period of time sufficient for them to recover; the length of time and amount of the unrealized loss; and the credit ratings of the issuers of the investments, the Company held nineteen investments and six investments as other-than-temporarily impaired at December 31, 2011 and 2010, respectively. The other-than-temporary impairments during 2011 were due to appraisal valuations and Management’s analysis of discounted mortgage loans and real estate. The other-than-temporary impairments during 2010 were due to changes in expected future cash flows of investments in stocks as well as in bonds backed by trust preferred securities of banks. In addition, the Company recognized an other-than-temporary impairment in a mortgage loan as a result of its appraisal valuation. The other-than-temporary impairments are detailed below:
Securities designated as trading securities are reported at fair value, with gains or losses resulting from changes in fair value recognized in net investment income on the consolidated statements of operations. Trading securities include exchange traded equities, exchange traded equity options, and futures. The fair value of trading securities included in assets was $8,519,064 and $37,029,550 as of December 31, 2011 and 2010, respectively. The fair value of trading securities included in liabilities was $(5,471,475) and $(18,429,677) as of December 31, 2011 and 2010, respectively. Trading securities’ unrealized gains were $4,319,155 and $5,574,151 as of December 31, 2011 and 2010, respectively. Unrealized losses due to trading securities were $(4,130,240) and $(3,770,422) as of December 31, 2011 and 2010, respectively. Trading securities carried as liabilities are securities sold short. A gain, limited to the price at which the security was sold short, or a loss, potentially unlimited in size, will be recognized upon the termination of the short sale. Realized gains and (losses) from trading securities were $(3,464,352) and $184,546 for the year ended December 31, 2011 and 2010, respectively. Trading securities are classified in cash flows from operating activities. Trading revenue charged to net income from trading securities was:
MORTGAGE LOANS - The Company has in place a monitoring system to provide management with information regarding potential troubled loans. Letters are sent to each mortgagee when the loan becomes 30 days or more delinquent. Management is provided with a monthly listing of loans that are 60 days or more past due along with a brief description of what steps are being taken to resolve the delinquency. All loans 90 days or more past due are placed on a non-performing status and classified as delinquent loans. Quarterly, coinciding with external financial reporting, the Company reviews each delinquent loan and determines how each delinquent loan should be classified. Interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status. Management believes the current internal controls surrounding the mortgage loan selection process provide a quality portfolio with minimal risk of foreclosure and/or negative financial impact. There are no mortgage loans past due as of December 31, 2011 or 2010.
REAL ESTATE - Real estate acquired through foreclosure, consisting of properties obtained through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, is reported on an individual asset basis at the lower of cost or fair value, less disposal costs. Fair value is determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. When properties are acquired through foreclosure, any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is recognized and charged to the income statement. Based upon management’s evaluation of the real estate acquired through foreclosure, additional expense is recorded when necessary in an amount sufficient to reflect any declines in estimated fair value. Gains and losses recognized on the disposition of the properties are recorded as realized gains and losses in the consolidated statements of income.
As is customary in the insurance industry, the insurance subsidiaries cede insurance to, and assume insurance from, other insurance companies under reinsurance agreements. Reinsurance agreements are intended to limit a life insurer's maximum loss on a large or unusually hazardous risk or to obtain a greater diversification of risk. The ceding insurance company remains primarily liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. However, it is the practice of insurers to reduce their exposure to loss to the extent that they have been reinsured with other insurance companies. The Company sets a limit on the amount of insurance retained on the life of any one person. The Company will not retain more than $125,000, including accidental death benefits, on any one life. At December 31, 2011, the Company had gross insurance in force of $1.663 billion of which approximately $401 million was ceded to reinsurers.
Currently, UG is utilizing reinsurance agreements with Optimum Re Insurance Company, (Optimum) and Swiss Re Life and Health America Incorporated (SWISS RE). Optimum and SWISS RE currently hold an “A-” (Excellent) and "A+" (Superior) rating, respectively, from A.M. Best, an industry rating company. The reinsurance agreements were effective December 1, 1993, and covered most new business of UG. Under the terms of the agreements, UG cedes risk amounts above its retention limit of $100,000 with a minimum cession of $25,000. Ceded amounts are shared equally between the two reinsurers on a yearly renewable term (YRT) basis, a common industry method. The treaty is self-administered; meaning the Company records the reinsurance results and reports them to the reinsurers.
On September 30, 1998, UG entered into a coinsurance agreement with The Independent Order of Vikings, (IOV) an Illinois fraternal benefit society. Under the terms of the agreement, UG agreed to assume, on a coinsurance basis, 25% of the reserves and liabilities arising from all in-force insurance contracts issued by the IOV to its members. At December 31, 2011, the IOV insurance in-force assumed by UG was approximately $1,582,000, with reserves being held on that amount of approximately $365,000.
On June 7, 2000, UG assumed an already existing coinsurance agreement, dated January 1, 1992, between Lancaster Life Reinsurance Company (LLRC), an Arizona corporation and Investors Heritage Life Insurance Company (IHL), a corporation organized under the laws of the Commonwealth of Kentucky. Under the terms of the agreement, LLRC agreed to assume from IHL a 90% quota share of new issues of credit life and accident and health policies that have been written on or after January 1, 1992 through various branches of the First Southern National Bank. The maximum amount of credit life insurance that can be assumed on any one individual’s life is $15,000. UG assumed all the rights and obligations formerly held by LLRC as the reinsurer in the agreement. LLRC liquidated its charter immediately following the transfer. At December 31, 2011, the IHL agreement has insurance in-force of approximately $711,000, with reserves being held on that amount of approximately $9,000.
During 2010, the Company committed to invest up to $2,000,000 in Llano Music, LLC, which invests in music royalties. Llano does capital calls as funds are needed to acquire the royalty rights. At December 31, 2011, the Company has $1,646,000 committed that has not been requested by Llano.
On November 9, 2011, ACAP shareholders approved a proposed merger with UTG whereby ACAP shareholders received 233 shares of UTG for each share previously held of ACAP. On November 14, 2011, the merger was completed. Certain of the ACAP shareholders dissented to the merger requesting the courts determine the value of the ACAP shares. The legal case is currently in the discovery phase. The Company has established a contingent liability in its year end financial statements of $2,550,822 to conservatively cover the anticipated proceeds due to the dissenting shareholders and associated legal and other costs.
On February 20, 2003, UG purchased $4,000,000 of a trust preferred security offering issued by FSBI. The security has a mandatory redemption after 30 years with a call provision after 5 years. The security pays a quarterly dividend at a fixed rate of 6.515%. The Company received $264,219 of dividends in 2011 and 2010. On March 30, 2009, UG purchased $1,000,000 of FSBI common stock. The sale and transfer of this security is restricted by the provisions of a stock restriction and buy-sell agreement.
On November 14, 2011, the merger of UTG, Inc and ACAP took place. Shareholders of ACAP received shares of UTG in exchange for their ACAP shares. ACAP was a 73% owned subsidiary of UG. The merger reduced the corporate structure and provided certain efficiencies and economies to the Companies. All ACAP shareholders, other than UTG or UG, have the right to receive 233 shares of UTG common stock for each share of ACAP common stock they owned at closing. Under the terms of the exchange ratio, UTG issued 50,328 shares to former ACAP shareholders. An additional 129,548 UTG shares were not issued due to dissenting ACAP shareholders. See discussion in note 9 relating to the ACAP dissenting shareholders.
On September 28, 2011 UTG entered a joint ownership agreement with Bandyco, LLC and First Southern National Bank, for an 8.08% interest in an aircraft. Bandyco, LLC is affiliated with Ward, F Correll, who is a director of the Company. The Company was responsible for an initial payment of $150,000 on September 30, 2011, along with a $125,000 payment on October 30, 2011. The Company will pay a monthly operational fee of $25,000 starting in November 2011 and lasting through July 2013. The aircraft is issued for business related travel by various officers and employees of the Company. For years 2011 and 2010 UTG paid $392,227 and $308,362 for costs associated with the aircraft.
The Company from time to time acquires mortgage loans through participation agreements with FSNB. FSNB services the Company's mortgage loans including those covered by the participation agreements. The Company pays a .25% servicing fee on these loans and a onetime fee at loan origination of .50% of the original loan amount to cover costs incurred by FSNB relating to the processing and establishment of the loan. The Company paid $136,457 and $190,297 in servicing fees and $89,651 and $508,283 in origination fees to FSNB during 2011 and 2010, respectively.
The Company reimbursed expenses incurred by employees of FSNB relating to travel and other costs incurred on behalf of or relating to the Company. The Company paid $15,392 and $23,763 in 2011 and 2010, respectively to FSNB in reimbursement of such costs. In addition, the Company began reimbursing FSNB a portion of salaries and pension costs for Mr. Correll, Mr. Ditto and a third employee. The reimbursement was approved by the UTG Board of Directors and totaled $348,610 and $433,340 in 2011 and 2010, respectively, which included salaries and other benefits.
On November 14, 2011, ACAP was merged into UTG. The merger was a share exchange with ACAP shareholders receiving 233 UTG shares for each ACAP share held. UTG issued 50,328 shares of common stock under this transaction.
The following is a reconciliation of the numerators and denominators of the basic and diluted EPS computations as presented on the income statement.
On December 8, 2006, UTG borrowed funds from First Tennessee Bank National Association through execution of an $18,000,000 promissory note. The note is secured by the pledge of 100% of the common stock of UG. The promissory note carries a variable rate of interest based on the 3 month LIBOR rate plus 180 basis points. Interest is payable quarterly. Principal is payable annually beginning at the end of the second year in five installments of $3,600,000. The loan matures on December 7, 2012. The Company made principal payments of $3,600,000 and $3,600,351 during 2011 and 2010, respectively. At December 31, 2011 and 2010, the outstanding principal balance on this debt was $3,291,411 and $6,891,411, respectively.
On February 7, 2007, HPG Acquisitions ("HPG"), a 74% owned affiliate of the Company, borrowed funds from First National Bank of Midland, through execution of a $373,862 promissory note. The note is secured by real estate owned by the HPG. The note bears interest at a fixed rate of 5%. The first payment was due January 15, 2008. There will be 119 regular payments of $3,965 followed by one irregular last payment estimated at $44,125. HPG made repayments of $36,089 during 2011 and $34,804 during 2010. At December 31, 2011 and 2010, the outstanding principal balance was $240,234 and $276,323, respectively.
The consolidated scheduled principal reductions on the long-term notes payable for the next five years are as follows:
On a cash basis, the Company paid $251,791 and $295,223 in interest expense for the years 2011 and 2010, respectively. The Company paid $5,801,521 and $1,888,000 in federal income tax for 2011 and 2010, respectively. During 2011, the Company closed on an ACAP share for UTG share transaction. All ACAP shareholders, other than UTG or UG, have the right to receive 233 shares of UTG common stock for each share of ACAP common stock they owned at closing. Accordingly, the Company no longer reports a non-controlling interest component of equity for the minority ownership in ACAP. The difference between the carrying value of the non-controlling interest and the consideration received was recorded as a non-cash flow increase to additional paid-in capital of $4,100,000.
The Company reinsures that portion of insurance risk which is in excess of its retention limits. Retention limits range up to $125,000 per life. Life insurance ceded represented 24.1% of total life insurance in force at December 31, 2011. Insurance ceded represented 27.9% of premium income for 2011. The Company would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.