We conduct operations as an insurance holding company emphasizing ordinary life insurance products in niche markets where we believe we can achieve competitive advantages. Our core operations include issuing:
final expense and limited liability property policies to middle to lower income households in Louisiana and Arkansas through approximately 540 employee and independent agents in our home service distribution segment.
Life Insurance. For over the past 30 years, CICA and its predecessors have accepted policy applications from foreign nationals for U.S. Dollar-denominated ordinary whole life insurance. Traditionally, this market has been concentrated in the top 3-5% of the population of a country in terms of income and net worth. In recent years, however, there has been a shift to encompass a broader spectrum of the population, as upper middle classes develop in Latin America and the Pacific Rim. We make our insurance products available using third-party marketing organizations and independent marketing consultants. The number of our producing independent consultants has expanded over the years in this segment to approximately 2,200, and we received applications from residents of 34 countries outside of the U.S. in 2008. Historically, the majority of our international business has come from Latin America. However, in 2004 the Pacific Rim began to represent a meaningful and growing source of new business, and in 2008 was one of the leading sources of new premium income.
In 2008, our Life Insurance segment generated revenue of $105.5 million, which accounted for 71.9% of our total revenue. For the year ended December 31, 2007, this segment produced revenue of $114.8 million or 67.7% of our total revenue, compared to 2006 when it produced approximately $101.9 million or 66.1% of total revenue. The decrease in 2008 revenues was due to the write-down of $13.6 million of equity mutual funds in this segment. Our strategy in operating our Life Insurance segment is to increase new business written through our existing marketers as well as expand the number of countries from which we receive policy applications. The development of new markets in the Pacific Rim and the expansion of existing markets in Latin America were the primary contributors to the insurance revenue growth in this segment.
From time to time we will issue new products to stay abreast of changes in the market and in our clients. In 2008, CICA introduced a new set of international products, which caused new production of insurance from non-U.S. residents to slow in the first nine months of 2008 compared to the same period in 2007. This was due to our less than optimum introduction process and slower than anticipated acceptance of these new policies. However, the products were well accepted in the international market during the latter half of 2008, as fourth quarter new business production exceeded the prior year’s fourth quarter.
We also realize revenues from our investment portfolio. Life insurance companies earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid out under policies. Changes in interest rates, changes in economic conditions and volatility in the capital markets, such as the ones caused by our impairment of our equity mutual funds in 2008, can all impact the amount of earnings that we realize from our investment portfolio.
Home Service Insurance. Through our subsidiaries, SPLIC and ONLIC, we provide final expense ordinary life insurance to middle to lower income individuals in Louisiana and Arkansas. Our policies in this segment are sold and serviced through home service marketing distribution system utilizing employee-agents who work on a route system to collect premiums and service policyholders or through networks of funeral homes who collect premium and provide personal service to policyholders.
In 2008, SPLIC’s property insurance subsidiary, SPFIC, was negatively impacted by Hurricanes Gustav and Ike. Losses incurred by SPFIC were $500,000 for Hurricane Gustav and $285,000 for Hurricane Ike. The Company also incurred $478,000 in reinstatement premiums. During 2005, Hurricane Katrina devastated the Gulf Coast. Commencing in 2005 and through December 31, 2007, total incurred losses related to Hurricane Katrina not covered by reinsurance amounted to $4.0 million, resulting in SPLIC’s need to provide $4 million of additional capital to SPFIC. Legislative and judicial decrees further extended for an additional year the period for filing claims beyond that provided under SPFIC’s insurance contracts. Due to this extended claims filing period, an incurred but not reported claim and loss adjustment expense (LAE) liability of $500,000 was recorded at December 31, 2006 to cover any claims filed in 2007. When the extended deadline for filing of claims expired in the third quarter of 2007, SPFIC released approximately $425,000 of liabilities, which SPFIC determined were not payable under the contracts.
As discussed earlier, the Company completed the acquisition of ONLIC in the fourth quarter of 2008. ONLIC writes both final expense and home service ordinary life insurance in Arkansas and is included in the Home Service segment. As the income statement contains only two months of ONLIC operations, there is an insignificant impact upon revenue, expenses or net income. ONLIC increased the Home Service operation assets by $26.0 million and liabilities by $17.2 million.
We are exposed to a variety of risks, including the current financial recession as well as the credit crisis and corresponding potential changes in the fair value of our investments. Financial markets in the United States and elsewhere have experienced extreme volatility and disruption, due largely to stresses affecting the global banking system, which accelerated significantly in the second half of 2008. The global economies have entered a severe recession that is likely to persist well into and perhaps through and even beyond 2009, despite past and expected governmental intervention in the world’s major economies. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. The current economic environment could also reduce the persistency of our existing insurance policies.
In the fourth quarter of 2008, the Company completed its acquisition of ONLIC for $8.0 million and had additional acquisition related expenses of $900,000. The Company completed its acquisition of Integrity Capital Corporation in exchange for 1,292,000 shares of Citizens, Inc. Class A common stock in the first quarter of 2009. Integrity Capital Corporation is the parent of Integrity Capital Insurance Company, an Indiana life insurance company. The transaction was valued at $8.4 million when the transaction closed on February 27, 2009.
Increase in Fair Value of Warrants. As the market value of our Class A common stock increased during 2008, we incurred a loss on the increase in fair value of warrants of $2.7 million in 2008, compared to a gain of $828,000 in 2007 and a loss of $244,000 in 2006. The sizeable loss in 2008 was directly related to the increase in the price of our Class A common stock, as well as an increase in volatility. The warrant liability is calculated using the Black-Scholes option pricing model, which attempts to predict the value of the warrants when they expire in July 2011 and 2012. Current accounting standards require the change in the value of the warrant liability be recorded as a component of revenues. When the liability increases we incur a loss, and when the liability decreases we generate income. The warrant liability has no affect on the Company’s cash flows, as the Company expects the warrants will be converted into our Class A common stock in July 2011, or sooner, at the election of the warrant holders, or expire.
Claims and Surrenders. As noted in the table below, claims and surrenders increased 11.2% from $50.6 million in 2007 to $56.3 million in 2008. The 2008 increase primarily related to an increase in property claims in SPFIC from Hurricanes Gustav and Ike, as well as an increase in death claims, surrender expense and endowments.
Policy surrenders increased 10.0% in 2008 to $15.2 million from $13.8 million in 2007, up from $13.3 million in 2006. The increase in surrender expense is in line with management expectations, considering the inforce business has increased over the last three years. Surrenders as a percent of inforce business were 0.4% in 2008, 2007 and 2006.
Deferred Policy Acquisition Costs. Capitalized deferred policy acquisition costs (“DAC”) decreased 8.0% from $26.2 million in 2007 to $24.1 million in 2008. These costs were $27.0 million in 2006. The 2008 decrease from 2007 was primarily related to flat new life production discussed above, and tracked consistently with the slight increase in commissions. Amortization of these costs was $15.6 million, $12.5 million and $11.4 million in 2008, 2007 and 2006, respectively. Amortization is higher due to higher deaths and surrenders. In addition, the DAC asset has grown 8.4% since December 31, 2007, which resulted in higher amortization in 2008. Also, the write-off of DAC on internal replacements under the American Institute of Certified Public Accountants (AICPA) Statement of Position, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1), added $917,000 to amortization in 2007.
Analysis of goodwill for CNLIC, a reporting unit within the Life Insurance segment, showed it to be impaired at December 31, 2006. Due to significant declines in new business issued by CNLIC, the fair value of this reporting unit was below its carrying value. As a result, an impairment loss of $1.0 million was recognized in the fourth quarter of 2006. The fair value of that reporting unit was estimated using the present value of estimated future cash flows. The remaining goodwill is associated with CICA and ONLIC. At December 31, 2007 and 2008, there was no impairment of goodwill.
The administration of our investment portfolios is handled by our management, pursuant to board-approved investment guidelines, with all trading activity approved by a committee of the respective boards of directors of our insurance company subsidiaries. The guidelines used require that bonds, both government and corporate, are of high quality and comprise a majority of the investment portfolio. The assets selected are intended to mature in accordance with the average maturity of the insurance products and to provide the cash flow for our insurance company subsidiaries to meet their respective policyholder obligations.
At December 31, 2008, investments in fixed maturity and equity securities were 92.8% of our total investments. All of our fixed maturities were classified as available-for-sale securities at December 31, 2008 and thus are reported on our consolidated financial statements at fair value; equity securities are also reported at fair value. We had no fixed maturity or equity securities that were classified as trading securities at December 31, 2008.
Includes U.S. Treasury securities of $14,419,000 and U.S. Government-sponsored corporations of $281,062,000.
The effect of reinsurance on life insurance in force is as follows:
For calendar year 2006, SPFIC elected to increase the amount of first and second event catastrophe reinsurance to $10.0 million per event from $7.1 million and raise the retention level to $500,000 per event from $250,000, after the negative effects from Hurricane Katrina in 2005. Thus, the first $500,000 of incurred claims and any claims in excess of $10.0 million were SPLIC’s responsibility. The same reinsurance levels were in place for 2007 and 2008. The reinsurance premium for first event catastrophe reinsurance was $750,000 in 2008, $840,000 in 2007 and $799,000 in 2006. In 2008, SPFIC also paid reinsurance premiums in the amount of $478,000 for second and third event coverage due to Hurricanes Gustav and Ike.
The liquidity requirements of our Company are met primarily by funds provided from operations. Premium deposits and revenues, investment income and investment maturities are the primary sources of funds, while investment purchases, policy benefits, and operating expenses are the primary uses of funds. We historically have not had to liquidate investments to provide cash flow, but in 2008 SPFIC sold $237,000 of bonds because of liquidity needs as a result of Hurricanes Gustav and Ike. Also, during the first six months of 2006, SPFIC sold approximately $3.1 million of bonds in order to meet the cash outflow related to claims from Hurricanes Katrina and Rita. Our investments consist primarily of marketable debt securities that could be readily converted to cash for liquidity needs. See Note 9 of the “Notes to Consolidated Financial Statements” for a table disclosing our contractual obligations.
Stockholders’ equity at December 31, 2008 was $171.5 million compared to $176.2 million at December 31, 2007. The 2008 decrease was largely due to the OTTI loss on mutual funds during the period, offset by capital contributions from the Company’s preferred stock investors.
Investments decreased to $569.3 million at December 31, 2008 from $585.3 million at December 31, 2007. Invested assets decreased 2.7% during 2008, due to the decrease in values in the Company’s portfolio resulting from the overall market conditions; however, cash increased by $42.7 million. Fixed maturities are categorized into fixed maturities available-for-sale, which are carried in our consolidated financial statements at fair value. Fixed maturities available-for-sale were 85.2% of investments at December 31, 2008.
Policy loans comprised 5.1% of invested assets at December 31, 2008 compared to 4.4% at December 31, 2007. These loans, which are secured by the underlying policy values, have yields ranging from 5% to 12% and maturities that are related to the maturity or termination of the applicable policies. Management believes we maintain adequate liquidity despite the uncertain maturities of these loans.
Our cash balances at our primary depositories were significantly in excess of Federal Deposit Insurance Corporation coverage at December 31, 2008 and December 31, 2007. Management monitors the solvency of all financial institutions in which we have funds to minimize the exposure for loss. Management does not believe we are at significant risk for such a loss. During 2008, we intend to continue to utilize short term agencies and U.S. Treasuries as a cash management tool to minimize excess cash balances.
The NAIC has established minimum capital requirements in the form of Risk-Based Capital (“RBC”). Risk-based capital factors the type of business written by an insurance company, the quality of its assets, and various other aspects of an insurance company’s business to develop a minimum level of capital called “Authorized Control Level Risk-based Capital” and compares this level to an adjusted statutory capital that includes capital and surplus as reported under statutory accounting principles, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level risk-based capital fall below 200%, a series of actions by the affected company would begin. At December 31, 2008 and 2007, all of our insurance subsidiaries except ONLIC and SPFIC were above required minimum levels. The Company plans to contribute $1.0 million to both ONLIC and SPFIC to eliminate the RBC level of action. This plan is pending insurance department approval.
A recoverability test that considers, among other things, actual experience and projected future experience is performed at least annually. The annual recoverability test is based upon SFAS 60, paragraph 35. We estimate the discounted value of the cash flows using our liability assumptions. We then compare that to the policy liabilities and the deferred policy acquisition costs. Based upon the analysis performed to capitalize expenses that vary with and are directly related to the acquisition of new and renewal insurance business, utilization of the factor method and annual recoverability testing, management believes that our deferred policy acquisition costs and related amortization as of and for the years ended December 31, 2008, 2007 and 2006 limits the amount of deferred costs to its estimated realizable value.
One of the significant estimates related to available-for-sale securities is the evaluation of investments for other-than-temporary impairments. If a decline in the fair value of an available-for-sale security is judged to be other-than-temporary, a charge is recorded in net realized capital losses equal to the difference between the fair value and cost or amortized cost basis of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. The fair value of the other-than-temporarily impaired investment becomes its new cost basis. For fixed maturities, the Company accretes the new cost basis to par or to the estimated future cash flows over the expected remaining life of the security by adjusting the security’s yield.
Each quarter, during the Company’s analysis, the Company asserts its intent and ability to retain until recovery those securities judged to be temporarily impaired. Once identified, these securities are restricted from trading unless a valid reason exists. The Company will only authorize the sale of these securities based on predefined criteria that relate to events that could not have been reasonably foreseen. Examples of the criteria include, but are not limited to, the deterioration in an issuer’s creditworthiness, a change in regulatory requirements or a major business combination or major disposition.