The Company leases approximately 62,000 square feet of office space in Louisville, Kentucky under a lease agreement (the "Lease") which expires on September 1, 2006, and which is subject to two five-year renewal options. This office space accommodates the executive, marketing, product development, actuarial, accounting, corporate finance, and legal functions of the Company. The Company has a standby letter of credit in the amount of approximately $1.7 million with one of its lending institutions to secure the Company's obligations under the Lease.
information has been derived from consolidated financial statements of the Company, prepared in conformity with GAAP, that have been audited by Ernst & Young LLP.
(2) "Operating earnings" is defined as net income applicable to common shareholders excluding, net of tax, realized investment gains and losses, non-recurring charges and for 1997 and 1996, income from defined benefit pension plan asset management operations which were sold in November 1997.
(3) Excludes from carrying amount shareholders' equity the net unrealized gains and losses on securities classified as available-for-sale, net of related amortization and taxes.
(4) The methodologies used to estimate fair value are described in the notes to the consolidated financial statements contained herein.
The Company specializes in the growing asset accumulation business with particular emphasis on retirement savings and investment products. The Company's products and services are sold in two principal markets, the retail and institutional markets, through a broad spectrum of distribution channels. The Company derives its earnings from the investment spread and fee income generated by the assets it manages. The Company groups its operations into three operating segments (retail spread products and options, institutional spread products and retail variable fund options) and a corporate segment, based on the market through which the products or services are sold and the earnings characteristics of the products or services.
The Company earns a spread between what is earned on invested assets and what is credited to customer accounts with its retail spread products and options segment (primarily fixed and indexed annuities) and institutional spread products segment (funding agreements, GICs and certificates). The Company receives a fee in exchange for managing customers' deposits, and the customer accepts the investment risk with its retail variable fund options segment (variable annuity mutual fund options). Fee-based business is less capital intensive than the spread businesses and provides the Company with diversified sources of income. The Company believes that market forces and population demographics are producing and will continue to generate strong consumer demand for long-term savings and retirement products, including retail fixed, indexed and variable annuity products. In addition, the Company expects to benefit from the growing institutional marketplace by developing new products and applications for existing and new markets.
Net income during 1998 was $43.8 million compared to $27.6 million for 1997. Operating earnings (net income applicable to common shareholders excluding, net of tax, realized investment gains and losses, non-recurring charges and for 1997, income from defined benefit pension plan asset management operations which were sold in 1997) were $43.3 million and $34.1 million for 1998 and 1997, respectively. The increase in operating earnings is primarily attributable to an increase in net investment spread and variable annuity fees due to the growth of assets under management which increased from $6.9 billion at December 31, 1997 to $9.9 billion at December 31, 1998.
Pro forma operating earnings for 1997 (operating earnings including a pro forma adjustment to reflect investment income at an assumed rate of 7.5% on the net proceeds of the Company's June 1997 initial public offering of Class A common stock assuming it occurred on January 1, 1997) were $36.3 million. Operating earnings per diluted share (pro forma for 1997) were $1.78 and $1.51 for December 31, 1998 and 1997, respectively. This pro forma information for 1997 is not necessarily indicative of what would have occurred had the initial public offering occurred on the earlier date.
Sales represent premiums and deposits received for products offered through the Company's insurance and certificate subsidiaries. Sales by market and type of product for 1998 and 1997 were as follows:
services and distribution channels to enable it to achieve targeted sales within different interest rate environments.
Operating expenses were $35.1 million in 1998 compared to $32.5 million in 1997. The increase in operating expenses was mainly attributable to increased spending in 1998 for systems and technology enhancements. This spending reflects the Company's continued strategic emphasis on growing its retail franchise by investing in and enhancing Internet applications and its technology infrastructure.
Amortization of value of insurance in force related to operations of $6.0 million and $9.3 million for 1998 and 1997, respectively, primarily reflects the amortization of the value of insurance in force established as an asset by the Company in connection with the 1995 acquisition of SBM Company's
The Company recorded non-recurring charges of $4.7 million in 1998, of which $3.6 million was part of a retirement package for John Franco, the Company's former Co-Chairman and Co-Chief Executive Officer, and $1.1 million was related to registration expenses associated with the Company's secondary offering of common stock. The Company recorded non-recurring charges of $14.8 million for 1997 which included a non-cash stock-based compensation expense charge and other non-recurring costs primarily related to the relocation and consolidation of the Company's operations facilities from Ohio to Louisville, Kentucky.
Other expenses, net, increased to $2.8 million in 1998 from $0.4 million in 1997. The increase is due to decreased 1997 net other expenses as a result of mortgage loan prepayment penalty income and the favorable resolution of a reinsurance claim, both in 1997.
Net income during 1997 was $27.6 million compared to $23.4 million for 1996. Operating earnings (net income applicable to common shareholders excluding, net of tax, realized investment gains and losses, non-recurring charges and income from defined benefit pension plan asset management operations which were sold in 1997) were $34.1 million and $22.2 million for 1997 and 1996, respectively. The increase in operating earnings was primarily attributable to an increase in net investment spread due to both deposit growth from sales of retail and institutional spread products and ongoing asset/liability management and, to a lesser extent, an increase in fee income as a result of a larger base of variable annuity deposits.
Net investment spread for the years ended December 31, 1997 and 1996 was as follows:
The increase in net investment spread is attributable to the increase in average spread-based customer deposits which were $4.24 billion in 1997 compared to $3.23 billion in 1996.
Investment income on consolidated surplus assets was $9.3 million and $6.6 million for the years ended December 31, 1997 and 1996, respectively.
The increase in investment yields reflects the benefits of ongoing investment portfolio management. The average credited rate pattern is dependent upon the general trend of market interest rates (which were somewhat higher on average in 1997), frequency of credited rate resets and business mix.
Fee income increased to $24.6 million in 1997 from $17.8 million in 1996. This increase is attributable to variable annuity fees, which are based on the market value of the mutual fund assets supporting variable annuity customer deposits in nonguaranteed separate accounts. Variable annuity fees increased to $14.6 million in 1997 from $10.8 million in 1996 principally due to asset growth from the receipt of variable annuity deposits and from a market-driven increase in the value of existing variable annuity deposits invested in mutual funds. Variable annuity deposits averaged $970.3 million in 1997, an increase from $728.2 million in 1996. In addition, asset management fees earned by ARM Capital Advisors, Inc. ("ARM Capital Advisors") on off-balance sheet assets, primarily related to defined benefit pension plans (and, in 1996 only, fees from the State Bond Mutual Funds which were sold by the Company in December 1996), increased to $8.6 million in 1997 from $5.8 million in 1996, reflecting a significant increase in the off-balance sheet assets managed due to sales.
On December 13, 1996, the Company transferred its contracts to perform management and advisory services for the State Bond Mutual Funds to Federated Investors for $4.5 million. Had the sale of ARM Capital Advisors' operations and the sale of the management contracts for the State Bond Mutual Funds occurred on January 1, 1996, they would not have had a material effect on the Company's net income for the years ended December 31, 1997 and 1996.
Total sales during 1997 rose to $2.3 billion, an increase of approximately 113% over 1996. The growth is primarily attributable to continued diversification and expansion in the retail and institutional markets. The growth in retail spread product sales is largely due to an increase in marketing efforts for the Company's guaranteed rate option annuity products. Institutional spread product sales increased as a result of (i) the addition of sales staff and further penetration into institutional channels and (ii) the launching of a new funding agreement product. In November 1997, the Company received a deposit of $500 million for the new product, which was sold in partnership with BLB and initially matures in five years and is renewable annually thereafter.
Income tax expense was $14.1 million and $5.2 million in 1997 and 1996, respectively, reflecting effective tax rates of 33.9% and 18.1% as a percentage of pretax income. If the non-recurring stock-based compensation charge was added back to pretax income, the effective tax rate for 1997 would be 28.3%. A tax benefit was not recognized for the charge because a full valuation allowance was provided on the Company's non-life deferred tax assets.
Agency pass-through certificates are mortgage-backed securities ("MBSs") which represent an undivided interest in a specific pool of residential mortgages. The payment of principal and interest is guaranteed by the U.S. government or U.S. government agencies. Collateralized mortgage obligations ("CMOs") are pools of mortgages that are segregated into sections, or tranches, which provide prioritized retirement of bonds rather than a pro rata share of principal return as in the pass-through structure. The underlying mortgages of agency CMOs are guaranteed by the U.S. government or U.S. government agencies. Of the Company's non-agency CMO investments at December 31, 1998 (on an amortized cost basis), 81% used mortgage loans or mortgage loan pools (primarily residential in nature), letters of credit, agency mortgage pass-through securities, and other
Total cash and investments (on an amortized cost basis) were 95% investment grade or equivalent at both December 31, 1998 and 1997. Investment grade securities are those classified as 1 or 2 by the NAIC or, where such classifications are not available, having a rating on the scale used by Standard and Poor's Corporation ("S&P") of BBB- or above. Yields available on non-investment grade securities are generally higher than are available on investment grade securities. However, credit risk is greater with respect to such non-investment grade securities. The Company attempts to reduce the risks associated with non-investment grade securities by limiting exposure to any one issuer and by closely monitoring the credit worthiness of such issuers. Additionally, the Company has a diversified portfolio of dollar denominated bonds issued in the U.S. by foreign governments, banks and corporations, including a limited exposure to the Asian and Latin American markets. Such foreign securities represented 9% of the Company's cash and investments at December 31, 1998 (on an amortized cost basis), with Asian and Latin American securities representing 2.7% of total cash and investments. The Company's investments in foreign securities were 79% investment
grade at December 31, 1998. The Company reduces the risks associated with buying foreign securities by limiting the exposure to both issuer and country. The Company closely monitors the creditworthiness of such issuers and the stability of each country. The Company's investment portfolio has minimal exposure to real estate, mortgage loans and common equity securities, which represented less than 0.3% of cash and investments as of December 31, 1998.
Pursuant to SFAS No. 115, the Company classifies its entire fixed maturities portfolio as available-for-sale. Fixed maturities classified as available-for-sale are carried at fair value and changes in fair value, net of related value of insurance in force and deferred policy acquisition cost amortization and deferred income taxes, are charged or credited directly to shareholders' equity and classified as accumulated other comprehensive income from net unrealized gains and losses on available-for-sale securities.
$74.5 million of deferred income tax benefit) at December 31, 1998, compared to net unrealized gains of $20.3 million (net of $15.8 million of related amortization of deferred policy acquisition costs and value of insurance in force and $10.9 million of deferred income taxes) at December 31, 1997. The unrealized losses on available-for-sale securities at December 31, 1998 were attributable to volatility in the bond market during 1998. Economic contractions in Asia, Latin America and Russia created a "flight to quality," mainly U.S. Treasury securities, which decreased values in the rest of the bond market as a result of the widening of yield spreads on bonds (i.e., the yield on an investment above the yield of a U.S. Treasury security with a similar duration). In addition, during the fourth quarter of 1998 the liquidity in the bond market diminished which further depressed bond prices. Even in this environment the Company continues to meet overall investment objectives because of its integrated asset/liability management approach.
The change in net unrealized gains and losses on available-for-sale securities for the year ended December 31, 1998 decreased reported shareholders' equity by $158.6 million as compared to an increase of $16.6 million for the year ended December 31, 1997. This volatility in reported shareholders' equity occurred as a result of SFAS No. 115, which requires that available-for-sale securities be carried at fair value while other assets and all liabilities are carried at historical values. At December 31, 1998 and December 31, 1997, shareholders' equity excluding the effects of SFAS No. 115 was $348.8 million and $287.2 million, respectively.
On March 9, 1999, the Company named BlackRock Financial Management, Inc. ("BlackRock") as the core fixed income manager for the Company's investment portfolio. BlackRock will provide the Company with investment management services for a broad range of asset classes and investment strategies.
BlackRock, headquartered in New York City, is majority-owned by PNC Bank Corp., one of the largest diversified financial services companies in the U.S. As of December 31, 1998, BlackRock managed $131 billion of assets on behalf of individual and institutional investors worldwide. As one of the largest independent managers of insurance assets in the nation, BlackRock has combined its capital markets capabilities with its sophisticated proprietary investment technology to customize service on behalf of insurers in the U.S. and abroad.
During product development, the Company sets product features and rate crediting strategies only after it has devised an appropriate investment strategy. The Company employs an extensive, iterative modeling process to test various asset combinations against proposed product features over sets of randomly generated interest rate scenarios. The modeling evaluates whether a particular investment strategy backing the product features under consideration will provide adequate cash flow and generate yields that achieve specified minimum targets consistently over a reasonable range of interest rate environments. If necessary, the Company redesigns investment strategies or product features until these objectives are met.
Once the Company has constructed an asset portfolio having the desired performance characteristics, the Company's investment managers have the flexibility to trade the portfolio in order to increase investment returns while remaining within well-defined risk parameters (such as duration, convexity, credit quality, and liquidity). In so doing, these professionals follow prescribed measures designed to (i) limit exposure to credit risks; (ii) manage call, prepayment or extension
In pursuing its investment spread objectives, the Company focuses primarily on cash flow risks
The Company's array of retail and institutional spread deposits, with crediting rates pegged to various points on the interest rate yield curve, also supports the Company's approach to asset/liability management. The liability structures, in combination with asset structures, generally are aimed at providing balance in the portfolio as interest rates fluctuate. As a result, the Company believes it is better positioned to achieve stable margins. In addition, the Company believes that this diversity gives it flexibility to respond to changing market conditions and to take advantage of investment opportunities.
As a component of its asset/liability risk management strategy, the Company invests in various derivative financial instruments in order to hedge certain market risks. These derivative financial instruments are discussed below.
The Company also uses interest rate swaps to convert fixed-rate securities into floating rate investments to support its variable rate institutional spread deposits. The Company has agreed to exchange with counterparties a fixed-rate of interest it receives on certain investment securities for floating-rate interest amounts calculated by reference to agreed-upon notional principal amounts. Either the Company or the counterparty makes a single net payment at each due date resulting in a decrease or an increase, respectively, to investment income in the statement of income. The Company had approximately $346 million of notional principal contracts outstanding at December 31, 1998.
HOLDING COMPANY OPERATIONS The Company's principal need for liquidity has historically consisted of debt service obligations under its bank financing agreement, dividend payments on its common and preferred stock, operating expenses not absorbed by management fees charged to its subsidiaries, and corporate development expenditures. The Company is dependent on dividends from Integrity and management
The ability of the Company's insurance subsidiaries to pay dividends and enter into agreements with affiliates for the payment of services or other fees is limited by state insurance laws. During 1998, the Company received dividends of $6.0 million from Integrity. The maximum dividend payments that may be made by Integrity to the Company during 1999 without the prior approval of the Ohio Insurance Director are $37.8 million. The Company had cash and investments at the holding company level of $41.7 million at December 31, 1998. In addition, the Company has a $75.0 million syndicated bank credit facility of which $37.0 million was available to the Company at December 31, 1998.
In May 1998, the Company completed a secondary public offering of approximately 12.4 million shares of common stock held by the Morgan Stanley Stockholders. The Company did not receive any of the proceeds from the public offering. As a result of the public offering, the Morgan Stanley Stockholders no longer own any shares of the Company's outstanding common stock and all of the Company's outstanding Class B common stock was converted into Class A common stock.
During 1998, Integrity entered into total yield swap transactions with 312 CC and 312 CC. The swap transactions generally provide that Integrity guarantees certain levels of book yield and asset fair values in 312 CC and 212 CC, and if these levels are not maintained, Integrity would be required to make payments under the swaps to 312 CC or 212 CC.
During the years ended December 31, 1998, 1997 and 1996, the Company met its liquidity needs entirely by cash flows from operating activities and principal payments and redemptions of investments. At December 31, 1998, cash and cash equivalents totaled $525.3 million compared to $228.2 million at December 31, 1997. The Company's aim is to manage its cash and cash equivalents position in order to satisfy short-term liquidity needs. In connection with this management of cash and cash equivalents, the Company may invest idle cash in short-duration fixed maturities to capture additional yield when short-term liquidity requirements permit.
The Company will experience spread compression when it is unable to maintain the margin between its investment earnings and its crediting rates. When interest rates rise, the Company may not be able to replace the assets in its investment portfolio with sufficient higher-yielding assets to fund higher crediting rates or to maintain full profit margins without assuming excessive asset side risk. As a result, the Company may experience either a decrease in sales and an increase in surrenders where it is able to maintain its spread by not raising its crediting rates, or spread compression if it is willing or contractually required to increase its crediting rates. Conversely, when interest rates fall, the Company would have to reinvest the cash received from its investments (i.e., interest and payments of principal upon maturity or redemption) in the lower-yielding instruments then available. If the Company chose not to or was unable (i.e., due to guaranteed minimum or fixed crediting rates or limitations on the frequency of crediting-rate resets) to reduce the crediting rate on its spread-based products or acquire relatively higher-risk securities yielding higher rates of return, spread compression would occur.
regardless of whether the Company realizes an investment loss, surrenders would produce a decrease in invested assets, with an adverse effect on future earnings therefrom.
The Company follows asset/liability strategies that are designed to mitigate the effect of interest rate changes on the Company's profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads. Significant amounts of the Company's customer deposits are held by a relatively small number of institutions. Such concentrations may impair the ability of the Company to mitigate the effect of interest rate changes.
The Company has undertaken a Year 2000 project that includes all of its subsidiaries. The Company has completed the assessment phase of the project for all production applications, hardware (personal computers and servers), system software, vendors, and business partners. Although the Company is still receiving information from a few vendors and business partners and assessing various logistic concerns with its facilities, the Company's major production systems are substantially Year 2000 compliant. Where Year 2000 problems were found, the necessary upgrades and repairs have begun and are scheduled for completion no later than May 31, 1999.
As well as assessing its facilities, the Company is also in the repair and certification testing phase of its project. The testing phase will serve to verify the results of repairs and assessments. Steps needed to correct any problems uncovered during testing will begin immediately at that time. The Company's Year 2000 project is well underway and because management believes that it will be Year 2000 compliant by May 31, 1999, it currently has no contingency plans for system issues in place beyond its normal disaster recovery procedures. As a precaution, the Company is developing a contingency and business resumption plan to address various logistic concerns with its facilities. The contingency and business resumption plan is scheduled for completion no later than September 30, 1999.
The estimated date on which the Company believes it will complete its Year 2000 compliance efforts, and the expenses related to the Company's Year 2000 compliance efforts are based upon management's best estimates, which were based on assumptions of future events, including the availability of certain resources, third party modification plans and other factors. There can be no
assurance that these results and estimates will be achieved, and the actual results could materially differ from those anticipated.