Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Liberty owns a 487,000 square foot building at 2001 Third Avenue South, Birmingham, Alabama which currently serves as Liberty’s, UILIC’s, and Torchmark’s home office. Approximately 160,000 square feet of this building is leased or available for lease to unrelated tenants by Liberty. Liberty also operates from 55 company-owned district offices used for agency sales personnel.
United American owns and is the sole occupant of a 140,000 square foot facility, located in the Stonebridge Ranch development in McKinney, Texas (a north Dallas suburb).
(2) Return on average equity is defined on page 37 of this report.
Summary of Operating Results. Torchmark’s management computes a classification of income called “net operating income” that it has used consistently over time to evaluate the operating performance of the company. Net operating income is also the corresponding after-tax sum of the pretax measures of profit or loss for each of Torchmark’s reportable segments required to be disclosed in accordance with GAAP. (See Note 19 Business Segments in the Notes to Consolidated Financial Statements.) Torchmark’s core operations are segmented into insurance underwriting operations and investment operations. Insurance underwriting operations are further segmented into life insurance, health insurance, and annuity products. The measure of profitability for its insurance segments is underwriting income before other income and administrative expense. This represents the gross profit margin on insurance products before administrative expenses. This measure of underwriting income is computed as premium income less net policy obligations, commissions, and acquisition expenses. Insurance segments are further subdivided into component distribution channels which are also evaluated by underwriting income. The measure of profitability for the investment segment is excess investment income. Excess investment income represents the earnings on the investment portfolio, less the interest required to service net policy liabilities and less the financing costs associated with Torchmark’s debt and preferred securities.
1) Realized investment losses, including the realized gains from the adjustment in fair value of Torchmark’s interest rate swaps, net of tax;
4) The effect of the required change to a new accounting principle revising the method for valuing certain asset-backed security investments, which resulted in an after-tax charge of $26.6 million in 2001;
5) A one-time charge relating to discontinued energy operations in 2001 in the amount of $3.3 million; and
Net realized investment losses were $62 million in 2002, compared with $2 million in 2001 and $5 million in 2000. A component of realized investment losses is the gain or loss from adjusting Torchmark’s interest rate swaps to fair market value at the end of each accounting period as required by accounting rules. The market value adjustments resulted in pretax gains in each of the three years as
Torchmark does not consider realized investment gains and losses a component of its core operations and, accordingly, they are not a component of net operating income. Fixed maturities, which comprise 92% of the investment portfolio, are generally held to maturity, but are sometimes sold because of deteriorating credit quality, for tax purposes, or other reasons. These sales result in gains and losses which can be significant in relation to Torchmark’s core earnings. Torchmark’s core insurance business is very long-term in nature, with the realization of actual profits emerging over many years. Including investment gains and losses in net operating income could distort the operating trends.
Effective January 1, 2002, Torchmark adopted Statement of Financial Accounting Standards No. 142-Goodwill and Other Intangible Assets (SFAS 142). This statement prohibits goodwill amortization after 2001, but does not allow the restatement of prior periods for comparability when goodwill has been amortized. Instead, after adoption, companies are required to consider goodwill for impairment under a set of guidelines described in the Statement. Torchmark tested its goodwill in accordance with the provisions of SFAS 142 and determined that goodwill was not impaired. Therefore, Torchmark’s unamortized goodwill balance at December 31, 2001, in the amount of $378 million, was unchanged in 2002. In order to compare operating performance in prior periods with 2002, Torchmark has restated net operating income in 2001 and 2000 to remove the effect of goodwill amortization. The goodwill amortization charge was $12 million in both 2001 and 2000. See Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements for more information.
$119 million. Insurance administrative expenses rose 6% in 2001. As a percentage of premium, administrative expense has been stable in each of the past three years at 5.5%, 5.4%, and 5.5% in 2002, 2001, and 2000, respectively. The components of Torchmark’s revenues and operations are described in more detail in the following discussion of Insurance and Investment segments.
Life insurance premium rose 7% in 2002 to $1.22 billion from $1.14 billion in 2001. Life premium increased 6% in 2001 from $1.08 billion. Sales of life insurance, in terms of annualized premium, were $334 million in 2002, increasing 13% over 2001 sales of $295 million. This compares with 1% growth in 2001 sales over 2000 sales of $291 million. Annualized life premium in force is often indicative of future premium income over the near term. Annualized life premium in force was $1.34 billion at December 31, 2002, compared with $1.26 billion at 2001 year end, an increase of 7%. Annualized life premium in force grew 5% in 2001 from $1.20 billion at year-end 2000. Annualized life premium in force and issued data includes amounts collected on certain interest-sensitive life products which are not recorded as premium income but excludes single-premium income and policy account charges.
Life insurance products are marketed through several distribution channels. Life insurance premium by distribution method during each of the last three years is as follows.
Direct Response marketing is conducted primarily through direct mail, but also through co-op mailings, television and consumer magazine advertising, and direct mail solicitations endorsed by groups, unions and associations. Direct Response markets a line of life products primarily to juveniles, their parents, and other adults over age 50. The Direct Response operation accounted for almost 26% of Torchmark’s life insurance premium during 2002. Direct Response life premium rose 9% in 2002 to $316 million. Direct Response life premium was $289 million in 2001, increasing 8% over 2000 premium of $268 million.
The American Income Exclusive Agency focuses on members of labor unions, credit unions, and other associations for its life insurance sales. It is a high profit margin business characterized by lower policy obligation ratios. This agency was Torchmark’s fastest growing agency during both 2002 and 2001, accounting for the largest growth in both life sales and annualized life premium in force. Annualized life premium in force was $302 million at year-end 2002, an increase of 14% over 2001 premium in force of $266 million. Annualized life premium in force rose 8% in 2001. Sales, in terms of annualized premium issued, rose 38% in 2002 to $92 million, compared with an increase of 17% in 2001 to $66 million. The rapid growth in sales for this agency over the last three years was a result of the growth in the number of agents. This agency has grown steadily since 1999. The agent count rose 13% in 2000 to 1,352 agents at year end, grew 31% in 2001 to 1,768 agents, and further grew to 1,975 agents at year-end 2002. American Income’s marketing organization continues to implement efforts to improve agent recruiting, retention, and productivity in order to increase the size of this agency. At December 31, 2002 American Income’s annualized life premium in force was 22% of Torchmark’s total, compared with 21% at the end of the previous year. The American Income Agency contributed $277 million of life insurance premium income during 2002, an increase of 12% over 2001 premium of $247 million. Life premium rose 7% in 2001 over the prior year.
The United American Independent and Branch Office Agencies together represented about 6% of Torchmark’s total life annualized premium in force in 2002. On a combined basis, life premium income rose 5% to $70 million in 2002. Life premium rose 8% in 2001 to $67 million from $62 million. Annualized life premium issued in 2002 was $31 million, compared with $29 million in 2001 and $30 million in 2000. Annualized life premium in force rose 5% in 2002 to $79 million, but was flat in 2001 with the prior year at $75 million.
Torchmark’s Other life insurance distribution system consists of the United Investors Agency and other small miscellaneous sales agencies. The United Investors Agency is comprised of several independent agencies. Prior to 2001, United Investors’ distribution was primarily through the sales representatives of a former Torchmark subsidiary, Waddell & Reed. Torchmark spun off Waddell & Reed in 1998, and United Investors terminated the Waddell & Reed agency contract in 2001. Life premium income from the Other distribution category declined 4% to $107 million in 2002, but increased 3% to $111 million in 2001. Life premium income from the Other distribution group accounted for less than 9% of Torchmark’s total life insurance premium income in the year 2002. Annualized life premium in force declined 5% in 2002 to $127 million, after having declined 1% to $134 million in 2001. Annualized premium sold during 2002 in the Other distribution category was $8 million, a drop of 28% in 2002. Sales by this agency also declined in 2001 by 38% from $17 million in 2000 to $11 million.
Health Insurance. Torchmark markets its supplemental health insurance products through a number of distribution channels. The following table indicates health insurance premium income by distribution method during each of the last three years.
Health products sold by Torchmark insurance companies include Medicare Supplement, cancer, long-term care, and other under-age-65 limited-benefit supplemental medical and hospitalization products. As a percentage of annualized health premium in force at December 31, 2002, Medicare Supplement accounted for 69% and cancer 17%. The table below presents Torchmark’s health insurance annualized premium in force by major product category at December 31, 2002 and for the two preceding years.
Health insurance underwriting income before other income and administrative expense declined 3% in 2002 from $173 million to $167 million. In 2001, health underwriting income rose 8% from $161 million in 2000. As a percentage of premium, underwriting income before other income and administrative expense declined in both 2002 and 2001 from their respective prior years. The decreases in margins were caused primarily by increased policy obligations in a closed block of cancer policies and slightly higher acquisition costs in the United American agencies.
Annuities. Annuities are sold on both a fixed and variable basis. Fixed annuity deposits are held and invested by Torchmark and are obligations of the company. Variable annuity deposits are invested at the policyholder’s direction into his choice among a variety of mutual funds, which vary in degree of investment risk and return. A fixed annuity investment account is also available as a variable annuity investment option. Investments pertaining to variable annuity deposits are reported as “Separate Account Assets” and the corresponding deposit balances for variable annuities are reported as “Separate Account Liabilities.”
Annuity products are marketed by Torchmark to service a variety of needs, including retirement income and long-term, tax-deferred growth opportunities. Prior to 2001, Torchmark’s annuities were sold primarily by the Waddell & Reed sales force, which marketed United Investors’ products under a marketing agreement. In 2000, this sales force collected 96% of Torchmark’s total annuity collections. Effective April 30, 2001, Torchmark terminated the marketing agreement providing for the sale of Torchmark’s variable annuities by the Waddell & Reed sales force. Waddell & Reed was a former subsidiary of Torchmark which was spun off in 1998 but is no longer affiliated. In addition to no longer marketing United Investors’ products, Waddell & Reed has been replacing United Investors’ products with those of another carrier. As a result, Torchmark has experienced declines in annuity sales and deposit balances.
On March 19, 2002, an Alabama jury awarded United Investors $50 million in compensatory damages against Waddell & Reed. The dispute resulting in the litigation arose regarding certain compensation on United Investors’ in-force block of variable annuities and alleged a scheme by Waddell & Reed to improperly replace United Investors’ variable annuities with those of another company. On June 25, 2002, an order was issued by the Jefferson County Alabama Circuit Court entering the jury verdict. Interest on the $50 million award will accrue at an annual rate of 12% from June 25, 2002 until the date paid. Waddell & Reed has appealed the Circuit Court’s decision to the Alabama Supreme Court. In October, 2002, the Alabama Supreme Court affirmed the dismissal of counterclaims against Torchmark and an individual defendant but Waddell & Reed’s appeal from the jury verdict and trial court judgment remains pending. United Investors will not record the award or the related accrued interest as income until it is received, which will not occur until all appeals are completed. In addition, United Investors’ request for injunctive relief to prohibit future improper policy replacements by Waddell & Reed was denied by the Circuit Court, which specified that United Investors has the right to bring additional litigation against Waddell & Reed.
Variable annuity collections declined 77% in 2002 to $26 million from $112 million in 2001. Variable collections had previously declined 82% from $608 million in 2000. The variable annuity account balance declined 35% in 2002 to $1.5 billion at December 31, 2002 from $2.4 billion at December 31, 2001. It declined 34% in 2001 from $3.6 billion at December 31, 2000. The loss of the Waddell & Reed sales force, the replacement activity by Waddell & Reed, and the weaker financial markets have been major factors in the declines in variable annuity sales and the variable annuity deposit balance in both 2002 and 2001. Variable accounts are valued based on the market values of the underlying securities.
Excess investment income represents the profit margin attributable to investment operations and cash flow management. It is the measure that management uses to evaluate the performance of the investment segment. It is defined as net investment income on a tax-equivalent basis reduced by the interest cost credited to net policy liabilities and the interest cost associated with capital funding or “financing costs.”
New cash flow was invested primarily in taxable fixed-maturity securities in both 2002 and 2001. These securities consisted primarily of investment-grade corporate bonds and trust preferred securities. As a result, the mean taxable fixed-maturity balance has grown in each year, rising 8% in 2001 to $6.1 billion and 7% in 2002 to $6.6 billion.
At December 31, 2002, approximately 92% of invested assets were held in fixed-maturity securities. The major rating agencies considered approximately 92% of the portfolio to be investment grade. The average quality of the portfolio continues to be “A-.” The investment strategy of the company is to purchase only investment-grade obligations. The increase in below investment-grade issues were the result of ratings downgrades of existing holdings.
During 2002, Torchmark wrote down several individual holdings to estimated fair value as a result of other-than-temporary impairment. The impaired securities met some or all of Torchmark’s criteria for other-than-temporary impairment as discussed in its Critical Accounting Policies on page 41 of this report. In total, eleven individual issues with combined book values of $121 million were written down to $32 million, creating a pre-tax charge of $89 million. Bonds of eight of the issuers were held at year end. Five of these issuers were delinquent in interest payments. The writedown was partially offset by net realized gains of $13 million on other investments. An analysis of the 2002 writedowns by industry sector at the date of writedown is as follows:
At the end of 2002, the fixed-maturity portfolio had a book value of $6.9 billion and fair market value of $7.2 billion, for an unrealized gain of $306 million. This compares with an unrealized loss of $1.8 million at the end of 2001. The increase in unrealized gain in 2002 resulted primarily from the decline in rates in financial markets. However, gross unrealized losses on fixed maturities were $177 million at December 31, 2002, compared with $195 million a year earlier. The following tables disclose selected information about the gross unrealized losses of Torchmark’s fixed maturities at December 31, 2002.
During 2001, Torchmark adopted a new accounting principle, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interest in Securitized Financial Assets (EITF 99-20), which changed the method of accounting for certain of its asset-backed securities. As a result of the requirements of the new principle, Torchmark wrote these investments down $41 million, or $27 million net of tax, which has been reported as a change in accounting principle. Subsequent to adoption, impairments of these assets have been and will be reported as realized investment losses. In 2001, after the adoption of the new rule, an additional impairment loss of $1.6 million after tax was recorded. Additionally, certain of the asset-based securities were sold during both 2002 and 2001. These sales resulted in proceeds of $40 million at an after-tax loss of $170 thousand in 2001, and proceeds of $13 million at an after-tax loss of $3 million in 2002. At year-end 2002, Torchmark held less than $300 thousand at fair value of asset-backed securities considered impaired by EITF 99-20. For more information on the effects of this accounting rule, see Note 11-Change in Accounting Principle in the Notes to Consolidated Financial Statements on page 65 of this report.
Torchmark reduces credit risk by maintaining investments in a wide range of industry sectors. The following table presents the highest ten percentage holdings of Torchmark’s corporate fixed maturities by industry sector at December 31, 2002.
Otherwise, no individual industry represented 1.9% or more of Torchmark’s corporate fixed maturities.
The actual interest rate risk to Torchmark is reduced because the effect that changes in rates have on assets is offset by the effect they have on insurance liabilities and on debt. Interest assumptions are used to compute the majority of Torchmark’s insurance liabilities. These insurance liabilities, net of deferred acquisition costs, were $3.8 billion and debt and preferred securities were $.9 billion at December 31, 2002, compared with fixed-maturity investments of $6.9 billion at amortized cost at the same date. Because of the long-term nature of insurance liabilities, temporary changes in value caused by rate fluctuations have little bearing on ultimate obligations. In accordance with GAAP, insurance liabilities and debt are generally not marked to market.
Market risk is managed in a manner consistent with Torchmark’s investment objectives. Torchmark seeks to maintain a portfolio of high-quality fixed-maturity assets that may be sold in response to changing market conditions. However, it is Torchmark’s primary objective to hold securities to maturity. Torchmark’s strong operating cash flow and stable, long-term policy liabilities decrease the likelihood of needing to sell fixed investments for operating liquidity. Some sales may be made to preserve capital due to changes in credit quality of individual securities or for tax purposes. Potential volatility in the value of Torchmark’s longer-term fixed-maturity holdings is reduced by the Company’s practice of holding securities to maturity, which has resulted in 33% of the fixed portfolio being expected to repay within five years and 68% within ten years. Also, the portfolio and market conditions are constantly evaluated for appropriate action.
The liability for Torchmark’s insurance policy obligations is computed using interest assumptions, some of which are contractually guaranteed. A reduction in market interest rates of a permanent nature could cause investment return to fall below guaranteed amounts. Torchmark’s insurance companies participate in the cash flow testing procedures imposed by statutory insurance regulations, the purpose of which is to insure that such liabilities are adequate to meet the company’s obligations under a variety of
interest rate scenarios. Those procedures indicate that Torchmark’s insurance policy liabilities, when considered in light of the assets held with respect to such liabilities and the investment income expected to be received on such assets, are adequate to meet the obligations and expenses of Torchmark’s insurance activities in all but the most extreme circumstances.
Liquidity. Liquidity provides an institution such as Torchmark with the ability to meet on demand the cash commitments required by its business operations and financial obligations. Torchmark’s liquidity is derived from three sources: positive cash flow from operations, portfolio of marketable securities, and a line of credit facility.
Torchmark’s capital structure consists of long and short-term debt, preferred securities, and shareholders’ equity. Torchmark’s debt consists of its funded debt and its commercial paper facility. An analysis of Torchmark’s funded debt outstanding at year-ends 2002 and 2001 at par value is as follows:
In connection with this issuance, Torchmark entered into a five-year swap agreement with an unaffiliated party to swap the 6 1/4% fixed rate payment obligation for a floating rate obligation. The floating rate is based on the six-month LIBOR and resets every six months. At December 31, 2002, the floating rate was 2.63%. The swap arrangement added $3.6 million net of tax to Torchmark’s 2002 net operating income. This swap derivative qualifies as a hedge under accounting rules. Therefore, changes in its market value are substantially offset by changes in the value of the debt security. Torchmark’s derivative instruments are classified as Other Invested Assets.
In 2002, Torchmark acquired $75 thousand principal amount of its 7 7/8% Notes due 2023 at a cost of $76 thousand, resulting in a $2 thousand loss on debt redemption after tax. In 2001, $8.1 million par value of the 7 7/8% Notes was acquired by Torchmark at a cost of $8.3 million, resulting in an after-tax loss of $277 thousand. In 2000, $4.6 million principal amount of Torchmark 7 7/8% Notes and $2.0 million principal amount of the 7 3/8% Notes were acquired at a cost of $4.2 million and $1.9 million, respectively. The redemption of this debt in 2000 resulted in an after-tax gain of $202 thousand.
after November 2, 2006. They are subject to a mandatory redemption on November 1, 2041. Distributions are cumulative and are paid quarterly at an annual rate of 7 3/4%, or at a rate of $1.9375 per share. All payments by the Trusts regarding the trust preferreds are guaranteed by Torchmark. The Capital Trusts are wholly-owned consolidated subsidiaries of Torchmark.
The two offerings resulted in proceeds to the Capital Trusts of $145 million, after underwriters’ discount and issue expenses. The Capital Trusts used the proceeds to buy 7 3/4% Junior Subordinated Debentures from Torchmark in like amount. Torchmark used these proceeds to redeem the remaining $110 million of outstanding 9.18% MIPS and to pay down short-term debt.
Short-term debt consists of Torchmark’s commercial paper outstanding. The commercial paper balance outstanding at December 31, 2002 was $201 million at carrying value, compared with a balance of $204 million a year earlier. The commercial paper borrowing balance fluctuates based on Torchmark’s current needs.
The following table presents information about Torchmark’s debt-to-capitalization. As discussed on page 34 , Torchmark removes the effect of fluctuations in shareholders’ equity resulting from changes in interest rates caused by accounting rule SFAS 115. Management believes the debt-to-capitalization ratio excluding SFAS 115 provides a more meaningful presentation of Torchmark’s capitalization. In addition, lending banks require that the capitalization ratios specified in the debt covenants concerning Torchmark’s short-term debt agreements be computed on the basis excluding SFAS 115. Debt-to-capitalization is also presented whereby preferred securities are included as either equity or debt.
The following table presents book value per share information on a basis in which the effect of accounting rule SFAS 115 has been removed from common shareholder’s equity, which is the numerator in this ratio. As discussed on page 34, the removal of SFAS 115 eliminates the volatility in book value caused by interest rate fluctuations in financial markets that have little bearing on Torchmark’s ongoing operations. The increases in book value excluding SFAS 115 and book value per diluted share excluding SFAS 115 in each period resulted primarily from the addition of earnings and were achieved in spite of the Torchmark share purchases of $303 million in 2001 and $182 million in 2002.
The following table displays Torchmark’s return on average equity excluding the effect of SFAS 115. Additionally, Torchmark management prefers to use net operating income as defined on pages 16-18 as the numerator of this ratio.
Litigation. Torchmark and its subsidiaries continue to be named as parties to pending or threatened litigation, much of which involves punitive damage claims based upon allegations of agent misconduct at Liberty in Alabama. Such punitive damage claims are tried in Alabama state courts where any punitive damage litigation may have the potential for significant adverse results since punitive damages in Alabama are based upon the compensatory damages (including mental anguish) awarded and the discretion of the jury in awarding compensatory damages is not precisely defined. Additionally, it should be noted that Torchmark subsidiaries actively market insurance in the State of Mississippi, a jurisdiction which is nationally recognized for large punitive damage verdicts. Bespeaking caution is the fact that it is impossible to predict the likelihood or extent of punitive damages that may be awarded if liability is found in any given case. It is thus difficult to predict with certainty the liability of Torchmark or its subsidiaries in any given case because of the unpredictable nature of this type of litigation. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not presently
considered by management to be material. For more information concerning litigation, please refer to Note 18-Commitments and Contingencies in the Notes to Consolidated Financial Statements beginning on page 75.
During 2001, Torchmark entered into a coinsurance agreement with First Command’s life subsidiary whereby Torchmark cedes back to First Command approximately 5% of the new life insurance business sold by First Command on behalf of Torchmark’s insurance subsidiaries. Under the terms of this agreement, First Command pays Torchmark a maintenance expense allowance equal to 5.5% of all premium collected and an issue allowance of 2.9% of first year premium collected. Torchmark is also reimbursed for actual commissions, premium taxes, and claims paid on the business ceded to First Command. Also under the agreement, Torchmark provides First Command certain administrative, accounting, and investment management services. Premium ceded in 2002 was $780 thousand and in 2001 was $108 thousand. At December 31, 2002, life insurance ceded was $139 million and annualized ceded premium was $1.2 million.
Baxley. William J. Baxley is a partner in the law firm of Baxley, Dillard, Dauphin & McKnight which performs legal services for Torchmark and certain of its subsidiaries. In 1997, Mr. Baxley was loaned $668 thousand on an unsecured basis at a rate of 6.02%. Repayments are made in the form of legal services at customary rates and are applied against the outstanding balance, amortizing the loan with interest over its remaining term. In October, 2001, the terms of the loan were revised and an additional amount of $395 thousand was loaned to Baxley. The interest rate was revised to 5.6% and the term of the loan was extended until July, 2013. The loan is being repaid in accordance with its amortization schedule and all payments are current. At December 31, 2002 and 2001, the outstanding balance of this loan was $743 thousand and $788 thousand, respectively.
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (FASB Statement No. 145) is effective for fiscal years beginning after May 15, 2002. This Statement supersedes previous accounting rules regarding debt extinguishments and certain lease modifications. It prohibits reporting gains and losses from debt extinguishments as extraordinary on the income statement unless it is material, infrequent, and unusual. It requires reclassification of such amounts previously classified as extraordinary into continuing operations. As a result, Torchmark’s gains and losses from the purchase of its debt and preferred securities will be included upon adoption as a component of realized gains and losses on the income statement, with prior periods reclassified. Torchmark had pretax losses of $425 thousand on debt redemptions and $6.6 million from the redemption of its MIPS in 2001. In 2002, the loss from debt redemptions was $2.6 thousand pretax. The provisions regarding leases are immaterial to Torchmark.
Accounting for Costs Associated with Exit or Disposal Activities (FASB Statement No. 146) is effective for exit or disposal activities initiated after December 31, 2002, with early application encouraged. Statement 146 amends previous accounting standards to require the recognition of a liability for the cost associated with an exit or disposal activity at the time the liability is incurred. Previously, this liability was recognized at the time of commitment to an exit plan. The provisions of this Statement should have no material impact on Torchmark.
Deferred Acquisition Costs and Value of Insurance Purchased. The costs of acquiring new business are generally deferred and recorded as an asset on the balance sheet. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new insurance sales. Additionally, the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies are also deferred and recorded as assets under the caption “Value of Insurance Purchased.” Deferred acquisition costs are amortized in a systematic manner which matches these costs with the associated revenues. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest-sensitive and deposit-balance type products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses taking inflation into account. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, this deficiency would be charged to expense as a component of amortization and the asset balance is reduced by a like amount. Different assumptions with regard to deferred acquisition costs could produce materially different amounts of amortization. For more information about accounting for deferred acquisition costs see Note 1-Significant Accounting Policies and Note 5-Deferred Acquisition Costs and Value of Insurance Purchased in the Notes to Consolidated Financial Statements on pages 53 and 61 of this report, respectively.
Policy Claims and Other Benefits Payable. This liability consists of known benefits currently payable and an estimate of claims that have been incurred but not yet reported to the company. The estimate of unreported claims is based on prior experience. Torchmark management makes an estimate after careful evaluation of all information available to the company. However, there is no certainty the stated liability for claims and other benefits, including the estimate of unsubmitted claims, will be Torchmark’s ultimate obligation.
Investment income is reported as revenue by Torchmark when it is earned less investment expenses. The investment activities of Torchmark are integral to its insurance operations. Because life and health insurance claims and benefits may not be paid until many years into the future, the accumulation of cash flows from premium receipts are invested. Anticipated yields earned on investments are reflected in premium rates, contract liabilities, and other product contract features. These yield assumptions are implied in the interest required on Torchmark’s net insurance liabilities (future policy benefits less deferred acquisition costs) and contractual interest obligations in its insurance and annuity products. Torchmark benefits to the extent actual net investment income exceeds the required interest on net insurance liabilities and the interest on its debt. During 2002, the yield on the investment portfolio exceeded the weighted-average contractual interest requirement by 187 basis points. Regardless of the level of investment yield, it is Torchmark’s responsibility to provide for all future contractual obligations. For more information concerning revenue recognition, investment accounting, and interest sensitivity, please refer to Note 1-Significant Accounting Policies on page 53, Note 3-Investments beginning on page 59 in the Notes to Consolidated Financial Statements and discussions under the captions Annuities on page 26, Investments on page 28, and Market Risk Sensitivity on page 32 of this report.
These and other factors are analyzed, and if a security is considered to be permanently impaired, it is written down to the fair value. The writedown is recognized as a realized investment loss. While every effort is made to make the best estimate of status and value with the information available, it is difficult to predict the ultimate recoverable amount of a distressed or impaired security.
The actuarial assumptions used in determining Torchmark’s obligations for pensions include employee mortality and turnover, retirement age, the expected return on plan assets, projected salary increases, and the discount rate at which future obligations could be settled. These assumptions have an important effect on the pension obligation. A decrease in the discount rate or rate of return on plan assets will cause an increase in Torchmark’s pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. These assumptions are subjective in many cases and small changes
In order to remove volatility in the changes in the market values of plan investments from year to year, GAAP permits and Torchmark utilizes a “market-related value” whereby changes in the market values of investments are recognized systematically over a moving five-year period. Additionally, the difference in the pension obligation arising from actual results versus the expected results using actuarial assumptions is generally not recognized in the current period. Pension cost in future periods is affected by the amount of unrecognized gain or loss in market value and actuarial estimates. An unrecognized gain will reduce future cost and an unrecognized loss will increase future costs. At December 31, 2002, Torchmark had an unrecognized actuarial loss of $3 million.
At December 31, 2002 Torchmark’s qualified pension plans were under-funded by $8.2 million. An analysis of the funded status of Torchmark’s pension plans is also disclosed in the above-mentioned Postretirement Benefits Note.
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2002
Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31, 2002
Principles of Consolidation: The consolidated financial statements include the results of Torchmark and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Derivatives: Effective January 1, 2001, Torchmark adopted Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, and accounts for all derivative instruments in accordance with that Statement. At December 31, 2002 and 2001, Torchmark had three swap contracts in place, which were carried at fair market value in the consolidated financial statements. Fluctuations in these values adjust realized investment gains and losses. If a derivative qualifies as a fair value hedge under SFAS No. 133, gains and losses in the derivative are substantially offset by changes in the underlying hedged instrument.
Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to SFAS No. 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Variable annuity products are also assessed an investment management fee and a sales charge. Life premium includes policy charges of $69.0 million, $71.3 million, and $71.4 million for the years ended December 31, 2002, 2001, and 2000, respectively. Other premium includes annuity policy charges for the years ended December 31, 2002, 2001, and 2000, of $39.0 million, $59.5 million, and $52.2 million, respectively. Profits are also earned to the extent that investment income exceeds policy requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
Deferred acquisition costs, including the value of life insurance purchased, for policies other than universal life-type policies, are amortized with interest over the estimated premium-paying period of the policies in a manner which charges each year’s operations in proportion to the receipt of premium income. For limited-payment contracts, acquisition costs are amortized over the contract period. For universal life-type policies, acquisition costs are amortized with interest in proportion to estimated gross profits. The assumptions used as to interest, persistency, morbidity and mortality are consistent with those used in computing the liability for future policy benefits and expenses. If it is determined that future experience will probably differ significantly from that previously assumed, the estimates are revised. Deferred acquisition costs are adjusted to reflect the amounts associated with realized and unrealized investment gains and losses pertaining to universal life-type products.
Policy Claims and Other Benefits Payable: Torchmark establishes a liability for known policy benefits payable and an estimate of claims that have been incurred but not yet reported to the company. The estimate of unreported claims is based on prior experience. Torchmark makes an estimate after careful evaluation of all information available to the company. However, there is no certainty the stated liability for claims and other benefits, including the estimate of unsubmitted claims, will be Torchmark’s ultimate obligation.
Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight line method over the estimated useful lives of these assets which range from two to ten years for equipment and five to forty years for buildings and improvements. Ordinary maintenance and repairs are charged to income as incurred. Impairments, if any, are accounted for in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
In accordance with SFAS 142, Torchmark has tested goodwill as of December 31, 2001 for impairment. The test involved dividing the Company’s operations into “reporting units” as defined by the Statement. For Torchmark, these reporting units are subdivisions of Torchmark’s operating segments. Assets and liabilities were then assigned to these units. Each of these units was then valued under the procedures outlined in the Statement. The resulting “fair market values” for each unit were then compared with the underlying carrying values of the net assets assigned to that unit (including goodwill). Because the fair value of each unit exceeded the carrying values assigned to those units, there was no goodwill impairment.
SFAS No. 142 also requires that goodwill be tested annually for impairment. Torchmark again tested its goodwill for impairment as of June 30, 2002 following similar procedures and determined there was no goodwill impairment.
Litigation: As described in Note 18, Torchmark and its subsidiaries continue to be named as parties to legal proceedings. Because much of Torchmark’s litigation is brought in Alabama, a jurisdiction known for large punitive damage verdicts bearing little or no relationship to actual damages, the ultimate outcome of any particular action cannot be predicted. It is reasonably possible that changes in the expected outcome of these matters could occur in the near term, but such changes should not be material to Torchmark’s reported results or financial condition.
In 2001 and 2000, $29.4 million and $2.4 million, respectively, were related to the restoration grants as discussed in Note 17 - Employee Stock Options.
In 2001, Liberty National Life Insurance Company (Liberty) paid $40 million in extraordinary dividends to Torchmark. Extraordinary dividends require regulatory approval.
A reconciliation of Torchmark’s insurance subsidiaries’ statutory shareholders’ equity to Torchmark’s consolidated GAAP shareholders’ equity is as follows:
The overall average interest assumption for determining the liability for future life and health insurance benefits in 2002 was 6.0%.
The following table summarizes Torchmark’s noncash transactions, which are not reflected on the Statements of Cash Flows:
Torchmark has net operating loss carryforwards of approximately $41.4 million at December 31, 2002 of which $.4 million expire in 2007; $4.2 million expire in 2018; $6.8 million expire in 2019; $25.3 million expire in 2020; and $4.7 million expire in 2021. No valuation allowance is required to be recorded with respect to these net operating losses.
Asset-Backed Securities. Torchmark adopted new accounting guidance Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20) effective April 1, 2001. EITF 99-20 changed the method of accounting for most of Torchmark’s asset-backed securities, and also set forth specific new rules regarding the impairment of asset-backed securities. Future impairments, if any, are to be recognized as a component of realized investment losses. On initial application of this standard, impairments were recognized as a change in accounting principle. Reversals of impairment charges recognized subsequent to adoption of EITF 99-20 are prohibited.
In accordance with this guidance, in 2001, Torchmark evaluated the expected cash flows on its asset-backed securities under the new rules. As a result, Torchmark determined that these assets were impaired by $41 million, or $27 million after tax, resulting in a remaining balance at fair value of $63 million. This impairment charge was recorded as a cumulative effect of a change in accounting principle in the second quarter of 2001. Also, during 2001, Torchmark sold an additional $40 million of these securities after adjustment for the impairment at no gain or loss. An additional impairment of $2.5 million was recognized in the fourth quarter of 2001 and was included in realized investment losses. Torchmark’s total investment at fair market value in asset-backed securities considered impaired according to the accounting guidance at December 31, 2001 was approximately $19 million. During 2002, all of these securities were sold for proceeds of $13 million, at a loss of $6 million.
In accordance with SFAS No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, the following table presents a reconciliation from the beginning to the end of the year of the benefit obligation and plan assets. This table also presents a reconciliation of the plans’ funded status with the amounts recognized on Torchmark’s consolidated balance sheet.
For measurement purposes, a 7.5% annual rate of increase in per capita cost of covered healthcare benefits was assumed for the years 2000 through 2002. Torchmark has assumed that the health care cost trend rate will remain stable at 7.5% in future periods. This trend rate assumption has a significant effect on the amounts reported, as illustrated in the following table which presents the effect of a one percentage point increase and decrease on the service and interest cost components and the benefit obligation:
The amount of debt that becomes due during each of the next five years is: 2003-$201,479, 2004-$0, 2005-$0, 2006-$180,000, 2007-$0, and thereafter-$362,412.
The Notes, due August 1, 2013, were issued in July, 1993 in the principal amount of $100 million. Interest is payable on February 1 and August 1 of each year at a rate of 7 3/8%. In 2000, Torchmark purchased $2.0 million principal amount in the open market at a cost of $1.9 million. An after-tax gain on the redemption of debt of $36 thousand was recorded in 2000. These notes are not callable prior to maturity and have equal priority with other Torchmark unsecured indebtedness.
The Senior Notes, due December 16, 2006, were issued in December, 2001 in the principal amount of $180 million for net proceeds of $178 million. Interest is payable on June 15 and December 15 of each
year at a rate of 6 1/4%. The notes are unsecured, may not be redeemed prior to maturity, and have no sinking fund requirement. These notes have equal priority with other Torchmark unsecured indebtedness.
In connection with the issuance of the Senior Notes, Torchmark entered into a five-year swap agreement with an unaffiliated party to swap the 6 1/4% fixed rate payment obligation for a floating rate obligation. The floating rate is based on the six-month LIBOR plus 120.5 basis points and resets every six months. At December 31, 2002, this rate was 2.63%. This swap derivative qualifies as a hedge under accounting rules. Therefore, both the swap and the Senior Notes are carried at fair value. Changes in the swap’s fair market value will be substantially offset by changes in the fair market value of the debt security. Torchmark’s derivative instruments are classified as Other Invested Assets.
Torchmark has in place a line of credit facility with a group of lenders, which allows unsecured borrowings and stand-by letters of credit up to $625 million. The facility includes a $325 million 364-day tranche, which matures November 27, 2003 and a $300 million five-year tranche that matures November 30, 2006. Interest is charged at variable rates for each tranche. In addition, Torchmark can request up to $200 million letters of credit to be issued against the $300 million five-year tranche. The line of credit is further designated as a back-up credit line for a commercial paper program, which cannot exceed $600 million. Torchmark may borrow from the credit facility or issue commercial paper, with total commercial paper outstanding not to exceed $600 million. At December 31, 2002, Torchmark had $202 million face amount of commercial paper outstanding, $170 million of letters of credit issued, and no borrowings under the line of credit. During 2002, the short term borrowings under the combined facilities averaged approximately $192 million, and were made at an average yield of 1.9%. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire $625 million facility, at a rate of 8 basis points for the 364-day tranche and 10 basis points for the five-year tranche. For letters of credit issued, there is an issuance fee of 25 basis points and a fronting fee of 5 basis points. Additionally, if borrowings on both the line of credit and letters of credit exceed 33% of the total $625 million facility, there is a usage fee of 10 basis points. During 2002, Torchmark’s usage of the facility was below this threshold and no usage fee was required. Torchmark is subject to certain covenants for the agreements regarding capitalization and earnings, with which it was in compliance at December 31, 2002.
When the MIPS were originally issued in 1994, Torchmark entered into a ten-year swap agreement with an unrelated party which remains in effect. The agreement provides for Torchmark to pay a variable rate based on the one-month LIBOR plus 139 basis points, while collecting at a rate of 9.18% on a notional amount of $200 million. The swap expires on September 30, 2004. The rate resets each month. At December 31, 2002, the variable rate was 2.83%. The swap is accounted for as a free standing derivative and is marked to fair market value at the end of each accounting period. The fair market value of the swap agreement was a benefit of $20.8 million and $19.2 million at December 31, 2002 and 2001, respectively.
Restrictions: Restrictions exist on the flow of funds to Torchmark from its insurance subsidiaries. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. These restrictions generally limit the payment of dividends by insurance subsidiaries to statutory net gain from operations before realized capital gains or losses on an annual noncumulative basis in the absence of special approval. Additionally, insurance companies are generally not permitted to distribute the excess of shareholders’ equity as determined on a GAAP basis over that determined on a statutory basis. In 2003, $283 million will be available to Torchmark for dividends from insurance subsidiaries in compliance with statutory regulations without prior regulatory approval.
Stock options to purchase 5,551,271, 3,305,025, and 7,497,546 as of December 31, 2002, 2001, and 2000, respectively, are considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
Certain employees, directors, and consultants have been granted options to buy shares of Torchmark stock, generally at the market value of the stock on the date of grant, under the provisions of the various Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring ten years and two days or eleven years after grant. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Formula-based director grants generally vest in six months. A grant in August, 2001 vested immediately for all optionees other than those subject to SEC Section 16(a) reporting, whose options vest in six months. A grant in December, 2000 vested in six months. Stock options awarded in connection with compensation deferrals by certain directors and executives vest over ten years. Torchmark generally issues shares for the exercise of stock options out of treasury stock.
As previously stated in Note 1-Significant Accounting Policies, Torchmark accounts for its employee stock options in accordance with SFAS 123, Accounting for Stock-Based Compensation as amended by SFAS 148, and has elected to account for its stock options under the intrinsic value method as outlined in APB 25 and permitted by SFAS 123. The fair value method requires the use of an option valuation model, such as the Black-Scholes option valuation model, to value employee stock options, upon which compensation expense is based. The estimated fair value of the options is then amortized to expense over the options’ vesting period. The Black-Scholes option valuation model was not developed for use in valuing employee stock options. Instead, this model was developed for use in estimating the fair value of
traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because Torchmark’s employee stock options have characteristics significantly different from those of traded options, changes in the subjective input assumptions can materially affect the fair value estimate of its employee stock options. Under the intrinsic value method, compensation expense for Torchmark’s option grants is only recognized if the exercise price of the employee stock option is less than the market price of the underlying stock on the date of grant.
As required by SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure, the pro forma earnings giving effect to the fair value method of option accounting has been reported in Note 1-Significant Accounting Policies. The fair value for Torchmark’s employee stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2002, 2001, and 2000:
Torchmark executed a stock option exercise and restoration program on August 9, 2001 through which 122 Torchmark directors and employees exercised vested stock options. These participants were granted a reduced number of new options at the current market price. The August 9, 2001 program resulted in the issuance of 4.0 million shares of which 3.5 million shares were immediately sold by the directors and employees through the open market to cover the cost of the purchased shares and related taxes. Another small restoration program was effected on December 20, 2000 involving two employees who were not able to participate in an earlier 1999 restoration program. They exercised vested options resulting in the issuance of 433 thousand shares, of which 283 thousand shares were sold by the employees to pay the exercise price and minimum withholding taxes. As a result of these restoration programs, management’s ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
Guarantees: Torchmark has in place three guarantee agreements, all of which are either parent company guarantees of subsidiary obligations to a third party, or parent company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2002, Torchmark had no liability with respect to these guarantees.
Trust Preferred Securities: A performance guarantee for the obligations of the Torchmark Capital Trusts I and II. The guarantee was entered into when the trust preferred securities were issued by those trusts. It guarantees payment of distributions and the redemption price of the securities until the securities are redeemed in full, or all obligations have been satisfied should one or both of the Capital Trusts default on an obligation. The total redemption price of the trust preferred securities is $150 million.
Agent Receivables: Torchmark issued a guarantee to an unaffiliated third party, which has purchased certain agents’ receivables of Torchmark’s wholly-owned subsidiary American Income. The guarantee covers all obligations and recovery of capital to the third party under the receivables purchase agreement up to a maximum amount of $100 million. Under the terms of the revolving purchase arrangement, the third party has purchased the agents’ receivables and receives the earned commissions as they are applied to the balance. The term of the guarantee corresponds with the purchase arrangement, which is annually renewable. Torchmark would be liable to the extent that future commission collections were insufficient to repay the purchased amount. As of December 31, 2002, the present value of future commissions substantially exceeded the purchased balance.
On December 8, 1999, purported class action litigation was filed against Liberty in the United States District Court for the Northern District of Alabama (Moore v. Liberty National Life Insurance Company, Case No. CV-99-BU-3262-S), on behalf of all African-Americans who have or have had at the time of policy termination an ownership interest in certain life insurance policies ($25,000 face amount or less) marketed by Liberty and certain of its former subsidiaries. The alleged class period covers virtually the entire twentieth century. Plaintiffs allege racial discrimination in Liberty’s premium rates in violation of 42 U.S.C. § 1981, breach of fiduciary duty in sales and administrative practices, receipt of excessive and unreasonable premium payments by Liberty, improper hiring, supervision, retention and failure to monitor actions of officers, agents and employees, breach of contract in dismantling the debit premium collection system, fraudulent inducement and negligent misrepresentation. Unspecified compensatory and punitive damages are sought together with a declaratory judgment and equitable and/or injunctive relief, including establishment of a constructive trust for the benefit of class members. Defendants filed a motion for
judgment on the pleadings or in the alternative for summary judgment on January 27, 2000. On April 7, 2000, the District Court entered an order granting Liberty’s motion for judgment on the pleadings and dismissing plaintiffs’ claims under 42 U.S.C. § 1981 with prejudice as time-barred and dismissing their state law claims without prejudice to re-file in state court if desired. Plaintiffs subsequently filed motions with the District Court to reconsider its April 7, 2000 order and for permission to file an amended complaint adding similar claims under 24 U.S.C. § 1982. Liberty opposed this motion. On June 22, 2000, purported class action litigation with allegations comparable to those in the Moore case was filed against Liberty in the Circuit Court of Jefferson County, Alabama (Baldwin v. Liberty National Life Insurance Company, Case No. CV 00-684). The Baldwin case is currently stayed pending disposition of the Moore case.
On March 15, 2001, purported class action litigation was filed against Liberty in the United States District Court for the District of South Carolina (Hinton v. Liberty National Life Insurance Company, Civil Action No. 3-01-68078 19), containing allegations largely similar to the Moore case filed in the Federal District Court for the Northern District of Alabama. Liberty was described in the suit as successor in interest of New South Life Insurance Company (New South), an insurer acquired out of receivership by an entity which was subsequently acquired by Peninsular Life Insurance Company (Peninsular). In 1985, Liberty reinsured a block of insurance business from Peninsular, including business formerly written by New South. Liberty has requested indemnification in the Hinton litigation from Peninsular and its successors in interest. Liberty sought a writ of mandamus in Hinton from the Fourth Circuit Court of Appeals as well as a change of venue to consolidate the Hinton case with the Moore case currently pending in Federal District Court in Alabama. Both the change in venue and the writ of mandamus were denied. However, the South Carolina District Court issued an order inviting the parties to resubmit a motion for change of venue. Liberty National filed such a motion to transfer the case to the U.S. District Court for the Northern District of Alabama, which was granted by the South Carolina District Court on February 12, 2002.
Another action with similar allegations to Moore, which also includes claims for race discrimination under 24 U.S.C. §§1981 and 1982, was filed against Liberty in U.S. District Court for the Northern District of Alabama on January 28, 2002 (Hull v. Liberty National Life Insurance Company, Civil Action No. CV-02-C-0219-W).
unconscionable in that such premiums exceeded the face amount of insurance issued. Unspecified actual and punitive damages, attorneys fees, costs and interest, as well as the imposition of a constructive trust or disgorgement are sought for claims of fraud and fraudulent inducement, breach of the duty of good faith and fair dealing, tortuous breach of contract, breach of fiduciary duty, money had and received, unjust enrichment, negligence and/or gross negligence, violations of the Mississippi Consumer Protection Act, conversion and violations of Mississippi Code Ann. § 83-7-3 (prohibiting discrimination by life insurers in the assessment of premiums to policyholders).
On February 4, 2003, an order was entered in the Kansas District Court litigation granting that portion of the defendants’ judgment as regarded claims against Torchmark and one individual defendant by Waddell & Reed and W&R. Other portions of the defendants’ motion were denied so that Waddell & Reed and W&R’s claims against the other two individuals defendants as well as all claims of Waddell & Reed Investment Management Company, another Waddell & Reed subsidiary, remain pending. The order also lifted the discovery stay.
On September 28, 2001, a shareholder derivative action was filed in the Circuit Court of Jefferson County, Alabama against Torchmark, two unaffiliated limited liability companies, and three individual defendants (Bomar v. Torchmark Corporation, Case No. CV 0105981). The derivative action arises from an October 1, 1999 transaction in which the three individual defendants (one of whom is a director and former Chairman of Torchmark and a second of whom is a former officer of a former real estate subsidiary of Torchmark) acting through two unaffiliated limited liability companies acquired the majority of the investment real estate of Torchmark together with other properties. Plaintiff alleges that, despite review and approval of the transaction by all independent and disinterested members of the Torchmark Board of Directors, the transaction was procedurally and substantively unfair to Torchmark and resulted from the breach of fiduciary duties of loyalty owed to Torchmark by two of the above described individual defendants and the knowing participation of the third individual defendant in the alleged breach of fiduciary duty. Establishment of a constructive trust for such assets for the benefit of Torchmark and its shareholders, an accounting for profits and unspecified compensatory and punitive damages were sought. The request for establishment of a constructive trust was subsequently deleted by the plaintiff.
On October 3, 2002, the Circuit Court entered an order granting motions for summary judgment in favor of all defendants in Bomar. The Circuit Court stated in its order that demand on the Torchmark Board of Directors by the plaintiff was not excused, that a majority of the Board and all members of the special litigation committee were independent and disinterested, that the special litigation committee conducted its investigation thoroughly and in good faith, that the special litigation committee’s findings and conclusion that the Bomar action should be dismissed and that the real estate transaction in question was well within the scope of the business judgment rule was correct and such findings were adopted by the Circuit Court and that the special litigation committee’s conclusion that the transaction “was entirely fair to Torchmark” was fully supported by the record and the law. On November 13, 2002, the plaintiff filed a notice of appeal to the Alabama Supreme Court of the Circuit Court’s order.
On September 12, 2002, a trial court jury in Chambers County, Alabama Circuit Court returned a $3.2 million verdict against Liberty in Ingram v. Liberty National Life Insurance Company (Civil Action No. CV-96-62). This case, originally filed in March 1996, alleged that the plaintiff purchased an interest-sensitive life insurance policy from Liberty based upon agent representations that premiums on the policy would be due for ten years and thereafter it would have paid-up policy status. Plaintiff asserted fraud, misrepresentation of material facts, suppression, deceit, fraudulent deceit, wanton or intentional conduct, civil conspiracy, wanton hiring, retention, supervision of agents, bad faith, and conversion since the policy did not reach paid-up status at the end of the ten years of premium payments. The plaintiff had sought a declaratory judgment and compensatory and punitive damages in the Circuit Court. Liberty has pursued all available post judgment motions and will pursue appellate relief. On January 29, 2003 the Circuit Court denied Liberty’s motion for a new trial and ordered the $3.2 million verdict reduced to $240,000.
On January 30, 2003, purported class action litigation was filed against Liberty in the Circuit Court of Lowndes County, Alabama (Gordon v. Liberty National Life Insurance Company, Civil Action No. CV03-13). Plaintiffs assert state law claims that Liberty breached the insurance contracts with them, engaged in intentional, willful and/or negligent conduct and was unjustly enriched when Liberty allowed them to pay premiums on insurance policies that exceeded the “face value” and/or “amount of insurance” of the insurance policies. Unspecified monetary damages, injunctive relief and return of all proceeds is sought.
Investment segment includes preferred dividends, meet of swap benefit, on pretax basis.
First Command. Lamar C. Smith, a director of Torchmark, is an officer and director of First Command Financial Services, Inc. (First Command), a corporation 100% owned by the First Command Employee Stock Ownership Plan (First Command ESOP). Mr. Smith is a beneficiary of the First Command ESOP although he has no ability to vote the stock of First Command that is held by the First Command ESOP. First Command, with 545 home office agency employees and more than 1,000 appointed agents both inside and outside the United States, receives commissions as the Military Agency distribution system for selling certain life insurance products offered by Torchmark’s insurance subsidiaries. These commissions were $52.6 million in 2002, $48.2 million in 2001, and $43.5 million in 2000.
The collateral loan agreement was entered into in 1998 with an initial loan of $7 million. An additional $15 million was loaned in 2001. The loan bears interest at a rate of 7%. Initially, it was collateralized by a group of mutual funds in which the loan balance could never exceed 90% of the value of the collateral. In 2002, real estate owned by First Command was pledged as additional collateral due to weak financial markets. The collateral agreement was modified so that the loan balance is not to exceed the sum of 90% of the mutual funds pledged plus 75% of the appraised value of the real estate pledged. The real estate appraisal was performed by an independent firm. The loan accumulated interest until December 31, 2001, after which time First Command began making fixed monthly payments that will amortize the loan over fifteen years. The outstanding loan balance at December 31, 2001 was $22.9 million and was $22.0 million at December 31, 2002. Also at December 31, 2002, the appraised value of the collateral real estate was $17.6 million and the market value of the mutual funds pledged was $12.6 million.
Real Estate. Torchmark sold the majority of its investment real estate properties in two transactions in 1999. One of these transactions involved Elgin Development Company, of which R. K. Richey, the Chairman of the Executive Committee of Torchmark, was an investor. This transaction involved the sale of properties to an investor group of which Elgin Development Company was a 30% investor. Total consideration for the transaction was $97.4 million of which $85 million was cash and the balance was in a ten year collateralized 8% note from Elgin Development Company. Torchmark’s loss associated with this transaction was $10 million after tax. At the time of the transaction, Mr. Richey was a one-third investor in Elgin Development Company, with a total investment in Elgin Development of approximately $1.5 million. The outstanding balance of the collateralized note with Elgin Development Company, which is included in fixed maturities, was $10.1 million at December 31, 2002 and $10.5 million at December 31, 2001.
Additionally, Liberty loaned Mr. Baxley’s wife $883 thousand secured by a mortgage on a building sold to her in 1997. Interest is charged at a rate of 7.7%. Scheduled cash payments are made to amortize the loan over thirty years. However, there is a balloon payment due at the end of ten years (2007) in the amount of $712 thousand less a credit of $18 thousand if all payments are made timely. To date, all payments have been timely. During 2002, Liberty sold the loan to Torchmark. At December 31, 2002 and 2001, the outstanding balance of this loan was $809 thousand and $824 thousand, respectively.