The historical financial information for the five years ended December 31, 1999 and at December 31, 1999, 1998, 1997, 1996 and 1995 has been derived from the audited Consolidated Financial Statements of the Company. The selected consolidated financial data set forth below is qualified in its entirety by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K.
The volume of the Company's life insurance in force has increased 141% from $18.5 billion in 1989 to $44.5 billion in 1999. This growth has been the result of a combination of acquisitions, reinsurance assumed and new business written. Changes in the Company's volume of life insurance in force for the last three years is summarized in the following table.
Life insurance operations. Income before income taxes decreased $10.5 million from 1998 to 1999. This decrease in profits is primarily due to a $9.6 million increase in death benefits. Income before income taxes increased only slightly from 1998 and 1997.
Non-life insurance investments. Income before income taxes decreased $2.8 million from 1998 to 1999. The primary reason for the decrease is a $3.1 million decrease in net realized investment gains on the sale of investment properties in 1999 compared to 1998. Income before income taxes decreased $3.8 million from 1997 to 1998. The primary reasons for the decrease were (i) a decrease in income from Argus and (ii) a decrease in net realized investment gains on the sale of investment properties in 1998 compared to 1997.
Income before income taxes increased $4.2 million to $16.2 million in 1999. The primary reasons for the increase were (i) lower advisory and data processing fees paid to FHC and (ii) an increase in net realized gains, offset by (iii) a gain on the sale of Investors Guaranty in 1998, and (vi) higher death benefits in 1999. These items and significant changes in individual income statement components are discussed in more detail below.
The increased investment income related to the Company's bond portfolio is primarily due to an increase in assets owned resulting from assets acquired as part of the acquisition of the asset accumulation business in 1998. Assets related to the asset accumulation business also increased due to sales in the ARS division.
Net realized investment gains. Net realized investment gains totaled $4.2 million in 1999 compared with $8.3 million in 1998. The Company reported $0.9 million and $16.7 million of realized gains from the sale of fixed maturity investments held by the Reinsurer in 1999 and 1998, respectively. As described below, the sale of fixed maturity investments held by the Reinsurer resulted in increased amortization of cost of business acquired assets. Excluding the effects of these gains, the Company realized gains of $3.3 million in 1999 and realized losses of $8.4 million in 1998; this change in realized gains can be attributed to a $16.5 million increase in gains on common stock, offset by a $1.4 million decrease in gains on fixed maturity investments and $3.3 million of gains in 1998 related to real estate ventures.
Amortization expense. Amortization expense totaled $73.6 million in 1999 compared with $87.2 million in 1998. Amortization expense included $0.9 million and $16.7 million in 1999 and 1998, respectively, as a result of realized investment gains on the sale of fixed maturity investments held by the Reinsurer. The sale of these fixed maturity investments at a gain will reduce future investment income, requiring the recognition of additional amortization expense in the year of the realized gains. Excluding the effects of the sale of fixed maturity investments, amortization increased $2.2 million due to (i) an increase in amortization expense related to the Company's universal life insurance business, offset by (ii) a decrease in amortization expense related to a closed block of annuity business due to lower surrender charges in 1999.
During 1997, the Company entered into a transaction which impacted its results of operations. On April 15, 1997, Great Southern acquired all of the outstanding common stock of Ohio State and Investors Guaranty ("Ohio State Acquisition") from Farmers Group, Inc. On the acquisition date, Ohio State and Investors Guaranty had combined assets of $1,039 million and combined liabilities of $694 million. The acquisition was accounted for as a purchase. On April 16, 1997, Ohio State and Investors Guaranty entered into separate coinsurance agreements to reinsure 100% of their insurance liabilities to the Reinsurer in exchange for a ceding commission of $145.7 million. Concurrently, the Reinsurer and Great Southern entered into a modified coinsurance agreement under which the Reinsurer ceded certain risks on a 70% quota share basis on the same insurance liabilities to Great Southern. The results of operations of these acquired policies, less the net 30% coinsurance, are included in the Company's results of operations after the date of acquisition. The Reinsurer will receive 100% of the statutory profits from the reinsured policies until the Reinsurer has recovered the initial ceding commission.
In the above transaction with the Reinsurer, the invested assets related to the reinsured business are owned by the Reinsurer. At December 31, 1999, the insurance liabilities associated with this reinsurance transaction totaled $630.0 million. Results from the Ohio State Acquisition are included in the Company's results of operations from the date of the transaction.
The effect of the above transaction on the individual income statement components are set forth in the table below (in millions).
Net investment income. Net investment income totaled $226.5 million in 1998 compared to $219.3 million in 1997. Excluding the effect of the Acquisitions, net investment income decreased $1.1 million. Net investment income increased due to (i) an increase in net investment income on the Company's bond portfolio, (ii) a $2.3 million increase in net investment income related to a reduction in the unrecovered ceding commission due to the Reinsurer, offset by (iii) a $9.4 million decrease in net investment income on investments held by the Reinsurer and (iv) a $1.6 million decrease in income from equity subsidiaries.
The increase related to the Company's bond portfolio is due to increased assets owned resulting from the acquisition of the asset accumulation business in 1998.
Other operating expenses. Other operating expenses totaled $89.4 million in 1998 compared with $77.0 million in 1997. The increase in other operating expenses resulted from (i) the inclusion of twelve months of operating expenses related to Ohio State and Investors Guaranty in 1998 compared with nine months of operating expenses for these entities in 1997 following their April 1997 acquisition by the Company, (ii) $2.8 million of expenses related to the relocation of the Company's Columbus, Ohio operations to other Company locations during 1998, (iii) the operating expenses of marketing operations purchased by the Company in October 1998 and (iv) increased expenses associated with the continued development and expansion of the Company's product offerings and marketing capabilities. Increased expenses in these areas included both development expenses and expenses incurred on the Company's administrative systems.
Liquidity. The liquidity needs of Americo, whose principal assets are investments in its insurance subsidiaries, are dependent upon receipt of sufficient funds from its subsidiaries. The cash requirements of Americo consist of debt service requirements on notes payable, amounts due to FHC under advisory and data processing agreements and its own operating expenses. These cash requirements are met by payments of principal and interest on surplus debentures that Americo holds which are issued by United Fidelity and dividends from United Fidelity. Americo also receives payments under investment advisory and data processing agreements with the insurance subsidiaries which permit Americo to recover a portion of the amounts paid by it under similar agreements with FHC. On a stand-alone basis, at December 31, 1999, Americo had $24.3 million of cash and marketable equity securities available for debt service and other corporate requirements. During 1999, the Company repaid $21.0 million of amounts outstanding under a credit facility using available cash of Americo and $12.3 million of dividends received by Americo from the life insurance subsidiaries. This credit facility was terminated during 1999.
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.
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, 1999 was $87.2 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.
The ability of life insurance subsidiaries to pay dividends also may be affected by reinsurance treaties. Under reinsurance treaties with an unrelated reinsurer, National Farmers Union is restricted from declaring dividends if adjusted surplus is less than $7.5 million. Adjusted surplus is defined in the treaties as statutory capital and surplus, plus AVR, less the admitted asset value of all affiliated investments. At December 31, 1999, National Farmers Union had adjusted surplus of $50.5 million.
The Company believes that its investment portfolio will allow it to satisfy all existing contractual obligations to policyholders. At December 31, 1999, the Company's investment portfolio included cash and short-term investments totaling $122.8 million, marketable equity securities totaling $73.4 million as well as $339.9 million in U.S. Treasury and government securities, mortgage-backed securities and asset-backed securities and $586.0 million of corporate bonds classified as available for sale, all of which management believes could be readily converted to cash.
Financial condition. Stockholder's equity decreased to $228.6 million at December 31, 1999 from $257.2 million at December 31, 1998. The decrease was the result of net income of $14.7 million, a decrease in net unrealized investment gains of $41.0 million, and a $2.0 million dividend to FHC. Net unrealized investment losses in 1999 were recorded due to a decrease in the market value of the Company's available for sale fixed maturities. 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, 1999 includes $14.0 million relating to financial reinsurance agreements which is not included in stockholder's equity on a GAAP basis. Financial reinsurance treaties between National Farmers Union and unrelated parties contain minimum statutory surplus requirements and require National Farmers Union to place securities in an escrow account ($71.4 million at December 31, 1999) to secure National Farmers Union's obligations to the third party reinsurer.
(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, "BB or below".
(2) Carrying amount is amortized cost. The market value of held to maturity securities at December 31, 1999 was $821.3 million.
The primary risk associated with MBS is that a changing interest rate environment might cause prepayment of the underlying mortgages at speeds different than anticipated at the time of their purchase. The degree to which a security is at risk to either increases or reductions in yield is influenced by the difference between its carrying value and par value, the relative sensitivity of the underlying mortgages to prepayment in a changing interest rate environment and the repayment priority of the securities in each securitization structure.
At December 31, 1999, approximately $210.0 million in carrying value of the Company's investment portfolio consisted of mortgage loans, which were collateralized primarily by multi-family apartments, office buildings and retail properties located in 30 states. Approximately 34% of the portfolio was multi-family apartments, 16% was office buildings, 22% was retail space and 28% was other types of properties. At December 31, 1999, approximately 19% of the mortgage loan portfolio was secured by properties in Texas, 13% in Missouri and 13% in Kansas. No more than 10% of the remaining portfolio was secured by properties in any one state.
At December 31, 1999, 6.9% of the mortgage loan portfolio consisted of loans with balloon payments that mature before January 1, 2001. At December 31, 1999, mortgage loans delinquent by more than 90 days, as determined on a contract delinquency basis, totaled approximately $0.4 million, which constituted 0.2% of mortgage loans and was 0.02% of cash and invested assets. There were no loans foreclosed upon and transferred to real estate owned in the Company's consolidated balance at December 31, 1999. The favorable default experience is principally attributed to the Company's selectivity in the purchase of mortgages in connection with acquisitions of its life insurance subsidiaries and its origination of new mortgage loans. In light of the current market 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.
Real estate investments made up 1.5% of the carrying value of the Company's cash and invested assets at December 31, 1999.
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.
Management is aware that prevailing interest rates may shift significantly and has strategies in place to manage either an increase or decrease in interest rates. In a rising interest rate environment, the Company's cost of funds would increase over time as it prices its new and existing interest-sensitive and investment products to maintain generally competitive market rates. Management would seek to invest new and renewal premiums in investments which are high yielding and generally correspond to the duration of its liabilities. Management believes that liquidity to fund withdrawals would be available through a combination of incoming cash flow, the sale of short-term or floating rate instruments, and maturing short-duration assets thereby avoiding the sale of significant amounts of longer duration fixed-rate assets in an unfavorable bond market. In a declining rate environment, the Company's cost of funds would decrease over time, reflecting lower interest crediting rates on its fixed-rate liabilities. Should increased liquidity be required for withdrawals, management believes that a significant portion of its investments could be sold without adverse consequences in light of the general strengthening which would be expected in the bond market.
Asset-liability management is utilized by the Company to reduce the risks to the Company for interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed-rate investments that generate predictable rates of return in a variety of interest rate environments. The Company does not have a specific target rate of return. Instead, its rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, and general economic conditions. The Company's portfolio strategy is constructed with a view to achieving adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability management, liquidity and safety. The Company has structured its investment portfolio to reduce changes in the value of the assets under various rate environments. In that regard, the percentage of the Company's fixed-rate investment portfolio which is non-callable has increased from 44% in 1995 to 75% in 1999. In addition, the portfolio's concentration in mortgage-backed securities, which are subject to cash flow variability in changing interest rate environments, has decreased from 38% in 1995 to 18% in 1999. See "Investment Portfolio" section included elsewhere in Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information related to the Company's investments.
In order to reduce the probability of unexpected increases in policy or contract surrenders, which would create a need for increased liquidity, the Company has structured its interest-sensitive life insurance and annuity products to include substantial surrender charges. At December 31, 1999, approximately 87% and 93% of the reserves for interest-sensitive life insurance and annuity products, respectively, were for policies with surrender charges or otherwise not subject to discretionary withdrawal by the policyholder. Also at December 31, 1999, the aggregate cash surrender values of the Company's interest-sensitive life insurance and annuity products were approximately 87% and 91%, respectively, of the aggregate policyholder fund value.
As part of its asset-liability management, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under commonly-used interest rate scenarios. With the results of these computer 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, 1999, 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, 1999 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 $19 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.
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 provides guidance related to the accounting for derivative instruments and hedging activities focusing on the recognition and measurement of derivative instruments. This statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. Adoption of this statement is not expected to have a significant impact on the consolidated financial statements of the Company.